What is a “Keynesian-style” stimulus?
A Keynesian–style stimulus happens when policy-makers deliberately seek to stimulate one or more of
the components of aggregate demand to boost output, jobs and incomes during an economic recession.
United Kingdom, Output gap of the total economy
Percentage of potential GDP
Actual GDP - Potential GDP, measured as a percentage of potential GDP source: OECD
5
5
4
4
3
3
2
2
1
1
0
0
-1
-1
-2
-2
-3
-3
-4
-4
80
82
84
86
88
90
92
94
96
98
00
02
04
06
08
10
Source: OECD World Economic Outlook
Keynesians tend to believe that an economy can get stuck at high levels of unemployment with national
output persistently below its potential (i.e. operating with a negative output gap). When business and
consumer confidence is low (animal spirits have worsened) there is a danger that high rates of saving can
make a recession worse. This is known as the paradox of thrift. In this situation weaker demand for
goods and services causes further job losses and can cause negative multiplier and accelerator effects
particularly in industries that supply components and raw materials to manufacturers and service
businesses.
So a Keynesian stimulus is designed to actively manage the level of and rate of growth of aggregate
demand.
An example would be to inject extra government investment into infrastructure projects and finance this
through a higher level of government borrowing. Keynesian believe that the positive effect on national
income and jobs would help to reduce the risk of a higher budget deficit ‘crowding out’ activity in the
private sector. Economist David Blanchflower has been lobbying for a huge public sector investment
programme as a way of combating what he fears will be a return to mass unemployment with well in
excess of three million people out of work.
Another example would be tax cuts targeted at lower-income consumers, targeted at this group because
they tend to have a higher marginal propensity to spend any gains in income.
Some fiscal stimulus to demand is inevitable in a recession – this is due to the workings of the automatic
stabilisers - the in-built social welfare net which increases government debt during recessions. When
unemployment is rising, the government automatically provides more in welfare assistance. And in a
recession the revenue from taxation also diminishes.
UK Government Spending and Taxation
Measured as a percentage of national income
49
49
48
48
47
47
Per cent of GDP
46
46
Government Spending
45
45
44
44
43
43
42
42
41
41
Total Tax Revenue
40
40
39
39
38
38
37
37
36
36
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: OECD World Economic Outlook
Some evaluation points
1. Fiscal policy may be more effective than monetary policy during a credit crunch because in
today’s special circumstances, low interest rates have little impact if credit is not easily available.
In the past monetary policy has been the dominant tool of short-term demand management but if
zero interest rates seem to have little impact, the attention tends to switch to fiscal policy instead.
2. Are tax cuts to be preferred to extra government spending?
3. What are some of the potential effects of a huge government borrowing spree for the distribution
of income and wealth?
4. No one knows for sure just how large are the fiscal multipliers from extra government spending or
a tax cut – if they are large then a modest fiscal stimulus can have a significant effect on demand.
But the likely depth of the recession means that a Keynesian stimulus package will have to be
very large indeed.
5. The likely scale of government borrowing is enormous and there are real fears about what this will
mean in the medium term for the costs of servicing government debt and the likely tax increases
in years to come. Average inflation and interest rates are likely to be higher because of the
increase in government borrowing and the supply of money – this will constrain a future recovery
period. But it may stave off the damaging consequences of deflation in the near term. The
employers’ organisation the CBI is warning about the dangers of a further rise in state spending
and borrowing – “a further significant fiscal stimulus is unaffordable and would lead to businesses
and households retrenching in fear of higher tax bills.”
6. What might happen to the UK economy when a Keynesian style fiscal stimulus is ended? Will
there be sufficient confidence and momentum in the economy to keep a recovery going?