Keynesian Economics

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What is 'Keynesian Economics'

Keynesian economics is an economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed by the British economist John Maynard Keynes during the 1930s in an attempt to understand the Great Depression. Keynes advocated increased government expenditures and lower taxes to stimulate demand and pull the global economy out of the depression. Subsequently, Keynesian economics was used to refer to the concept that optimal economic performance could be achieved -- and economic slumps prevented -- by influencing aggregate demand through activist stabilization and economic intervention policies by the government. Keynesian economics is considered a "demand-side" theory that focuses on changes in the economy over the short run.

BREAKING DOWN 'Keynesian Economics'

Prior to Keynesian economics, classical economic thinking held that cyclical swings in employment and economic output would be modest and self-adjusting. According to this classical theory, if aggregate demand in the economy fell, the resulting weakness in production and jobs would precipitate a decline in prices and wages. A lower level of inflation and wages would induce employers to make capital investments and employ more people, stimulating employment and restoring economic growth. The depth and severity of the Great Depression, however, severely tested this hypothesis.

Keynes maintained in his seminal book, "General Theory of Employment, Interest and Money," and other works, that structural rigidities and certain characteristics of market economies would exacerbate economic weakness and cause aggregate demand to plunge further.

For example, Keynesian economics refutes the notion held by some economists that lower wages can restore full employment, by arguing that employers will not add employees to produce goods that cannot be sold because demand is weak. Similarly, poor business conditions may cause companies to reduce capital investment, rather than take advantage of lower prices to invest in new plants and equipment. This would also have the effect of reducing overall expenditures and employment. 

Keynesian Economics and the Great Depression

Keynesian economics is sometimes referred to as "depression economics," as Keynes' famous book, "The General Theory of Employment, Interest and Money" was written during a time of deep depression, not only in his native land of the United Kingdom but worldwide. The famous 1936 book was informed by directly observable economic phenomena arising during the Great Depression, which could not be explained by classical economic theory.

In classical economy theory, it is assumed that output and prices will eventually return to a state of equilibrium, but the Great Depression seemed to counter this assumption. Output was low and unemployment remained high during this time. The Great Depression inspired Keynes to think differently about the nature of the economy. From these theories, he established real-world applications that could have implications for a society in economic crisis.

Keynes rejected the idea that the economy would return to a natural state of equilibrium. Instead, he envisaged economies as being constantly in flux, both contracting and expanding. This natural cycle is referred to as boom and bust. In response to this, Keynes advocated a countercyclical fiscal policy in which, during the boom periods, the government ought to increase taxes or cut spending, and during periods of economic woe, the government should undertake deficit spending. (For more, read Can Keynesian Economics Reduce Boom-Bust Cycles?)

Keynes was highly critical of the British government at the time. The government cut welfare spending and raised taxes to balance the national books. Keynes said this would not encourage people to spend their money, thereby leaving the economy unstimulated and unable to recover and return to a successful state. Instead, he proposed that the government spend more money, which would increase consumer demand in the economy. This would in turn lead to an increase in overall economic activity, the natural result of which would be deflation and a reduction in unemployment.

Keynes also criticized the idea of excessive saving unless it was for a specific purpose such as retirement or education. He saw it as dangerous for the economy because the more money sitting stagnant, the less money in the economy stimulating growth. This was another of Keynes' theories geared toward preventing deep economic depressions.

Both classical economists and free-market advocates have criticized Keynes' approach. These two schools of thought assume that the market is self-regulating and natural forces will inevitably return it to a state of equilibrium. On the other hand, Keynes, who was writing while mired in a period of deep economic depression, was not as optimistic about the natural equilibrium of the market. He believed the government was in a better position than market forces when it came to creating a robust economy.

Keynesian Economics and the Multiplier Effect

The multiplier effect is one of the chief components of Keynesian economic models. According to Keynes' theory of fiscal stimulus, an injection of government spending eventually leads to added business activity and even more spending. This theory proposes that spending boosts aggregate output and generates more income. If workers are willing to spend their extra income, the resulting growth in gross domestic product( GDP) could be even greater than the initial stimulus amount.

The magnitude of the Keynesian multiplier is directly related to the marginal propensity to consume. Its concept is simple: Spending from one consumer becomes income for another worker. That worker's income can then be spent and the cycle continues. Keynes and his followers believed individuals should save less and spend more, raising their marginal propensity to consume, to effect full employment and economic growth.

In this way, one dollar spent in fiscal stimulus eventually creates more than one dollar in growth. This appeared to be a coup for government economists, who could provide justification for politically popular spending projects on a national scale.

This theory was the dominant paradigm in academic economics for decades. Eventually, other economists, such as Milton Friedman and Murray Rothbard, showed that the Keynesian model misrepresented the relationship between savings, investment and economic growth. Many economists still rely on multiplier-generated models, although most acknowledge that fiscal stimulus is far less effective than the original multiplier model suggests.

The fiscal multiplier commonly associated with Keynesian theory is one of two broad multipliers in macroeconomics. The other multiplier is known as the money multiplier. This multiplier refers to the money-creation process that results from a system of fractional reserve banking. The money multiplier is less controversial than its Keynesian fiscal counterpart.

Keynesian Economics and Interest Rates

Keynesian economics focuses on demand-side solutions to recessionary periods. The intervention of government in economic processes is an important part of the Keynesian arsenal for battling unemployment, underemployment and low economic demand. The emphasis on direct government intervention in the economy places Keynesian theorists at odds with those who argue for limited government involvement in the markets. Lowering interest rates is one way governments can meaningfully intervene in economic systems, thereby generating active economic demand. Keynesian theorists argue that economies do not stabilize themselves very quickly and require active intervention that boosts short-term demand in the economy. Wages and employment, they argue, are slower to respond to the needs of the market and require governmental intervention to stay on track.

Prices also do not react quickly, and only gradually change when monetary policy interventions are made. This slow change in prices, then, makes it possible to use money supply as a tool and change interest rates to encourage borrowing and lending. Short-term demand increases initiated by the government reinvigorate the economic system and restore employment and demand for services. The new economic activity feeds a circular, cyclical growth that maintains continued growth and employment. Without intervention, Keynesian theorists believe, this cycle is disrupted and market growth becomes more unstable and prone to excessive fluctuation. Keeping interest rates low is an attempt to stimulate the economic cycle by encouraging businesses and individuals to borrow more money. When borrowing is encouraged, businesses and individuals often increase their spending. This new spending stimulates the economy. Lowering interest rates, however, does not always lead directly to economic improvement.

Keynesian economists focus on lower interest rates as a solution to economic woes, but they generally try to avoid the zero-bound problem. As interest rates approach zero, stimulating the economy by lowering interest rates becomes more difficult. Interest rate manipulation may no longer be enough to generate new economic activity, and the attempt at generating economic recovery may stall completely.

Japan's Lost Decade during the 1990s is believed by many to be an example of this liquidity trap. During this period, Japan's interest rates remained close to zero but failed to stimulate the economy. 

The lower boundary of interest rates, then, is not necessarily an aspiration of Keynesian economists, but is rather a means to an end. When this method fails to deliver results, other strategies must be appropriated. Other interventionist policies include direct control of the labor supply, changing tax rates to increase or decrease the money supply indirectly, changing monetary policy, or placing controls on the supply of goods and services until employment and demand are restored. Keynesian theorists believe in interventionist methods, but are occasionally forced to look beyond interest rates.