Keynesian economics refers to a body of theory that attributes a significant amount of explanatory value to aggregate demand. While the theory and its applications have a broad range of interpretations, Keynesians generally focus on management of aggregate demand. This sometimes involves utilization of government intervention for situations in which market forces fail to achieve an optimal outcome on the macro level. Keynesian economics was popular in the period of economic growth following World War II, later being challenged by a surge of neoclassical free-market proponents in the 1980s.
Keynesian theory is generally associated more closely with fiscal policy than monetary policy, though modern proponents often suggest the two must work in tandem. Keynesian economics lost some credibility in the 1970s when it failed to provide a clear path to overcoming stagflation, which is a set of conditions leading to high inflation and slow economic growth. These events highlighted the importance of money supply control when implementing expansionary fiscal policy. This means central banks play an important role in Keynesian theory because they have unrivaled control over interest rates.
Role of Interest Rates
According to Keynesians, business investment levels are determined by future profit expectations and interest rates, so monetary policy could be employed to influence investment and aggregate demand through interest rate manipulation. Interest rates determine the cost of capital and play an important role in modern macroeconomic theory. They are determined by the market for loanable funds. Assuming demand for loanable funds is static, rising money supply causes interest rates to fall, pushing the quantity of money demanded higher. When the quantity of loanable funds demanded is excessively low or high, the economy can suffer from lack of activity or overextension.
Economists who subscribe to monetarist and Keynesian theory suggest that expansionary monetary policy should be combined with expansionary fiscal policy to overcome short-term disturbances to labor markets caused by economic shocks. Aggregate demand can decline from time to time as growth expectations sour, but fiscal stimulus can support demand while monetary stimulus can influence money supply and the quantity of capital demanded, thereby stabilizing employment. Some Keynesians also advocate contractionary policy to counteract excessive bullishness and unsustainably high employment.
Central banks often influence the interest rate indirectly through open market operations, which impact the money supply and, in turn, interest rates paid by banks for reserves. Central banks can also directly adjust interest rates, but these techniques have become less common in practice. Monetary policy is tremendously consequential for businesses, especially ones with high financial leverage, as evidenced by behavior in the aftermath of the 2008 financial crisis. Central banks therefore play a crucial role in modern Keynesian economics because they control the interest rates that are an essential element used to support aggregate demand along with fiscal stimulus.
The resurgence of Keynesian policy in the wake of global financial turmoil in 2009 was widespread, especially as emergent crises prompted more extreme measures by central banks around the world. The Bank of Japan and the European Central Bank both established negative nominal interest rates in 2016, something that had been considered theoretically infeasible by many economists just years earlier. The drastic measures and lack of progress led many economists to say Keynesian monetary policies lacked efficacy because marginal reductions in the cost of debt capital were insufficient to motivate businesses to expand operations while the outlook was still poor. Europe and Japan had low productive capacity utilization in the first quarter of 2016, with interest rates having modest impacts of capacity utilization growth and even less meaningful impact on employment.
While the apparent failings of aggressively dovish monetary policy in 2016 do not eliminate the role of central banks in Keynesian policy, they do highlight flaws with the model in scenarios in which aggregate demand falls sharply. Negative nominal rates also offer an extreme example that challenges the normal function of private banks that lend to businesses. Many countries with exceptionally low interest rates also run substantial fiscal deficits, making it difficult to complement monetary stimulus with fiscal stimulus, rendering realistic Keynesian options less effective.