Economic policy is the deliberate attempt to generate increases in economic welfare. Since the late 1920s, when many advanced economies were on the brink of complete collapse, economists have recognised that there is a role for government and monetary authorities in steering a macro-economy towards increased economic welfare.
During the late 1930s and early 1940s, Keynes outlined most of the policy ground rules for his, and later, generations of policy makers.
The general view before Keynes, including those of the Classical and Neo-Classical economists, was that an economy would move naturally towards maximum economic welfare and full employment when its markets were allowed to operate freely. However, the model of the macro-economy that Keynes had developed during the 1930s in response to the Great Depression clearly showed that a macro-economy would not always automatically or quickly self-correct. The contrast between the Classical and Keynesian perspective is often expressed in terms of the extent to which Adam Smith’s invisible hand works, or fails, to maximise economic welfare. Those on the Classical side of the argument believe it does, while those on the Keynesian side generally believe it does not, and that full employment equilibrium is a special, rather than a general case.
Keynes was able to demonstrate that a market economy could become trapped in a downward spiral of falling economic activity and diminishing economic welfare. Given the recent global financial crisis, and the Euro-debt problem, Keynes’ ideas are as relevant today as in the 1930s.
For Keynes, the key questions were:
- What events could cause a fall consumer or capital spending and trigger a downward spiral of aggregate demand, and economic activity?
- What processes might keep aggregate demand from bouncing back, as the Classical economists had assumed?
- How could governments and monetary authorities generate sustainable increases in aggregate demand?
Test your knowledge with a quiz
Feedback is provided after each question is attempted.
Following Keynes, modern policy makers favour the establishment of clear policy goals, or objectives. The main macro-economic objectives agreed by modern policy makers are:
Stable and sustainable economic growth and development
For advanced economies, stable and sustainable development means the desire to see national income grow in real terms in a way that can be sustained in the future, without generating other significant economic problems.
For developing economies, further development is often the primary goal, and can be summarised as the desire to increase the longevity of the population, increase access to education, and attain a decent standard of living.
Stable prices mean average prices rising by only a small amount, such as 2% per year.
Full employment occurs when the labour force is fully employed in productive work.
A balance of payments with the rest of the world
This means that a country is able to ‘pay its way’ in the world.
Care for the environment
Care for the environment means protecting the environment from misuse and overuse. The environment is increasingly recognised as an important asset that needs to be protected.
An equitable (fair) distribution of income
An equitable distribution of income means that the gap between rich and poor is not excessive, but still enough to create incentives to work.
Not all economists agree about the order of priority for achieving these objectives. Nor do they agree about which specific instrument should be used to achieve a given objective.
A sound structure to public finances
In terms of the role of the public sector, Keynes argued that more government spending could adequately compensate for lower private consumer and capital spending. In short, if an economy was in recession, it did not matter who injected the money – the public sector was just as productive as the private sector. However, as public (sovereign) debt has spiraled over the last decade, the control and reduction of debt levels has become a major policy objective.