Short and Sweet! Based on the article \"John Keynes and the Turbulent Birth of M

Question

Short and Sweet! Based on the article "John Keynes and the Turbulent Birth of Macroeconomics".

1. Explain how a recession can be understood using the concepts of leakages and injections. See pps. 116-118 in particular.

2. On page 117, the authors cite some savings statstics for the U.S. Which agents in the economy (businesses or households) saved the most in 2003? Given these savings statistics, why do you think Keynes was particularly interested in the role that expectations play in determining business investment?

3. Explain what Keynes meant by the liquidity trap.

Explanation / Answer

1) John Keynes described a alternative model for macroeconomics stability and that is by injections and leakages. Injections are inflow into the economy which are investment, government purchases and exports. While, leakages are outlow and described as savings, taxes and imports. Injections while contribute to the aggregate demand, leakages decreases amount available for consumption. The balance between these leakages and injections is necessary for macroeconomic stability.

As mentioned earlier leakages is the 'waste' of the total income available for consumption or for the factor payment. Any rise in such leakage factors or higher level than natural may impact overall aggregate demand and in such scenario there is a possibility of recession.

2) Consumption by the household is necessary for the growth of the economy. As a matter of fact it is much more dependent on the sentiments. Investment and savings decision are made by considering future economic scenario. When it is reasonablly sure that future growth will remain intact and any supply shocks are not immadiate possibliity, people will tend to consume relatively more as they are sure that in future income stream will continue for foresseable period. In such scenario there will be adequate aggregate demand and businesses will tend to invest in new products.

However, if sentiments turns bad because of any supply shocks or for that matter concerns over health of economy, then people start to save more for future rather than spend for consumption. Such situation will decrease overall aggregate demand and business will also curtail their plan for investments.

3) The invention of the concept of liquidity trap is widely credited to John Maynard Keynes. In the-1930s, Keynes described it as a situation in which a step taken or a toolwhich is used to stimulate the economy fails to achieve the expected results. According to this, reduction in interest rate which is used to stimulate the economy, if fails to put the growth back on to the path then it is a liquidity trap.

In such case people hold on to savings and do not buy bonds expecting a rise in interest rates soon. This defeats the actual intention of central bank as there will be no positive effect on output even after increasing the money supply.

The concept believes that liquidity trap arises when the zero interest rate fails to alleviate deflationary pressure by central banks using tools of reducing interest rates.

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