Exam 9: The Keynesian Model: Extensions to China and Beyond

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In the Keynesian framework a drop in demand in the economy results in only one variable changing - output, because the other variable, prices, is sticky and cannot act as a "safety valve" to relieve the pressure from the drop in demand - instead, output must absorb the shock fully in order for equilibrium to be restored. In China, the"great economic shock absorber" the labor force might accept a lower wage, work longer hours, be relocated and change the type of employment quickly. In a GDP sense, output need not fall as much given the negative shock because there is this additional shock absorber.

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For some emerging economies, an appreciating currency results from ill-conceived capital account liberalization, too much foreign borrowing (capital inflows) and a current account deficit. This does not appear to be the case for China. Rather, China's strong currency appears to reflect a fundamentally strong balance sheet and cashflow position from an international perspective. However, the longer a quasi-fixed exchange rate remains in place, the more likely other fundamental economic problems have the chance to build up without notice - setting the stage for larger and more difficult to manage problems.

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Clearly, fiscal policy will need to lean on (rely on) more heavily the other two major components of demand - consumption and government spending. In the former case, tax policy and or consumption subsidies would matter