Portfolio Management - Keynesian Theory

Returning to the subject of economic theory, there are two leading schools of economic thought: Keynesian and Monetarist. Neither is "right" or "wrong"; they both see the same data and share the same goal of understanding how the economy works. The difference between them is more a matter of emphasis.

  • Keynesian theory is a product of the Great Depression of the 1930s (not unlike most of the acts of Congress that govern the U.S. financial markets today). It was John Maynard Keynes' assertion that expenditure, meaning how much an economy spends on goods and services, is the key to economic stimulation.

    • Keynesians identify four components of expenditure:
      1. Consumption, the most important component, which refers to what consumers spend;

      2. Investment, which refers to what businesses spend on increasing capacity;

      3. Government purchases, meaning what all levels of government buy from the private sector; and

      4. Net exports, which are what the nation sells abroad, less what it buys from other nations.

    • Because Keynesian theory sees spending as the driver for economic growth, Keynesians consider personal savings - whatever a consumer earns but does not spend - to be a drag on the economy.

    • This drag is measured as the marginal propensity to consume (MPC), the additional consumption from an aggregate raise in pay divided by that aggregate raise in pay. The formula is simple enough:

MPC = Additional Consumption
Additional Income

The higher the MPC, the lower the savings rate.

Keynesians see one person's consumption as someone else's income - then someone else's, then someone else's. As a result, there is a multiplier at work that turns every dollar of individual expenditure into more dollars of national wealth.

The multiplier is the change in total income divided by the change that brought it about.

After all the algebra, it looks like this:

Multiplier = 1
1 - MPC

To work through the math with an example, suppose the country as a whole recently experienced a 10% growth in income. Consumers then chose to save 10% of their newfound bounty and spend the other 90%, so for every new dollar, 10 cents were saved and 90 cents were spent. The MPC would be $0.90 divided by $1.00, or 0.9. The multiplier, then, would be 1 divided by 0.1 (1 minus 0.9), or 10. That means that for every additional dollar spent in the economy, $10 of wealth was created.

If both business and consumers became pessimistic and chose to preserve rather than spend their money, then industry would cut production, there would be less output and the economy would go into contraction. The role of government, then, would be to "prime the pump," that is, to spend on new goods and services until other sectors of the economy were able to or were less reluctant to.

History buffs will recognize this as the cornerstone of Franklin Roosevelt's "New Deal", which is credited with stimulating an otherwise moribund economy during the Great Depression.
Monetarist Theory
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