Keynes thought that planned savings (S) do not depend on interest rates and that planned investments (I) depend on long term profit estimates that are somewhat influenced by interest rates. Lower interest rates make more projects feasible (see figure 5). Assume that there is equilibrium when planned savings and investment are IS1 and the interest rate is R1. If planned savings increase significantly to S1' then equilibrium could only be achieved at a negative interest rate. This does not happen so the economy will contract until a new equilibrium is reached at planned savings and investment of IS2 and an interest rate of R2.
figure 5: liquidity trap by Natural Money
figure 5: liquidity trap
and wages can adapt downwards but interest rates cannot go below
zero. Keynes thought that a liquidity trap can occur, which is a
floor under which interest rates cannot fall. He suspected that in
this trap any increase in money supply will cause bond holders to
sell bonds to obtain liquidity. This may be because nominal interest
rates cannot go below zero so there is little downward risk when
interest rates are low. The liquidity trap is also known as the Zero
Lower Bound Problem . The interest rate on money can not follow
any negative interest rate on capital during an economic downturn.
According to Keynesian economics, there is a trade off between employment and inflation. The Phillips curve reflects an assumed inverse relationship between the rate of unemployment and the rate of inflation. Increased aggregate demand is inflationary but it also reduces unemployment as it will lower real wages. This effect may only exist in the short run . If employees and businesses have little pricing power because of unemployment and unused capacity, increased aggregate demand may not produce price inflation. The overall effect of increased aggregate demand is still inflationary as it will prevent price deflation.
When a government increases spending or lowers taxes, the effect on the national income (Y) is in most cases greater than the amount of the spending increase or the amount taxes are lowered. The following example may illustrate this. Suppose that there is an equilibrium at a national income (Y) of 80 where consumption (C) is 70, investment (I) is 5 and government spending is 5. If the government starts to spend an additional 10, then national income (Y) initially increases with 10. Consumers may spend 5 of their additional income, while investments (I) rise with 2 and taxes (T) with 3.
National income (Y) rises with government spending (G) + consumption (C) + investment (I) = 10 + 5 + 2 = 17. Of the additional 7 national income (Y) generated by increased consumption (C) and investments (I), 4 may be spent on consumption (C), 1 on investment (I) and 2 on taxes (T), making the total increase in national income 22 if the additional tax income is not spent. The additional consumption and investment may lead to more consumption and investments and may finally lead to an increase in national income of 25, and an increase in tax income (T) of 7. In this case, an increase of government spending (G) of 10, increases national income (Y) by 25.
A change of government spending (G) has a multiplying effect on national income (Y). The 25 increase in national income (Y) generated by the 10 increase in government spending (G) may be spread over more than one year. The increase in national income (Y) is 2.5 times the increase in government spending (G). This is called the multiplier effect, which is expressed in the multiplier equation Multiplier (m) = ( Final Change In National Income (-"Y) / Initial Increase In Government Spending (-"G) ). In this case the multiplier is 2.5.
An increase in government debt of 3 produced an increase of national income of 25. In reality the effect of increased government spending is more limited. Keynesian thinking has led to an increase in government debts on which interest must be paid. Compound interest can over time reduce the effects of Keynesian economics, unless the economy grows at a higher rate or the value of money depreciates. In most cases, it is a combination of economic growth and inflation that have held government debts sustainable.
Government actions often make markets less efficient. Fiscal policies such as government spending tend to favour politically connected businesses. There is also a time lag between the occurrence of the problem and the effects of increased spending taking hold. At that time the recession may be over and the increased government spending can help to overheat the economy.
Keynesian thinking undermines fiscal discipline and government deficits have become the norm. When the economy is overheating, Keynesian economics prescribes that governments decrease spending or increase taxes, but this rarely happens. Government spending tends to increase year over year and government deficits have become a problematic issue in many countries.
Related to the previous problem is that politicians who raise taxes or reduce spending have a higher risk of not being re-elected. Some economists assume that there is a political business cycle. Incumbent politicians may use macro economic policy instruments to improve their chances on re-election by stimulating the economy just prior to an election.
Keynes saw stickiness of prices as a problem, but by increasing aggregate demand prices are less likely to correct. Keynesian policy actions therefore add to the stickiness of prices, which was an important reason to implement those policy actions in the first place. Only interest rates are truly sticky because they cannot go below zero. Keynesian policies, in the way they are implemented now, do not allow the overall price level to correct downwards, so they are inflationary overall.
The basic tenet of monetarism is that a change in the money stock will, in the long run and all other things being equal, lead to a proportional increase in price level . Among others, monetarists assume that the velocity of money is relatively stable in the long run. In the Keynesian view, there is a trade off between employment and inflation as is reflected in the Phillips Curve that suggests that more inflation goes together with less unemployment.
Monetarists think this effect only exists in the short run and solely because workers and businesses confuse a change in price level with a change in real prices and wages . When business owners see their costs rise and their profits drop and workers see their costs of living rise and demand higher wages, unemployment rises again, so there is no trade off between employment and inflation in the long term .