Keynesian Economic Theory – Definition

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Keynesian Economic Theory Definition

Keynesian economics was developed in the 1930s by John Maynard Keynes in the period of the Great Depression. It is an economics model that maintains that an economic output is greatly influenced by the total demand in the economy. This means that the aggregate demand and spending in an economy has impacts on the output as well as inflation in the economy.

According to Keynes’ economic model, optimal economic performance is achievable but to advise this, aggregate demand and increased expenditure must be stimulated in an economy.

During the Great Depression, Keynes advocated that the government should increase its expenditures (spending) and also facilitate demand in order tos pull the economy out of depression.

A Little More on Keynesian Economics

Keynesian economics was tested when the Great Depression was at its depth and severity. Keynesian economics is a theory about how positive changes can occur in an economy in the short run, through an aggregate demand and the economic intervention of the government.

The Keynesian economics is regarded as a ‘demand-side’ theory, this is because it advocates that government should lower taxes so that there will be  increased demand which in in turn restore optimal economic growth.

Keynesian economics is a new approach for studying spending, output and inflation in an economy. Keynes maintains that an economy with no aggregate demand would witness weak production and high rates of unemployment, which will in turn cause a decline in prices and wages.

Keynesian Economics and the Great Depression

Due to its relevance during the Great Depression, Keynesian economics is sometimes called the “depression economics”. Keynes, a British economist who developed this theory wrote a famous book in 1936, called  “The General Theory of Employment, Interest and Money.” The subject matters that Keynes explained in this book went beyond the expansion of classical economic theories.

Keynesian economics was put into use during the Great Depression and it countered the assumption by classical economist that output and prices will return to a natural state of equilibrium. Opposed to this assumption, Keynes maintains that the government should adopt a countercyclical fiscal policy during prosperous economic periods and deficit spending should be adopted during an economic and financial crisis.

According to this theory, when government spends more money, demands will increase which will translate to deflation and reduced rate of unemployment as well as an improved economy.

Unlike classical economists and advocates of free markets that believe that natural market forces will help output and prices return to a state of equilibrium, Keynes holds that government’s countercyclical fiscal policies are more effective than market forces in the creation of a robust and prosperous economy.

Keynesian economics is one that sees no justification for excessive saving, unless the saving is targeted at a cogent need. This is because if money is left in a vault stagnant, it is dangerous for economic growth. Government should instead spend more money to stimulate economic growth and prevent financial crisis or economic depressions.

Keynesian Economics and the Multiplier Effect

Keynesian economics has the Multiplier Effect as one of its central components. The multiplier effect is a theory that states that a change in an input (such as spending more money) , as it causes a higher increase in output and customer’s demand. Fiscal stimulus as Keynes’ theory maintains that spending (expenditure) increases outputs and income which will positively affect the gross domestic product (GDP) of an economy.

The Keynesian multiplier effect states that spending from one consumer serves as an income for another worker, while the worker also spends his income, and the cycle continues. Hence, one dollar spent creates more than one dollar in terms of growth. The Keynesian fiscal multiplier however generated much controversy, economists like Milton Friedman and Murray Rothbard, maintained that this model misrepresented the connection  between savings, investment and economic growth.

Keynesian Economics and Interest Rates

Keynesian economics is one that places value on the intervention of government as this provides remedy for financial woes and economic crisis. This model focuses on lower interest rates as an essential way to escape from economic woes. Lowering interest rates is a major government intervention that is needed in economic processes. Without an active intervention, it is believed that economic cycle can be interrupted which will cause economic woes such as that of the Great Depression.

Low interest rates stimulate demand in the economy, wages and employment also react positively to low interest rates. According to Keynesian theorists, wages, employment and prices respond slowly to the needs of the market, hence, an effective intervention is needed to enhance short-term demand in the economy.

Although lowering the interest rates does not automatically translate to an improvement in the economy, low interest rates encourage borrowing. When businesses and individuals borrow, they also increase their spending which helps the economy.

Despite the enticing benefits of low interest rates in an economy, this might not enhance improvement in the economy. Keynesian theorists often avoid zero-bind problems when advocating low interest rates, this is because low interest rates close to zero makes stimulating an economy a much difficult task.

For instance, in the 1990s, Japan’s interest rate was close to zero, instead of stimulating the economy, Japan lost so much during this period. An interest rate as such is then considered a ‘liquidity trap.’

Therefore, for Keynesian theorists, low interest rates in an economy is not the ultimate goal, rather, an aggregate demand must be maintained for restoration of the economy.

References for Keynesian Economic Theory

Academic Research on Keynesian Economic Theory

The Post-Keynesian approach to economics, Arestis, P. (1992).

The structure of Post-Keynesian Economics: the core contributions of the pioneers, Harcourt, G. C. (2016). In Post-Keynesian Essays from Down Under Volume IV: Essays on Theory (pp. 289-301). Palgrave Macmillan, London.

Foundations of post-Keynesian economic analysis, Lavoie, M. (1992).

Keynesian economics: the search for first principles, Coddington, A. (1976). Journal of Economic Literature, 14(4), 1258-1273.

Post-Keynesian economics: towards coherence, Arestis, P. (1996). Cambridge Journal of Economics, 20(1), 111-135.

Keynesian economics and general equilibrium theory: reflections on some current debates, Hahn, F. H. (1977). In The microeconomic foundations of macroeconomics (pp. 25-40). Palgrave Macmillan, London.

Post Keynesian economics: solving the crisis in economic theory, Davidson, L. (1990). In Money and Employment (pp. 279-299). Palgrave Macmillan, London.

An essay on post-Keynesian theory: a new paradigm in economics, Eichner, A. S., & Kregel, J. A. (1975). journal of Economic Literature, 13(4), 1293-1314.

The fall and rise of Keynesian economics, Blinder, A. S. (1988). Economic record, 64(4), 278-294.

The new Keynesian economics and the output-inflation trade-off, Ball, L., Mankiw, N. G., Romer, D., Akerlof, G. A., Rose, A., Yellen, J., & Sims, C. A. (1988). Brookings papers on economic activity, 1988(1), 1-82.

 

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