Figure 4 above shows the Business cycle. The business cycle is “the periodic fluctuations of national output round its long-term trend” ( Sloman J,2001:256). Figure 4 is a simplification of the cycle of booms and recession an economy experiences. The marker 2 is a period of rapid economic growth as utilisation of available resources grows the economy will approach its peak at marker 3 where growth begins to slow down or stop. Beyond this point closer to marker 4 the economy begins to slump and there is little or no growth. The cause of fluctuation in growth of the economy is stated to be a result of variations in the growth of aggregate demand. Aggregate demand is defined as “the sum of all expenditure within an economy” (Bannock G, 2003: 5).
Keynes supported the view that the fluctuation in output and employment is a result of the fluctuation in aggregate demand and also suggested stabilisation policies to straighten out the fluctuation (Sloman J, 2001:256). Keynes theory strongly suggested that government policy is effective in managing aspects of the economy, mainly aggregate demand. He backed the use of fiscal policy. In a situation such as Phase 2 were the economy is experiencing rapid economic growth there will likely be high inflation in order to control the inflation level Keynes will suggest cutting government expenditure or increases taxes by doing so the government will deduct money from the circular flow of income and as result decrease aggregate demand as people have less disposable income. On the other hand, if the economy was within phase4 thus experiencing a recession, low output and increase in unemployment rate, Keynes will likely suggest and an increase in government expenditure or decrease in taxes. Increasing government expenditure and decreasing taxes should stimulate investment within the economy and this will lead to increase business activity resulting increase in output within the economy and decrease in unemployment rate. Keynes believed “a more stable economy will provide a better climate for investment and the growth of both individual businesses and the economy as a whole” ( Sloman J, 2001:297).
Keynes strongly backed government intervention in the economy in order to maintain stability. Over the past two years the UK government have severely exercised their authority within the economy as a response to the recent economic downturn through the implementation of a combination of fiscal and monetary policies. Fiscal policy is defined as “policy to affect aggregate demand by altering the balance between government expenditure and taxation” (Sloman J, 2001:297). In response to the credit crisis the UK government implemented a range of fiscal policies such as the temporary decreases of 2.5% in Value added tax this cut VAT to 15% from its previous 17.5%. The chancellor intended to increase aggregate demand within the retail sector during the economy downturn. This change VAT is said to be a success as within the first 3 months retailers’ generated turnovers £2.1billion higher than it would have been without the change (timesonline.co.uk). Another fiscal policy implemented during the crisis was the Small enterprise loan guarantee scheme. The scheme involved the state insuring banks against company defaulting on loan payment in return for a fee. The main aim of the endeavour was encourage banks to lend sufficient funds to businesses which need the cash. However, this scheme fell under severe criticism as the British Bank association reported the lending to small businesses had decreased despite the £10 billion injection and also in order to finance this scheme the government either has to increase taxes or borrowing (bbc.co.uk). This will not comply with Keynes theory which suggests government cut taxes in an economic downturn.
Monetary policy is defined “central government policy with regard to the quantity of money in the economy, the rate of interest and the exchange rate” (Bannock G, 2003: 236). In the last 2 years the government has had to loosen monetary response in response to the recession. During the first quarter of 2009 the government cut interest rates to a historic low of 1.0 percent then a further 0.5% cut by February 2009 (bbc.co.uk). By doing so the government had hoped to stimulate more borrowing within the economy which should increase business activity and economic output. The lower the interest rate the more likely business will borrow money to invest in the economy. In addition the UK government introduced quantitative easing. The aim of quantitative easing was to increase the “amount of money in the UK’s financial system in attempt to boost bank lending” (bbc.co.uk). The scheme was highly criticised due to the fact the government had to print billions of pounds to finance this scheme. However, it can be argued that the scheme succeeded as the UK was one of the first countries to emerge out of the recession. However the UK government stop the programme on February 2010.
In conclusion Keynes has become more relevant as monetarist economist start to realize that the ideology that a market will regulate itself is no longer relevant. As evidence the past recession has proven what could or will happen in an economy of low regulation. The financial market was under little regulation and as a result the credit crisis was unpredictable by many monetarist economic advisors to the UK government. The laissez-faire approach to the economy has failed the UK economy and given rise to Keynesian theories. However, it can be argued that Keynes is not the ultimate solution. Keynes supported the idea of implementing fiscal policy in order to stabilize the economy.
Monetarists argue that increase in government spending leading to an increase in aggregate demand can result in an increase in price and output thus causing inflation. Figure 5 shows that a shift in the aggregate demand curves from AD1 to A2 results in an increase in prices. “According to monetarist inflation occurs when there is too much money supply in the economy” (Gillespie A, 2007: 383). If government increase the amount of money in circulation demand increase and so will higher prices. In addition, Keynes theories are criticised for promoting the situation known as ‘crowding out’. Crowding out is defined as “the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate thereby reduces investment spending”( Mankiw N G, 2001: 748). If government are to inject money into the economy they will need to borrow adding to the country deficit. If government borrowing has a large effect on interest rate, spending and investment in the private sector falls as cost of borrowing spikes. Finally, Keynes states government intervention in the economy is the most efficient way to mange it but this statement brings to light concerns relating to public choice theory. If the government influence on the economy grows there is a chance the decision made by the government will not be in the interest of the public or the economy but to protect their authority and power. Government could make decision like cutting taxes to win votes rather than help the economy. In my opinion Keynes has always been relevant but in light of the recession he has become more relevant but it can be argued that Keynes theories are not the ultimate solution due to the problems they create and as a result the UK government should continue to consider a combination of Keynesian and monetarist ideas to tackle economic problems.