ECON102: Principles of Macroeconomics (2021.A.01)

Of particular importance in Keynes' early years was the role of fiscal policy. Keynes' theory suggested that active government policy could be effective in managing the economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated, what has been called, countercyclical fiscal policies. That is, policies which acted against the tide of the business cycle – deficit spending when a nation's economy suffers from recession, or when recovery is long-delayed and unemployment is persistently high, and the suppression of inflation in boom times by either increasing taxes or cutting back on government outlays.

Keynes argued that governments should solve problems in the short run rather than waiting for market forces to do it in the long run, because "...in the long run, we are all dead...".

Michael Polanyi concluded that the policy conclusions of the General Theory simply amounted to claiming that monetary expansion, by lowering interest rates, would be sufficient to increase output and employment. However, many of the early Keynesians (including Keynes himself), objected to the assertion that monetary policy was, in itself, sufficient to guarantee full employment. During the 1930s, interest rates had fallen considerably, yet it did not seem as if private investment was instigated into action. This was understandable: with so much excess capacity, the incentives to build even more capacity would be very little, even if financing was very cheap.

As a result, many Keynesians recommended that fiscal policy, increasing government spending or lowering taxes, would have to come in and fill the gap. Alvin H. Hansen took this idea and developed his famous "stagnation thesis". Loosely speaking, Hansen argued that the 1930s represented the "closing of the American frontier" and that, henceforth, there would be far fewer investment opportunities available than before. With the amount of profitable investment projects reduced permanently, Hansen concluded, the economy could no longer rely on private investment to increase employment, output and growth. The government, Hansen noted, did not require "profitability" to initiate building projects. Consequently, government fiscal policy will (and ought to) be henceforth responsible for a permanently larger portion of economic activity.