Theories of the Business Cycle - Keynesian School

Keynes observed that a generalized price and wage reduction, necessary to bring markets back to equilibrium during a recession, would be hard to attain.

Keynes believed there could be circumstances in which lower interest rates would not reignite growth because business confidence or “animal spirit” was too low. As a consequence, Keynes advocated government intervention in the form of fiscal policy.

The practical criticisms that are often expressed about Keynesian fiscal policy are:

1 Fiscal deficits mean higher government debt that needs to be serviced and repaid eventually. There is a danger that government finances could move out of control.

2 Keynesian cyclical policies are focused on the short term. In the long run, the economy may come back and the presence of the expansionary policy may cause it to “overheat”. This result is because of the typical lags involved in expansionary policy taking effect on the economy.

3 Fiscal policy takes time to implement. Quite often, by the time stimulatory fiscal policy kicks in, the economy is already recovering.