Keynes Solution to Mystery

Keynes provides answer to puzzle as there is supply and demand, both are available but these forces are not clearing the market. Basically factories are not working because the people are not demanding their products but if factories hire the people to produce the goods then they will have the money to buy goods. According to economic theories existing at that time this problem is solved by itself as it is self-repairing process. Self-regulation means that if there is any problem then it will be resolved by itself and there is no need for any intervention outside the system for example if there is huge amount unemployment then wage will go down, factories will hire more laborers, cost of production of factories will go down so products will be sold at lower prices, due to lower prices purchasing power of the people will go up and they will start buying the products, it will cause increase in demand of goods and factories will start to supply more of it and due to increase in production of factories the demand for labor will also increase and at the end issue of unemployment will be resolved. But it did not happen in case of Great Depression.

To solve this issue Keynes gave solutions and one of them is that the wages are fixed in nominal terms and cannot go down. But it was not true because in Great Depression wages went down by 30%. It should make a big enhance in level of employment but it did not happened. So sticky nominal wages is not the solution although it is true that wages are sticky downward in nominal terms this problem can be solved by changes in prices. If prices go up the real wage will go down and it should have the same effect but actually it was not the Keynesian solution.

What was the reason the in January 1929 the US economy was booming and unemployment was very low but in December 1929 there were millions of people unemployed and economy went into recession? Why were people out of work?

Keynes answered it as there is failure of supply and demand. Demand and supply should match at equilibrium but the demand of laborers is not the Effective Demand. This means that one man is unemployed but if he was employed he would have the income and use it to buy any good which causes factories to increase the supply of good for which they hire laborers, these laborers would then earn income which causes to increase the demand of other products and in this chain reaction the demand of laborers would be expressed in the market. It is what would make the demand an Effective Demand. Demand would be effective if somebody goes and buy something.

Keynes said that there is demand but it was hidden and factories don’t see it because laborer do not had the money with which they can express their demand for goods. Now because the factories do not see the demand so they are not producing but if they produced the goods then workers would get wages and can demand other goods. So economy is stuck and it is sort of trap in a sense that factories think there is no demand and worker say that they don’t have jobs, these two factors are balancing out each other. Keynes proposed the solution to through some money in the economy to solve get out of this trap. Keynes called it Priming the Pump means that when water pump get stuck then we need to put little bit of water in it to make it work properly. He said that all we need is to get start it up and once the system is started then it will go towards equilibrium by itself. It was the monetary policy. Now problem was that the government cannot go around and through money so government expands the money supply in economy by chain mechanism. What the government does is to expand the money available to banks and if the people borrow this money and use it in some productive way then money supply increases. Idea was to lower the interest rate so that people can borrow the money at lower cost and can increase the effective demand. According to Keynes such monetary policy can get an economy out of recession, however, there are some situations where monetary policy does not work. Keynes named such situation as Liquidity Trap. Suppose that bank is willing to lend money at very low interest rate but nobody is willing to borrow money because they see around them at factories are already closing so that will he do with the money. Money is there in the banks but it does not get into hand of people. In this case the problem cannot be solved by monetary policy. This monetary policy was the favorite tool for fighting recessions after post WWII. However in deep recessions monetary policy does not work as the economy will get into Liquidity Trap. Here the problem is zero lower bound interest rate. Negative interest rate can solve this problem but in reality negative interest rate is not possible. Negative interest rate is like having inflation in the economy as negative interest rate as one person lend the money but when money is paid back its value is declined because of inflation. If person has to pay back less than what he borrows then it will be negative interest rate situation. Inflation, that give negative interest rate, is one way to fight recession. One of the lessons of Keynes is that interest rate should be low or zero to pull the economy out of recession and it corresponds to Islamic ideology.

When monetary policy do not work then fiscal policy come into picture. Private sector is required to make some investments but due to limitations of private sector government can do this job. Government can start up some projects and hire people to produce some goods and once this process is started then money will go into hands of people, demand will become effective, factories will start production, to produce more factories will hire people, people will get job and money and hence there will be a multiplier effect and eventually things will go back to equilibrium. It was the Keynesian solution. Keynes proposed these ideas just after the Great Depression but these were not adopted until after the WWII. So, without understanding the history we can’t understand the economics.