what is keynesian economics 
keynesian economics is a macroeconomic theory of total spending in the economy and its effects on output employment and inflation it was developed by british economist john maynard keynes during the 1930s in an attempt to deal with the effects of the great depression the central belief of keynesian economics is that government intervention can stabilize the economy keynes theory was the first to sharply separate the study of economic behavior and individual incentives from the study of broad aggregate variables and constructs based on his theory keynes advocated for 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 could be prevented by influencing aggregate demand through economic intervention by the government keynesian economists believe that such intervention can result in full employment and price stability jessica olah investopediaunderstanding keynesian economicskeynesian economics represented a new way of looking at spending output and inflation previously classical economic thinking held that cyclical swings in employment and economic output create profit opportunities that individuals and entrepreneurs would have an incentive to pursue in so doing they would correct imbalances in the economy according to keynes view of this so called 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 1however keynes believed that the depth and persistence of the great depression severely tested this hypothesis 1in his book the general theory of employment interest and money and other works keynes argued against this construct of classical theory asserting that during recessions business pessimism and certain characteristics of market economies would exacerbate economic weakness and cause aggregate demand to plunge further than it already had 1for example keynesian economics disputes the notion held by some economists that lower wages can restore full employment because labor demand curves slope downward like any other normal demand curve 1similarly 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 also would have the effect of reducing overall expenditures and employment 2keynesian economics and the great depressionkeynesian economics is sometimes referred to as depression economics as keynes general theory was written during a time of deep depression not only in his native united kingdom but worldwide the famous 1936 book was informed by keynes understanding of events arising during the great depression which keynes believed could not be explained by classical economic theory as he portrayed it in his book other economists had argued that in the wake of any widespread downturn in the economy businesses and investors taking advantage of lower input prices in pursuit of their own self interest would return output and prices to a state of equilibrium unless otherwise prevented from doing so keynes believed that the great depression seemed to counter this theory 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 argued that once an economic downturn sets in for whatever reason the fear and gloom that it engenders among businesses and investors will tend to become self fulfilling and can lead to a sustained period of depressed economic activity and unemployment in response to this keynes advocated a countercyclical fiscal policy by which during periods of economic woe the government should undertake deficit spending to make up for the decline in investment and boost consumer spending to stabilize aggregate demand 2keynes was highly critical of the british government at the time 3 the government greatly increased welfare spending and raised taxes to balance the national books keynes said that this would not encourage people to spend their money thereby leaving the economy unstimulated and unable to recover and return to a successful state 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 more money sitting stagnant meant less money in the economy stimulating growth 4 this view was tied to another of keynes theories geared toward preventing deep economic depressions many economists have criticized keynes approach they argue that businesses responding to economic incentives will tend to return the economy to a state of equilibrium unless the government prevents them from doing so by interfering with prices and wages and making it appear as though the market is self regulating on the other hand keynes who was writing while the world was mired in a longstanding period of deep economic depression was not as optimistic about the natural equilibrium of the market he believed that the government was in a better position than market forces when it came to creating a robust economy keynes proposed that the government spend more money and cut taxes which would increase consumer demand in the economy this would in turn lead to an increase in overall economic activity and a reduction in unemployment 2keynesian economics and fiscal policythe multiplier effect developed by keynes student richard kahn is one of the chief components of keynesian countercyclical fiscal policy 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 5the magnitude of the keynesian multiplier is directly related to the marginal propensity to consume spending by consumers becomes income for businesses that then spend on equipment worker wages energy materials purchased services taxes and investor returns workers income can then be spent and the cycle continues keynes and his followers believed that individuals should save less and spend more raising their marginal propensity to consume to effect full employment and economic growth keynes fiscal stimulus theory was the dominant paradigm in academic economics for decades eventually though other economists such as milton friedman and murray rothbard showed that the keynesian model misrepresented the relationship between savings investment and economic growth 6 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 the keynesian theory is one of two broad multipliers in economics 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 7 the money multiplier is less controversial than its keynesian fiscal counterpart according to the multiplier effect 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 now provide justification for politically popular spending projects on a national scale keynesian economics and monetary policykeynesian 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 often places keynesian theorists at odds with those who argue for limited government involvement in the markets wages and employment keynesians argue are slower to respond to the needs of the market and require government intervention to stay on track furthermore they argue prices do not react quickly and change only gradually when monetary policy interventions are made giving rise to a branch of keynesian economics known as monetarism 8if prices are slow to change this makes it possible to use the money supply as a tool and change interest rates to encourage borrowing and lending lowering interest rates is one way that governments can meaningfully intervene in economic systems thereby encouraging consumption and investment spending 8short term demand growth initiated by interest rate cuts reinvigorates the economic system and restores employment and demand for services the new economic activity then feeds continued growth and employment 2without 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 they then spend the money that they borrow this new spending stimulates the economy lowering interest rates however does not always lead directly to economic improvement monetarist economists focus on managing the money supply and lowering 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 less effective because it reduces the incentive to invest rather than simply hold money in cash or close substitutes like short term treasurys 9interest rate manipulation may no longer be enough to generate new economic activity if it can t spur investment and the attempt at generating economic recovery may stall completely this is a type of liquidity trap 