From Malaysian Restaurant's Menu to Great Depression (Economics from Keynes' perspective)
A long one, but worth reading. --------------------------------------------------------------
This afternoon, I went to eat at a low-budget Malaysian restaurant, and the moment I opened the menu, it got me thinking about a famous economic phenomenon known as "Inflation".
Now, inflation is a general rise in price or decrease in purchasing power of your money. Simply put, 4% annual inflation means that the price of a $100 basket of goods this year will cost you $104 next year. Nothing too complicated.
And this is true in a real-world setting. I remember my grocery costing me less last year if compared to this year. Well, that must mean it also costs the restaurant more to buy its inputs this year (meat, eggs, veggies, spice, etc). But, what is surprising to me is that the prices on the menu are exactly the same as they were last year. Of course, I frequent the restaurant, so I would notice even the slightest change.
Why is that? It seems that to the owner, changing price is actually inconvenient and costly at the same time. Inconvenience in a sense that he needs to make an effort in figuring out the new price for each of the dishes (for like 100 dishes or something, not to mention combo and stuffs). And, costly in a sense that he needs to spend time doing that, and it costs him money to print out a new menu. You might say "Hey, why bother? Just writing it on top of the old price", in which case my response to you is "Go take a marketing course or something".
So you see, a slight change in price is not worth changing the menu. But, slight changes in business make the difference between profit and loss. When price does not follow the force of the market, this very idea is called "sticky price" (in fancy economic term, "nominal rigidity"), and it plays a significant role in explaining the persistent fall in outputs (GDP) during a recession. It is also a major part of the argument that economists use to justify government intervention.
In the olden days, back when we had fairy and sasquatch running around, classical economists thought that market is self-correcting. In other words, when there is a recession or depression (general falls in outputs), say, due to a shock that decrease aggregate demand, then price and wage would automatically fall to maintain a good level of demand in the economy, and given time, this demand would in turn spur the growth of production to its natural (normal) level.
That is a nice way of thinking, but history tells us the opposite. During the great depression in the UK in the 1930s, many economists were baffled by the fact that the outputs kept falling further and price/wage just refused to fall. It didn't make sense.
This is what economists nowadays call "Downward Rigidity" or "Sticky-down" meaning that price/wage has the tendency to rise but resists to fall. Several factors were the causes, but one way to explain is the menu cost and another is the work contract (which kept wage at a certain level). There is also the labour union who works to keep wage from falling. Also, the minimum wage law doesn't seem to help much in this case. There are many more reasons to be listed, but we'll just go with what we have now.
Because price and wage could not fall, employers (rational thinkers), who needed to keep their businesses afloat then, resorted to another method: "firing people". So, unemployment increased and with more people out on the street, the economy produced even less. Outputs fell further, and the UK went into a depression.
John Maynard Keynes, a brilliant mind, an excellent economist back then, observed this "sticky-down" situation, and he devised a clever solution. To Keynes, the problem stemmed from the demand-side of the economy. People were scared. They saved too much money, and since everyone spent less and invested less, there was a lot less money in circulation causing everyone to earn even less and a heap load of unused saving (liquidity trap) not being put into investment that could have created jobs.
Thus, Keynes thought that the remedy to this persistent fall in output is to boost demand through higher government spending and lower taxes. How? Government can spend more on various projects that result in more jobs being created. The more people with jobs, the more demand there would be for products and services. The lower the taxes, the higher the internal rate of return (IRR) of many investment projects, and thus, it encourages businesses to invest more. When demand is revived, businesses will produce more and hire more leading to higher output (i.e. economic recovery).
Keynes also explained the importance of government spending by stressing the multiplier effect. He noted that a dollar spent by the government can yield a hundred-dollar worth of GDP (ex: spending on physical infrastructure like road and bridge which have long-term positive impact).
So, what is the verdict? Were the classical economists wrong? Not really. The market is indeed a self-correcting system. In the case of the great depression in the UK, had we let it be, would the UK have been able to recover? The answer is probably YES. But, it would take a very long long long period, and many people would suffer for a long long long time in the process. So, in such a situation, doing nothing is probably not the best remedy. Like Keynes once said: "In the long-run, we are all dead (anyway)".