Text 1. Keynesian Theory

Date: 2015-10-07; view: 336.

UNIT 3: BUSINESS CYCLES

One problem with laissez-faire economics is its insistence that government should do little about economic depressions(periods of high unemployment and business failures) or about raging inflation(when price increases decrease the value of currency). Inflation is generally measured by the Consumer Price Index (CPI). Since the beginning of the Industrial Revolution, capitalist economies have suffered through many cyclical fluctuations. The United States has experienced more than fifteen of these business cycles—expansions and contractions of business activity, the first stage accompanied by inflation and the second stage by unemployment. No one had a theory that really explained these cycles until the Great Depression of the 1930s.

That was when John Maynard Keynes, a British economist, theorized that business cycles stem from imbalances between aggregate demand and productive capacity. Aggregate demand is the income available to consumers, business, and government to spend on goods and services. Productive capacity is the value of goods and services that can be produced when the economy is working at full capacity. The value of the goods and services actually produced is called the gross national product (GNP).

When demand exceeds productive capacity, people pay more for available goods, which leads to price inflation. When productive capacity exceeds demand, producers cut back their output of goods, which leads to unemployment. When many people are unemployed for an extended period, the economy is in a depression. Keynes theorized that government could stabilize the economy (and flatten or eliminate business cycles) by controlling the level of aggregate demand.

Keynesian theory holds that aggregate demand can be adjusted through a combination of fiscal and monetary policies. Fiscal policies involve changes in government spending and taxing. When demand is too low, government should either spend more itself or cut taxes, to give people more money to spend. When demand is too great, the government should either spend less or raise taxes, giving people less money to spend. Monetary policies involve changes in the money supply and operate less directly on the economy. Increasing the amount of money in circulation increases aggregate demand, and thus increases price inflation, assuming full employment. Decreasing the money supply decreases aggregate demand and inflationary pressures.

Keynesian theory has been widely adopted by capitalist countries. At one time or another, virtually all have used the Keynesian technique of deficit financing—spending beyond tax revenues—to combat an economic slump. The objective of deficit financing is to inject extra money into the economy to stimulate aggregate demand. Most deficits are financed by funds borrowed through the issuing of government bonds, notes, or other securities. The theory holds that deficits can be paid off with budget surpluses after the economy recovers.

Because Keynesian theory requires government to play an active role in controlling the economy, it runs counter to laissez-faire economics. Before Keynes, no administration in Washington would undertake responsibility for maintaining a healthy economy. In 1946, the year in which Keynes died, Congress passed an employment act fixing under law "the continuing responsibility of the federal government to ... promote maximum employment, production and purchasing power." It also created the Council of Economic Advisers (CEA) within the Executive Office of the President to advise the president on maintaining a stable economy. The CEA normally consists of three economists (usually university professors) appointed by the president with Senate approval. Aided by a staff of about twenty-five people (mostly economists), the CEA helps the president prepare his annual economic report, also a provision of the 1946 act. The chair of the CEA is usually a major spokesperson for the administration's economic policy. This was not the case under Reagan, however, primarily because Reagan's views on economics did not always coincide with those of the economists on the council.

The Employment Act of 1946, which reflected Keynesian theory, had a tremendous impact on government economic policy. Many people believe it was the primary source of "big government" in America. Even Richard Nixon, a conservative president, admitted that "we are all Keynesians now."

Consumer Price Index

Inflation in the United States is usually measured in terms of the Consumer Price Index. The CPI is based on prices paid for food, clothing, shelter, transportation, medical services, and other items necessary for daily living. Data are collected from eighty-five areas across the country, from nearly 60,000 housing units and almost 20,000 businesses.

The CPI is not a perfect yardstick. One problem is that it does not differentiate between inflationary price increases and other price increases. A Ford sedan bought in 1981 is not the same as a Ford sedan bought in 1991. To some extent, the price difference reflects a change in quality as well as a change in the value of the dollar. For example, improvements in fuel economy improve the car's quality and justify a somewhat higher price. The CPI is also slow to reflect changes in purchasing habits. Wash-and-wear clothes were tumbling in the dryer for several years before the government agreed to include them as an item in the index.

These are minor issues compared with the weight given over time to the cost of housing. Until 1983, the cost of purchasing and financing a home accounted for 26 percent of the CPI. This formula neglected the facts that many people rent, rather than buy, homes and that few people buy a home every year. A better measure of the cost of shelter is the cost of renting houses similar to those that are owned. Using this method of calculating the cost of shelter dropped the weighting given to housing in the CPI from 26 percent to 14 percent. Before the correction, the CPI overstated the rate of inflation for the average citizen.

The government uses the CPI to make cost-of-living adjustments in civil service and military pension payments, social security benefits, and food stamp allowances. Moreover, many union wage contracts with private businesses are indexed to the CPI. Because the CPI almost always goes up each year, so do the payments that are tied to it. In a way, then, indexing payments to the CPI adds to both the growth of government spending and inflation itself. The United States is one of the few nations that also ties its tax brackets to a price index, which reduces revenues by eliminating the "bracket creep" of inflation.

Despite its faults, the CPI is at least a consistent measure of prices and is likely to go on being used as the basis for adjustments to wages, benefits, and payments affecting millions of people.

(from “The Challenge of Democracy”)

Tasks:

do the phonetic reading and written literary translation of

a) the sixth passage of the text;

b) the ninth and tenth passages of the text;

put 12 questions to the text;

give the summary of the text;

retell the text as if you were:

1. Keynes.

2. A professor from CEA.

3. A person responsible for including items in CPI.

4. A person from the National Association of Purchasing Managers.