Mankiw on Keynes

Economic View - What Would Keynes Have Done? - NYTimes.com

According to Keynes, the root cause of economic downturns is insufficient aggregate demand. When the total demand for goods and services declines, businesses throughout the economy see their sales fall off. Lower sales induce firms to cut back production and to lay off workers. Rising unemployment and declining profits further depress demand, leading to a feedback loop with a very unhappy ending.

The situation reverses, Keynesian theory says, only when some event or policy increases aggregate demand. The problem right now is that it is hard to see where that demand might come from.

The economy’s output of goods and services is traditionally divided into four components: consumption, investment, net exports and government purchases. Any expansion in demand has to come from one of these four. But in each case, strong forces are working to keep spending down.

In normal times, the Fed can bolster aggregate demand by reducing
interest rates. Lower interest rates encourage households and companies
to borrow and spend. They also bolster equity values and, by
encouraging international capital to look elsewhere, reduce the value
of the dollar in foreign-exchange markets. Spending on consumption,
investment and net exports all increase.

But these are not normal
times. The Fed has already cut the federal funds rate to 1 percent,
close to its lower bound of zero. Some fear that our central bank is
almost out of ammunition.

Fortunately, the Fed has a few secret
weapons. It can set a target for longer-term interest rates. It can
commit itself to keeping interest rates low for a sustained period.
Most important, it can try to manage expectations and assure markets
that it will do whatever it takes to avoid prolonged deflation. The Fed’s decision last week to start buying mortgage debt shows its willingness to act creatively.

It
is hard to say how successful monetary and fiscal policy will be in
avoiding a deep downturn. But as events unfold, you can be sure that
policymakers in the Fed and Treasury will be looking at them through a
Keynesian lens.

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