In the popular framework of thinking, which originates in the writings of John Maynard Keynes, economic activity is presented in terms of a circular flow of money. Spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings. In the Keynesian framework, the key to prosperity is the ever-expanding monetary flow. Monetary expenditure drives economic growth. Words: 542

In further edited excerpts from the original article* Frank Shostak (www.mises.org) goes on to say:

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditures and raise their savings. If, for instance, for some reason people have become less confident about the future, they will cut back on their outlays and hoard more money. So, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending. Consequently, a vicious circle sets in. The decline in people’s confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more.

In order to prevent a recession from getting out of hand, the central bank must lift the money supply and aggressively lower interest rates. Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby reestablishing the circular flow of money, so it is held.

Keynes suggested, however, that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to a level from which they could not fall further. This, according to Keynes, could occur because people might adopt the view that interest rates have bottomed out and that rates will subsequently rise, leading to capital losses on bond holdings. As a result, peoples’ demand for money would become extremely high, implying that they would hoard money and refuse to spend it no matter how much the central bank tried to expand the money supply.

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.

Keynes suggested that, once a low-interest-rate policy becomes ineffective, authorities should step in and spend. The spending could be on all sorts of projects — what matters here is that a lot of money must be pumped in order to boost consumers’ confidence. With a higher level of confidence, consumers would lower their savings and raise their expenditures, thereby reestablishing the circular flow of money.

It is interesting to note that Keynesian economic ideas have been embraced and implemented by the governments and central banks of the major economies of the world [with the Obama Administration its greatest endorser].

*http://blog.mises.org/?p=010700

Editor’s Note:
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