Keynesian economics comes from the theories of John Maynard Keynes. In a nutshell it believes that economic performance is determined by aggregate demand – net spending in the economy. Aggregate demand is the total amount of goods and services purchased in an economy by consumers, companies and government bodies, including foreign participants (also called total spending).
The central tenet of Keynesian Economics is that government intervention can stabilize the economy.
In Keynesian economics aggregate demand is not always equal to the productive capacity of the economy. Alternatively, aggregate demand is determined by a number of factors and behaves irregularly, directly affecting employment and inflation.
Keynesian economics was theorized during the 1930s by the British economist John Maynard Keynes (1883-1946) in an effort to determine what caused the Great Depression.
The Great Depression started in 1929 and lasted for most of the 1930s. It was the most severe, longest-lasting, and most widespread depression of the 20th century. From 1929 to 1932, global GDP shrank by 15%. Unemployment in the United States reached 25%, and 33% in some advanced economies.
At the time Keynes proposed raising government spending and reducing taxes to increase demand and end the Great Depression that had devastated so many countries.
Reduce interest rates and spend
He published all his thoughts in a book, titled “The General Theory of Employment, Interest and Money”, which was published in 1936.
His solution to the Great Depression was to save the economy by:
- Reducing interest rates.
- Increasing government investment in infrastructure.
By reducing the interest rate that the central bank lends money to commercial banks, the government is instructing commercial banks to do the same for their customers.
Keynesian economics advocates a mixed economy that is driven by the private sector, but requires the government to intervene during times of economic decline.
People who follow Keynesian economics often say that decisions made by the private sector can sometimes trigger bad macroeconomic outcomes, which in turn requires the public sector to intervene with active policy responses, such as, monetary policy actions and fiscal policy actions by the government.
Fiscal policy refers to government spending and the collection of taxes.
After the Great Depression, Keynesian economics became the standard economic model in the developed nations. It lost some influence during the stagnation of the 1970s. However, after the global financial crisis in 2008, it made a comeback.
Keynes challenged Adam Smith’s theory
Before Keynes publicized his General Theory, most economists believed that there was a state of general equilibrium in the economy, as the needs of consumers were thought to be greater than the capacity of the producers to satisfy those needs.
Before Keynes’ General Theory emerged, economists had believed that all products and services that are produced will be bought when they are appropriately priced, and that the cyclical swings in economic output and employment would self-adjust naturally.
Keynes’ view that governments have a major role to play in economic management clashed with the laissez-faire economics of Adam Smith, who said that economies work best when markets are left free of state intervention.
The International Monetary Fund writes the following about John Maynard Keynes:
“He remembered the lessons from Versailles and from the Great Depression, when he led the British delegation at the 1944 Bretton Woods conference—which set down rules to ensure the stability of the international financial system and facilitated the rebuilding of nations devastated by World War II.”
“Along with U.S. Treasury official Harry Dexter White, Keynes is considered the intellectual founding father of the International Monetary Fund and the World Bank, which were created at Bretton Woods.”
“Keynes stated that if Investment exceeds Saving, there will be inflation. If Saving exceeds Investment there will be recession. One implication of this is that, in the midst of an economic depression, the correct course of action should be to encourage spending and discourage saving. This runs contrary to the prevailing wisdom, which says that thrift is required in hard times. In Keynes’s words, “For the engine which drives Enterprise is not Thrift, but Profit.”
Video – Keynesian Economics