Demand Side Economics
Keynes’s model is a “demand-side” model. Keynes believes that as long as there is enough demand, production (supply) will be sufficient and full employment will result. In order to increase demand, Keynes emphasized that the government needs to increase its spending. The government can obtain funds from three sources for this additional spending:
- Printing more money
- Incurring a deficit (borrowing from the public)
- Increasing taxes
The Effect of Printing More Money
One of the ways a government can obtain more money for additional government spending is to print more money. The Federal Reserve supplies additional money to the public primarily through Open Market Operations; this is discussed in Unit 9. Printing more money is inflationary. It may be true that initially some people feel wealthier because they are the recipients of the additional government money. These people can increase their spending relative to what it was before. However, as soon as inflation takes effect, people will be harmed by rising prices. In the long run (after the inflation takes effect), the decrease in purchasing power and the accompanying decrease in demand offsets the initial increase in demand. The harmful effects of inflation in the long run will cancel out or even outweigh the positive short-run effects of the government spending and money supply increase.
The Effect of Incurring a Deficit
Instead of the Federal Reserve printing more money, the government can borrow the money. By issuing Treasury bills, notes, and bonds (all called Treasury securities), the government obtains money for additional spending. When the government borrows money from the public in this way, money is merely transferred from the private sector (households and businesses) to the public sector (the government).
Government borrowing by itself is not inflationary, but it does increase the national debt and increases interest rates by decreasing the availability of funds in private financial markets. It also raises future tax liabilities. Critics of the Keynesian model believe that in the long run, the negative effects of government borrowing outweigh the positive short-run effects. They point to the economy of Greece to show the disastrous economic effects of too much government borrowing.
The Effect of Increasing Taxes
During recessions, Keynes did not recommend an increase in taxes. However, Keynes did mention that if you want to balance your budget, you can increase government spending and increase taxes by the same amount and still stimulate the economy (see Section 4). He admitted that if taxes increase, then private spending decreases. But, according to Keynes, the increase in total spending from a government spending increase is greater than the decrease in total spending from a tax increase. Keynes stated that when taxes increase, people would have saved a portion of the taxed income, had they been allowed to keep it. According to Keynes, this savings constitutes a “leakage” from the economy.
Keynes’s critics, however, believe that savings generates funds available for borrowers in the financial markets, and eventually becomes another form of spending. Therefore, it is not a leakage.
The Role of Savings
Consumer and business saving is essential to allow firms to add to production capacities and create additional wealth. When people save, it frees up funds, which businesses can use (borrow) to purchase capital goods. Additional capital goods beyond what is needed to replace worn out and obsolete machines allows for greater productivity. This enables businesses to pay higher real wages and create greater purchasing power for consumers.
If people don’t save, and they spend all their earnings on consumption, there will eventually be no funds to purchase capital goods. All the money is spent on cars, food, microwave ovens, clothes, etc. Businesses will find themselves with fewer and fewer production capacity and eventually with significantly less production. Less production means fewer jobs, less purchasing power and real demand, and a regressing economy. Eventually, without savings, the economy loses all capacity to produce.
Jean Baptiste Say was a classical economist who believed that any creation of wealth, production, and jobs must be initiated at the production side, not the demand side. Only when entrepreneurs and workers become more industrious and productive is additional real purchasing power created. This important conclusion is currently known as Say’s Law. Say, a French economist, stated that any supply creates its own demand.
To see Say’s Law in a different context, imagine an “economy” with no initial economic activity (like on the reality television show “Survivor”). There is no production, so there can be no purchasing power or demand. No government spending or other artificial stimulation of demand can change this situation and magically create demand if there is no production and no goods exist. Production must occur first, and then – from the fruits of the laborers’ work and earnings – demand follows.
Supply Side Economics
Supply or production creates wealth by combining labor with technology, along with the Earth’s abundant resources. If no money exists initially, the first products can be bartered to create economic activity. Eventually, a medium of exchange (for example, rocks, or gold and silver) can be produced to facilitate trade. Once a medium of exchange (money) exists, people can save their earnings. They can start their own businesses or invest in existing businesses, so that even more production can occur. Additional production creates additional jobs, which creates additional purchasing power and subsequent spending. The additional spending provides businesses with more funds, which, if reinvested, leads to still more production and increased purchasing power.
In conclusion, Keynes supported increases in government spending, consumption and other spending in order to stimulate economic activity. Jean Baptiste Say and other classical economists place more emphasis on increased saving. This may not stimulate the economy right now, but it allows households to be financially sound in the long run and it frees up capital for businesses to invest in capital goods and thus increase their productivity. As a reward for being productive, people’s consumption and overall greater wealth increase in the long run. This consumption increase then is made possible by the economy’s increased production efforts, and not by artificial stimulation of the economy by the government.