Keynesian economics

Keynesian economics

John Maynard Keynes, a British economist who founded his own body of economic theory, is regarded as the founder of modern macroeconomics. Keynes’ economic theories from the early 1900s significantly influenced both economic theory and governments’ economic policies. 

What is Keynesian economics? 

Sometimes referred to as demand-side economics, Keynesian economics is a theory of macroeconomics that studies all economic expenditure and how it impacts the economy’s production, employment, and inflation. It was named after British economist John Maynard Keynes. It generally focuses on the role of aggregate demand in determining economic output and inflation. 

Understanding Keynesian economics 

Keynesian economics is based on the principle that the government can help to stabilise the economy by using fiscal and monetary policies. These policies are used to influence the level of aggregate demand in the economy.  

Demand is crucial and usually unpredictable in Keynesian economics. Keynes noted that because the decline is driven by demand, wealth of entire economies may decrease even if their ability to create did not. 

Keynes argued against his construction of the classical theory in his book The General Theory of Employment, Interest and Money and other writings. He claimed that during recessions, business pessimism and specific traits of market economies would worsen economic downturns and end up causing aggregate demand to fall even further. 

Keynesian economics, for instance, challenges the belief of certain economists that full employment can be restored by lowering wages since labour demand curves slope downwards like any other typical demand curve. 

Similarly, unfavourable economic conditions could lead businesses to cut back on capital expenditures rather than buy new plants and machinery at reduced rates. Moreover, this would result in less total spending and employment. 

Keynesian economics aims to use government intervention to stabilise the economy and avoid the extreme ups and downs of the business cycle.  

History of Keynesian economics 

Existing economic theory could not give an acceptable public policy response to jump-start employment and production during the Great Depression of the 1930s, nor could it explain the reasons for the severe global economic downfall. 

John Maynard Keynes prompted a change in economic theory that disproved the then-dominant concept that free markets would automatically produce full employment, i.e., that everyone who desired employment would be able to find one as long as workers were willing to be flexible in their wage demands.  

The key plank of Keynes’s theory, for which he is best known, is the claim that aggregate demand, which is determined by adding up consumer, company, and governmental spending, is the most significant economic engine. 

Keynes further argued that free markets lack self-balancing mechanisms that provide full employment. Keynesian economists defend government intervention by promoting public policies that target price stability and full employment. 

Keynesian economics also asserted that aggregate demand is the most important determinant of economic output and inflation. Keynesian economics also argues that government spending can help stimulate the economy in a recession. 

New Keynesian theory 

A modern macroeconomic school of thinking, New Keynesian economics is an evolution of classical Keynesian economics. This updated theory deviates from classic Keynesian thought in terms of how rapidly prices and wages adapt. 

There are two fundamental underlying assumptions in new Keynesian economics. First, individuals and organisations exhibit rational behaviour and have reasonable expectations. Second, new Keynesian economics makes several assumptions about market inefficiencies, such as fixed wages and imperfect competition. 

Among other things, the new Keynesian theory sought to explain why prices move slowly and what causes them, as well as how market failures might be caused by inefficiencies and may call for government intervention. The advantages of government involvement are still a heated issue. In support of an expansionary monetary policy, New Keynesian economists argued that deficit spending promotes saving rather than raising demand or stimulating the economy. 

However, New Keynesian economics received criticism in some areas for failing to predict the Great Recession adequately and to account for the subsequent era of secular stagnation. 

Examples 

Barack Obama’s response to the world financial crisis started in 2007 is an illustration of the Keynesian theory in action. The Great Recession of the mid-2000s saw the implementation of substantial fiscal policies by President Obama. 

The American Recovery and Reinvestment Act, a $787 billion government stimulus plan intended to preserve current employment and generate new ones, was signed by President Obama in February 2009. Notwithstanding differences in opinion over the Recovery Act’s efficacy, most economists concurred that unemployment at the end of 2010 was less than it would have been without the stimulus package. 

Frequently Asked Questions

One major difference between the two is that although a supply-sider believes that producers and their desire to provide goods and services determine the rate of economic development, A true Keynesian claims to believe that consumers and their demand for products and services are significant economic drivers. 

The Keynesian solution for inflation is twofold:  

  • Tax increases or government spending must be decreased to stimulate aggregate demand. 
  • The money supply must be increased to increase the supply of money. 

The first part of the Keynesian solution is to decrease government spending. This will help to increase aggregate demand and, in turn, help to boost economic activity. The second part of the Keynesian solution is to increase the money supply. This will help increase the money supply and, in turn, help keep prices stable. 

The two main ideas of Keynesian economics are as follows. 

  • First, a short-run economic situation like a recession is more likely to have aggregate demand as its main cause than aggregate supply.  
  • Second, in a downturn in the economy, unemployment may occur due to sticky wages and prices. 

Unemployment benefits, government expenditures on infrastructure, and education are the three basic tools of Keynesian theory. 

 

Keynesian economics, by John Maynard Keynes in the 1930s, significantly influenced post-World War II economies in the middle of the 20th century. His beliefs have been criticised since the 1970s, resurfaced in the 2000s, and are still debated today. 

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