Keynesian economics definition and explanation

Keynesian economics: Definition and explanation

Keynesian economics is a school of thought in economics comprising several macroeconomic theories based on the work of British economist John Maynard Keynes, specifically on his 1936 book “The General Theory of Employment, Interest, and Money.”

Take note that Keynes wrote the aforementioned book in an attempt to explore and understand the causes of the Great Depression of the 1930s. Theories from classical economics and supply-side economics failed to explain the causes of this global economic downturn and provide a suitable public policy solution to stimulate production and employment.

Keynes provided an alternative perspective that challenged the different assumptions and arguments of classical economics, as well as other schools of thought in economics. Nonetheless, due to its impact during the Great Depression, Keynesian economics is sometimes referred to as depression economics.

What is Keynesian Economics: Assumptions and Arguments

1. Demand-Side Theory of Economic Growth

Supply-side economics argues that the most effective way to boost the economy is through the promotion of business growth by lowering taxes and decreasing regulations. Furthermore, a higher supply of low-priced goods and services in the market will increase employment and thus, boost productivity further.

However, according to Keynesian economics, economic growth is determined by aggregate demand or the total demand for goods and services within an economy because it supports and bolsters production and employment. This demand comes from four major components: consumption, investment, government expenditures, and net exports. In other words, to keep the economy afloat, demand must be maintained or improved.

2. Boom-And-Bust Cycle in the Free-Market

The primary assumption of classical economics is that a free-market capitalist economic system is a self-regulating economic system governed by the natural laws of production and exchange. For instance, the law of supply and demand allows the self-regulation of the business cycle. Thus, this school of thought in economics promotes a laissez-faire system in which the government has a very limited role in shaping the direction of the economy.

During an economic downturn, classical economics assumes that output and prices will eventually revert to a state of equilibrium because of the self-regulating nature of the free market. However, this was not the case during the Great Depression. Keynes argued that market economies undergo a boom-and-bust cycle. Essentially, economies are constantly in flux, both contracting and expanding. An economy sometimes behaves erratically, thus affecting production, employment, and inflation.

3. Government Interventions in the Economy

Of course, prior to the prevalence of Keynesian-based policies during and after the Great Depression, proponents of classical economics warned that government-induced economic stimulation through spending is dangerous because it discourages business investments, Essentially, government spending requires government borrowing, which then competes with business borrowings. The high demand for debt increases the interest rates, thus making borrowing expensive.

Keynesian economics has an opposing view. Because aggregate demand determines economic growth, and because government expenditure is one of the four major components of demand, then the government should play a direct role to boost and maintain demand. Government spending would increase demand. Some of the resulting economic or more specifically, fiscal policies emerging from this view include government spending on infrastructure, unemployment benefits, and education, among others. During an economic recession, the government can stimulate the economy through expenditures to boost demand and thereby, to promote production and employment.

4. The Keynesian Multiplier

The Keynesian multiplier or the multiplier effect is a model that represents how much demand each unit of currency of government spending generates. For instance, a multiplier of two involves $2.00 of gross domestic product for every $1.00 of government spending. Essentially, a dollar spent by the government creates more than one dollar in growth.

Central to the Keynesian multiplier model is an assumption that government spending ultimately leads to added business activity that in turn, leads to even more spending. Spending from the government becomes income for the public. Such income would promote consumer confidence. As consumers spend their earnings once again, the money they shell out becomes income for workers. This cycle continues until employment rate normalizes and economic growth stabilizes.

Special Note: Government Spending According to Keynesian Economics

Undeniably, one of the key contributions of Keynesian economics centers on the promotion and subsequent creation of economic policies that involve government intervention in the economy. Remember that this school of thought in economics argues that market economies constantly undergo a boom-and-bust cycle.

During the boom phase, Keynesian economics prescribes that the government should increase taxes to take advantage of the prospering business activities or cut spending to save public funds. However, during the bust phase or a period of economic downturn, the government should pursue deficit spending in which its expenditures are higher than the revenues it collects through taxation.

Excessive government spending during economic downturns can stimulate the economy, particularly by offsetting the negative impacts of reduced consumer spending on aggregate demand. Proponents of Keynesian economics believe that during the bust phase, people refuse to consume in an attempt to save money, thus resulting in the further contraction of economic activity due to reduced demand and thereby, reduced production that eventually affects employment.

Government expenditures will promote and sustain demand and thereby, bolster production to sustain employment or resolve high unemployment. To be specific, the multiplier effect illustrates that when a government spends, it creates employment that in turn, regenerates the buying power of the people and rejuvenates consumer confidence. Demand from the government and eventually, the public will further bolster employment rates until the economy goes back to the boom phase.

A downside of excessive expenditures by the government is inflation due to demand-pull inflation or an increase in aggregate demand. Such an increase in demand might stem from government spending, consumption by the public, increase in private investments, and the revitalizing of exports. However, once the economy stabilizes based on the normalization of production and employment activities due to government-influenced demand, the government can simply revert to raising taxes to relax consumption by the public and cut its spending to decrease government-influenced demand.