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Keynesian economics made simple

First Posted 11:30:00 09/16/2009

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I spoke at a forum yesterday for commerce students at the University of San Carlos about how to cope and survive with the global recession and what to do during the recovery in order to thrive. At the end of the forum two written thought-provoking questions were handed to me, which I was not able to respond in full for lack of time. The students had to go to their next class.

I will cover the first question today. It runs like this: If, following Keynes, consuming more is good for business and in stimulating to the economy, how come the Philippines is still poor when its people have a very high consumption rate like in the US?

It is true that more consumption is good for business and the economy but it is one thing to say this and another to say that more consumption will make the Philippines rich. In China, consumption is only half of the US consumption as a fraction of their Gross Domestic Product but what the Chinese do not consume, they export to other countries, mainly to the US. That is good for China just the same. Because of the recession, however, US consumers are now buying less or saving more. That makes exporting to the US a problem now. China has to find a another ready buyer for their massive output and this it sees in their own domestic market but this is possible only if the Chinese people can be persuaded to shake their habit of saving a big part of their income.

When one consumes, he or she must have the income or money to buy the goods that he or she wants. This presupposes then that the individual concerned or the person that give him or her the money to buy had also contributed in the production of another good from where he or she were also compensated for the effort. If one contributes labor, managerial skills or any related human effort, he or she gets a wage, or salary and other benefits; if in providing land, then rent; if capital, then interest; and if in risk- taking or entrepreneurial ability, the residual or profits.

It is clear from the above, that when a good is produced, the revenue from its sale is shared in some way by all those who contributed, directly or indirectly, to its production and sale. Given this, it is also clear that any good produced will generate income for some people which in total is just enough to buy the good being produced. The saying supply creates its own demand is then correct in this sense and that as long as the total income generated from production is returned to the system by way of consumption, the economy will be a stable one - no surplus or shortage.

What if some of those who earned do not spend all their income? In this case, the producers will find some of their goods unsold. Faced with this situation, they will respond by cutting down production. The trouble with this is that it will create unemployment of labor and leave other productive inputs unused. With lower output and employment, income will also fall, thus causing demand to fall likewise. Let of some those who are still lucky to be employed not spend all their income again and the producers will still find some of their output unsold, and thus repeating the process of cutting down production, employment, income, demand, and so on. Unless some intervention is made to break the fall, the downward spiral will continue. We call this recession. If the fall is much deeper, we call it depression.

The possibility of demand being lower than supply at the aggregate level is what John Maynard tried to illustrate in his General Theory of Employment. In this book, Keynes describes aggregate demand to consist mainly of consumption and investment. Consumption, according to Keynes, is determined by the level of income and that given an increase in income, consumption will also increase but a lower rate that the increase in consumption. What is not consumed is saved. If the person who saves is the same person who invests, then saving will equal investment. Thus, what is not consumed of the nation?s output is covered by investments. There will be no surplus or shortage.

But alas, savers and investors are not necessarily the same persons. Moreover, how much one invests is not determined by how much is saved but by the expected return on investments. If it is high, then more will be invested, if low, then less investments will follow. It appears to Keynes that because the expected return on investment could change drastically due to many factors, the level of investments could also vary drastically. The result is that aggregate demand is not guaranteed to equal aggregate supply all the time. When aggregate demand is high a boom will follow, when low, a recession or a depression will ensue.

The point is that demand, when excessive or greatly deficient, is destabilizing to the economy. Applying appropriate monetary and fiscal policy can smooth out demand and the movement of the economy. This is one story, the other, getting rich, is another because in the long run what the nation is capable of producing and consequently, in making its people prosperous, is determined more by the quantity and quality of resources available for productive use. This way of thinking is no longer Keynesian but classical. But then it is another story.

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