When I was in high school I used to go away to summer camp in Massachusetts along with some friends from Montreal. Midway through every summer, kids would receive their report cards by mail. During the early years at summer camp, I remembered that the average grade of the Canadians and Americans were roughly the same (usually in the mid 80’s). However, as the summers wore on, the Canadians were maintaining roughly the same grades whereas as the Americans were getting on average higher and higher grades. By the end of my years at summer camp, it seemed that every American kid had perfect grades and the smart ones had more than perfect grades. They had GPAs that exceeded the perfect 4.0 – it was a bit out of control. Anyways there are many parralels between the mentality that caused that situation and the current policies adopted today by economic Policymakers. This post will serve as an extended analogy to explain Keynesian economics.
So to explain what was going on lets call the American school – Keynesian high school and the Canadian one – Hayek high school. Hayek high school decides not to change their grading policies for many years, feeling that their grading policy creates a stable and clear system for others to interpret. Ultimately, the performance of the school is determined by the intelligence of the students and the quality of the teachers.
Keyesian high school has devised a ploy to improve the perceived performance of their school without altering the intelligence of the students or the quality of the teachers. Keynesian highschool has devised a scheme to gain an edge over their competition by temporarily increasing all the students grades in the school by 5%. On that particular year, Ivy leage schools like Harvard will have a couple more applications from students at KHS than in normal years and the grades will be a bit higher. Harvard, not knowing that the the high school boosted all the grades without any corresponding superior performance will initially interpret the grades as the outcome of a better than normal graduating class. As such they decide to admit a couple more students than in normal years, as do the other top Universities in America. So the trick has paid off and the students are admitted to better schools than they normally would have been admitted to given their academic prowess. As a result of this success, Keynesian high school receives more applications and attention than normal due to their perceived success. This serves as a stimulus for KHS.
Over the long term if KHS continued to boost grades by 5% annually than Harvard would anticipate for students to have 5% higher grades and would thereby discount all grades by that factor, negating any benefit of such an activity. The higher grades (grade inflation) would not be accompanied by greater admission records at Universities. However, KHS was still able to gain an advantage in the short run. The time delay that it takes for Harvard to start discounting appropriately is what allows for this to work. Similarly it is the delay that it takes for economic prices to adjust in the short run (price stickiness) that allows for Keynesian economists to stimulate the economy.
In the short, since it takes time for companies to change their prices – the Fed can take advantage of the stickiness of prices to boost the economy. If the Federal reserve were to expand the money supply by 5%, during the delay before prices rise, people would feel they had more purchasing power and would decide to spend more money than normal. In the long run, firms will raise their prices but in the short run greater spending will stimulate economic activity. The delay in discounting prices is they key in both cases as to why one can stimulate performance of a school or an economy in the short run.
Eventually one reaches a maximum to which they can stimulate. Grades cannot surpass 100% and interest rates cannot be lower than 0%. When I was in camp it seemed that this treshold was reached for grades and currently the Federal reserve has reached it’s lower bound of 0%. The Federal Reserve has a couple more tricks like extending the promised term of low interest rates and engaging in more quantitative easing but it seems that they are mostly our of firepower. Eventually you run the risk of exhausting your aresenal of tricks and it sometimes comes at a cost of lower credibility. S&P recently made the US government pay the price for its constant reflation.