What Is Demand-Side Economics?

Because Keynesian economists believe the primary factor driving economic activity and short-term fluctuations is the demand for goods and services, the theory is sometimes called demand-side economics. This perspective is at odds with classical economic theory, or supply-side economics, which states the production of goods or services, or supply, is of primary importance in economic growth.

Economist John Maynard Keynes developed his economic theories in large part as a response to the Great Depression of the 1930s. Before the Great Depression, classical economics was the dominant theory, with the belief that through the market forces of supply and demand, economic equilibrium would be restored naturally over time. However, Keynes believed that the Great Depression and its long-running, widespread unemployment defied classical economic theories, and his theories try to explain why the mechanisms of the free market were not restoring balance to the economy.

Key Takeaways

  • Demand-side economics refer to Keynesian economists' belief that demand for goods and services drive economic activity.
  • A core characteristic of demand-side economics is aggregate demand.
  • Government can generate demand for goods and services if people and businesses are unable to.

Insufficient Demand Causes Unemployment

Keynes maintained that unemployment is the result of inadequate demand for goods. During the Great Depression, factories sat idle, and workers were unemployed because there was not enough of a demand for those products. In turn, factories had insufficient demand for workers. Because of this lack of aggregate demand, unemployment persisted and, contrary to classical theories of economics, the market was not able to self-correct and restore balance.

One of the core characteristics of Keynesian or demand-side economics is the emphasis on aggregate demand. Aggregate demand is composed of four elements: consumption of goods and services; investment by industry in capital goods; government spending on public goods and services; and net exports. Under the demand-side model, Keynes advocated for government intervention to help overcome low aggregate demand in the short-term, such as during a recession or depression, to reduce unemployment and stimulate growth.

How the Government Can Generate Demand

If the other components of aggregate demand are static, government spending can mitigate these issues. If people are less able or willing to consume, and businesses are less willing to invest in building more factories, the government can step in to increase government spending to generate demand for goods and services. Keynesian economics supports heavy government spending during a national recession to encourage economic activity. Putting more money in the pockets of the middle and lower classes has a greater benefit to the economy than saving or stockpiling the money in a wealthy person's account.

Central banks can also achieve this goal by altering interest rates or selling or buying government-issued bonds. This type of intervention is known as monetary policy. These policies, such as changing interest rates, can be used to increase the total money supply in the economy or or the velocity of money flowing through the economy. Increasing the flow of money to lower and middle classes increases the velocity of money or the frequency at which $1 is used to buy domestically-produced goods and services. Increased velocity of money means more people are consuming goods and services and, thus, contributing to an increase in aggregate demand.