Actual GDP, potential GDP and Keynesian ( or Keynesian-looking ) measures

Each economic crisis has its own characteristic features. When there is a major market correction or major market failure ( in this article, by market failure we will mean a situation where a market does not clear over an unusually large time compared to the recent historical norm in that market ), there is a possibility of spillover effects, both dynamical and psychological. The dynamical spillover effects are due to economic linkages between businesses and between sectors. They are largely unavoidable once there has been a contraction in some sector. The psychological spillover effects can be due to consumer sentiment or investment sentiment being depressed more than is warranted by the economic situation. To take an extreme example, bank failures in some banks may precipitate bank runs in many banks if paranoia takes a hold of the public, even though these bank runs do not constitute " rational behavior ". Another example is hoarding of cash by businesses because they have a sense that demand for their products will not pick up any time soon, even though there is nothing in the economic data to suggest this directly ( a case of businesses acting in a very risk-averse manner because they feel they don't have enough information to predict future demand accurately enough or to feel confident about future demand ).

It is a useful exercise to distinguish carefully between the spillover effects of a major market correction or a major market failure on banks and financial institutions on the one hand and on other businesses on the other hand. After all, banks and financial institutions play a major role ( and a different kind of role compared to other businesses ) in determining how the savings of a society are allocated and the kind of investments that take place. Sometimes, the bailing out of financial institutions and banks becomes necessary despite all the negative aspects like moral hazard associated with bailouts. If banks have a sudden cash flow problem, helping them out through monetary or fiscal measures may be the right thing to do. Otherwise, the credit flow in the economy may be squeezed far more than is justified by the original market correction or market failure that triggered the economic contraction. This is a case where the judicious use of monetary or fiscal measures can prevent the GDP from falling more than it needs to.

Psychological spillover effects can lead to a contraction of GDP beyond the necessary amount following a large market correction or market failure. Keynesian monetary or fiscal measures can help counter the psychological spillover effects. Dynamical spillover effects, on the other hand, can lead to a contraction, not just of actual GDP, but also of potential GDP ( for example, a significant amount of capital in a certain business or a certain sector of the economy may need to just wait for a long time for a market failure to be resolved or it may need modification before being re-used ). The latter ( dynamic spillover ) consists of cases where necessary dynamical corrections are experienced by the economy even after the most aggressive Keynesian measures.

by C. Jayant Praharaj ( send comments to cjpraharaj.blog@gmail.com )