The Keynesian Based Demand Management Policies Economics Essay

For most of the open economies, the primary goal is to maintain the macroeconomic stability, which means the balances for both internal and external of a country. According to the history, the policymakers tried various ways to achieve it with different theories; the most notable one is Keynesianism which was based on the general theory from the influential economist Keynes.

This essay will firstly try to evaluate the Keynesian-based demand management policies, particularly focus on the expenditure changing and the expenditure switching policy, and their relationship with the balance of payments. Moreover, this assignment will try to assess the applicability of the methods regarding the contemporary UK economy. And finally, the essay will briefly review the development of the policies and restate the applicability of the Keynesian-based approaches regarding the current UK economy.

2. Expenditure switching policy (ESP)

As a macroeconomic policy, the expenditure switching policy focused on affecting the pattern of consumption on domestic and foreign goods of a country. More particularly, the aim of the policy is to alter the composition of expenditures on both foreign and domestic goods and therefore improves the current account of a deficit country. In another word, it will switch the spending from the imported goods to domestic manufactured products. The general methods that adopted by most countries are tariff, subsidies and devaluation of the currency.

2.1. Tariff

With the rapidly developing of international trade, some economists argued that too much imports will damage the domestic industry and therefore cause unemployment and deficit of the country. Consequently, the tariff had been introduced to push up the price of the imported goods by taxation as the tendency of protectionism.

The following diagram shows the effect of the import tariff on the domestic economy. By lifting up the price of the imported goods from Pworld to Ptariff, the domestic production will increase from QS1 to QS2 and causes the consumption on the imported goods decline from QC1 to QC2. It seems that the imposition of the tariff will lead to the aim of improve the deficit of BOP as it increased the domestic consumption and generated additional tax revenue for the government. But from a social welfare perspective, the two triangles in the table are the societal loss caused by tariff. Thus it is reasonable to figure out whether the gain from the tariff really outweighs the loss of it. However, there are theories and empirical evidences had shown that the size of winning from the removal of the tariff is larger than the losses (Steven, 2008) and that means as an ESP application, the tariff may not as efficient as it seems to be.

Figure 1

2.2. Devaluation

Devaluation of the currency is one of the most common policy tools of ESP; the theoretical support of this method is elasticities approach which was been brought out by economists Marshall and Learner. The assumption of the approach is the relative price is variable and the national income is constant, it suggested that the trade balance will be improved by devaluation if the sum of price elasticity of exports and imports is greater than unity. That is to say, if the imported goods are elastic to the price, the quantity of demand will fall proportionately more than the increase in price, in a similar way, the total expenditure on imported goods will decrease if the imports are elastic and therefore improve the deficit of the trade balance.

The policymakers are expected that the devaluation of the domestic currency will lead to the rise of the foreign currency and eventually make the imports goods more expensive and people will switch their expenditure on the domestic manufactured substitutes. On the other hand, the exported goods will be cheaper in the foreign markets as they were settled in the foreign currency, and therefore the exports will be improved which will together contribute to the trade balance of a country.

But there are some uncertain factors should be noticed in practice, firstly, not all the imports or exports are responsive to the price change, empirically, the goods are tend to be inelastic in the short run, as the rigidity of the consuming habit and a period of time is needed to change the consuming patterns. Another uncertain factor to the effect of devaluation is the attitude of the exporters; instead of lowering the price on foreign market in the aim of increasing sales, they may keep the foreign price if they want to make more money in term of the domestic currency. Thus it can be seen that the success of the devaluation policy mainly depends on the elasticities of the trading goods.

Last but not the least, there will be a time lag before the policy really works. When the ESP changes, the goods are tend to be inelastic in the first place, thus raise of the price of imports will worsen the BOP at the beginning. With the domestic market adjusting to the new price, the expected effects of ESP will make its appearance gradually on BOP. The following table shows how the deficit in the BOP changed into surplus with the delay and this phenomenon is called ¿½¿½J-curve effect¿½¿½.

Figure 2

2.3. The relationship of employment status and ESP

Beyond the factors that have been discussed above, the employment status of the country should be also taken into account before the implementation of ESP. If the ESP was carried out in a country that was close to full employment, the means of production will not substantially shift to meet the additional domestic demand in a short period as the output of the country is nearly at its maximum. From the following graph, it can be seen that even if the government pushed up the price of imported goods by tariff, the volume of domestic production Q1 remains the same as the output is maximized and the point F states full employment. Therefore, the domestic producers may raise the price to cope with the change of the market price which will make the domestic consumers the victims of the tariff rather than improve the balance of payment.

The absorption model is another way to explain the importance of the employment rate of a country when considering the possible effect of ESP. The equation of this model is changed from Keynesian national income model:

Y = C + I + G + (X – M)

Y is national income which can also been regarded as total domestic output, C stands for domestic consumption, I is domestic investment, G is net government spending, X is exports and M is imports. X-M is the trade balance of a country, and the C+I+G is the total absorption of a country. If we use A to replace the C+I+G and rearranging the formula, it will be apparently that the trade balance is equal to the total domestic output less the total domestic absorption.

Y ¿½C A = (X – M)

It can be drawn from the formula that the way to improve the imbalance of trade is either increase the total domestic output or decrease the absorption. If a country is at full employment, there is less possibility to change the total output of the country, thereby the only solution to cut the deficits is reduce the domestic absorption, which will be discussed further below as an ECP approach. Yet, the reallocating of the production resources will be more smoother if the ESP is brought out at an economy that not at full employment, making the policy affect the BOP properly as it was supposed to be.

In conclusion, the determinant for the success of the devaluation is the elasticities of the trading goods; in addition, the underemployment of the country is the important prerequisites of effective ESP implementation.

3. Expenditure changing policy (ECP)

Before the discussing about the ECP, it is reasonable to introduce the idea of marginal propensity to import at the first place, the marginal propensity to import indicates the change in national income will cause a change in imports, and thereby help to cure the deficits in BOP.

From the chart above, it can be seen that a same amount of change in imports ?M will need two different amounts of changes in national income, ?Y1 and ?Y2, due to the different import functions. According to the differed outcomes, the effectiveness of the ECP is depending on the marginal propensity to imports. On the whole, the more import dependency the higher possibility that the ECP will success.

Unlike the ESP, the aim of the ECP is to affect the domestic output according to the Keynesian model which has shown above (i.e. Y = C + I + G + (X – M)), usually the government will adopt fiscal and monetary policies with ECP.

3.1. ECP with fiscal policy and monetary policy changes

The policymakers are expected that this combination of policies will affect the domestic output either the exchange rate is fixed or flexible.

With the implementation of the fiscal expansion, the increase of money demand pushes up the interest rate. According to the crowding out effect, this will decrease the domestic private investment. Therefore the whole effect on the national income will be partly offset by the crowding out effect. Moreover, the more openness the country is, the smaller the expected effect on BOP will be, this is because the consumers will spend more of their income on imported goods. Generally, the effect of the fiscal policy is better in a closed economy than that in an open economy.

On the other hand, the ECP with monetary expansion reduce the interest rate and therefore increase the national income. The private investment activity is encouraged under this circumstances but this will worsen the BOP in short run.

In summary, both kinds of ECP lead to the identical results: expanding of the national income and worsening the BOP in the short run. Unusually, the monetary and fiscal policies are used in combination in order to get a better effect on the BOP; this is shown in the table below.

Economic circumstances Fiscal policy Monetary policy

Severe depression Expansionary Expansionary

Minor depression Expansionary Contractionary

Severe inflation Contractionary Contractionary

Minor inflation Contractionary Expansionary

Table 1: Different policy combinations under different economic circumstances

4. Applicability of the ECP and ESP on contemporary UK economy

Before the discussion about the applicability of both policies, it is reasonable to have a look at the UK BOP of recent years to determine whether an expansionary or a contractionary policy is required.

Figure 5: Total Trade in Goods and Current Account of UK between 1998 and 2008 (Source: Office for National Statistics)

From the chart, the UK trade balance in goods is in deficit over the last decade and the gap between imports and exports are is in a widening trend in general. And the current account is in deficit as well over the last ten years. Both factors indicate that the UK government should adopt an expansionary policy to cure the deficit of the BOP.

As what had been discussed above, before introducing the ESP, it is essential for the policymakers to have a look at the employment rate of the country, in order to determine whether there is still potential productivity within the country.

Figure 6: Unemployment rate and Working age employment rate of UK (Source: ONS)

As the unemployment rate is increasing over the last two years, it means the UK economy is under full capacity. Furthermore, the exchange rate regime is flexible which gives UK the right to devaluate its currency. Therefore the ESP is applicable to the UK economy according to the analysis of the essay.

Figure 7: Inflation rate of UK

Figure 8: UK GDP (Source: ONS)

As for the ESP, the economic position is precondition for choosing the proper policy. The main indicators of the economic status of UK are shown above, from which we can see the economy of UK is recovering while the inflation rate is still at a severe stage. For this reason, the ESP should be implemented with a combination of contractionary fiscal and monetary policy.

In conclusion, the ESP and ECP are still applicable for contemporary UK economy as the exchange rate system is flexible and there is potential productivity within the country. But the policymakers need to take a deeper look at the UK economic status for the purpose of implementing a more suitable ECP.