Keynesian Markets

Keynesian Economics and Monetary Policy

Keynesian economics focuses on demand-side solutions to recessionary periods. The intervention of government in economic processes is an important part of the Keynesian arsenal for battling unemployment, underemployment, and low economic demand. The emphasis on direct government intervention in the economy often places Keynesian theorists at odds with those who argue for limited government involvement in the markets. 

Keynesian theorists argue that economies do not stabilize themselves very quickly and require active intervention that boosts short-term demand in the economy. Wages and employment, they argue, are slower to respond to the needs of the market and require governmental intervention to stay on track. Furthermore they argue, prices also do not react quickly, and only gradually change when monetary policy interventions are made, giving rise to a branch of Keynesian economics known as Monetarism. 

If prices are slow to change, this makes it possible to use money supply as a tool and change interest rates to encourage borrowing and lending. Lowering interest rates is one way governments can meaningfully intervene in economic systems, thereby encouraging consumption and investment spending. Short-term demand increases initiated by interest rate cuts reinvigorate the economic system and restore employment and demand for services. The new economic activity then feeds continued growth and employment. 

Without intervention, Keynesian theorists believe, this cycle is disrupted and market growth becomes more unstable and prone to excessive fluctuation. Keeping interest rates low is an attempt to stimulate the economic cycle by encouraging businesses and individuals to borrow more money. They then spend the money they borrow. This new spending stimulates the economy. Lowering interest rates, however, does not always lead directly to economic improvement.

Monetarist economists focus on managing the money supply and lower interest rates as a solution to economic woes, but they generally try to avoid the zero-bound problem. As interest rates approach zero, stimulating the economy by lowering interest rates becomes less effective because it reduces the incentive to invest rather than simply hold money in cash or close substitutes like short term Treasuries. Interest rate manipulation may no longer be enough to generate new economic activity if it cannot spur investment, and the attempt at generating economic recovery may stall completely. This is a type of liquidity trap.

When lowering interest rates fails to deliver results, Keynesian economists argue that other strategies must be employed, primarily fiscal policy. Other interventionist policies include direct control of the labor supply, changing tax rates to increase or decrease the money supply indirectly, changing monetary policy, or placing controls on the supply of goods and services until employment and demand are restored.