Readers Question: Explain why Keynesians would argue that demand management policies are the most effective way of increasing the equilibrium level of output.
Keynesian fiscal stimulus is a decision by the government to increase government spending financed by government borrowing. Keynes advocated fiscal stimulus when the economy was stuck in a recession. In this situation, there is usually a rise in private sector saving and unused resources in the economy. Therefore, if the government borrow and spend, they can help kickstart the economy and provide economic recovery. see more at Keynesian economics
Keynesian Model of AD / AS
Keynesian theory argues demand management policies are most effective when the economy is in recession – when output is significantly below full employment.
Note: Keynesians wouldn’t argue for an increase in AD if the economy was near full capacity. Nor do Keynesians ignore the role of supply-side policies for long term growth.
Keynesians believe that the economy can remain below full capacity and high unemployment for a long time. (They believe LRAS is elastic as above. They reject the Monetarist view of an inelastic LRAS curve) They state in a recession resources can become idle and therefore it is necessary for the government to inject funds into the economy to boost Aggregate Demand and increase growth.
Paradox of thrift
The paradox of Thrift. Keynes noted that in a recession, low confidence caused a rise in private sector saving. This caused an even bigger fall in consumer spending. Therefore, he argued that it is was necessary for government spending to increase to offset the decline in private sector spending.
The government needs to borrow from the private sector to finance more spending. This doesn’t cause crowding out because the government is merely utilising the private sector saving. They are effectively utilising unemployed resources.
Multiplier effect. An increase in injections into the economy can cause a positive multiplier effect. Meaning initial government spending can cause a bigger final increase in Real GDP. A positive multiplier effect is important for a Keynesian stimulus to have a positive effect.