Keynesian economics

Keynesian economics (aka Keynesianism) is a theory based on the ideas of John Maynard Keynes, as put forward in his book The General Theory of Employment, Interest and Money, published in 1936.

The key central conclusion of Keynesian economics is that there is no strong automatic tendency for the level of output and employment in the economy to move toward the full employment level. This contrasts with the conclusion in neoclassical economics that adjustment in prices and interest rates would tend to produce full employment in the economy, often known as Say's law[?].

Historical background

Keynes developed these ideas in response to debate about the British economy that had started even before the Great Depression began in 1929. The nation had not achieved full employment since the end of World War I, and the neoclassical theory (referred to as 'Classical' by Keynes) suggested that it should have. In the neoclassical theory, departures from full employment were generally seen as short term aberrations, but during this period mass unemploment had become a persistent phenomenon in several economies across the world.

Keynes' theory

Keynes explained the level of output and employment in the economy as being determined by Aggregate Demand. Aggregate demand is the total demand for goods and services in the economy. In neoclassical theory, adjustments in prices, in particular wage and interest rates, would automatically make aggregate demand tend to the full employment level. Keynes' analysis suggested that these tendencies would be weak or non-existent.

In the neoclassical theory, two elements of an economic system were supposed to produce a state of full employment. First, the push and pull of supply and demand set the price of goods, and the constant shifting of price allowed the two forces to equalize. Second, when the system produced extra wealth, it could be either saved for future consumption or invested in future production, and there was a system of supply and demand that affected this choice too. The interest rate on savings behaved like a price, equalizing the supply and demand of investment funds.

Even in the worst years of the Depression, this theory defined economic collapse as the loss of incentives to produce. The proper solution was to reduce the price of labor to subsistence levels, causing prices to fall so that buying would pick up. Funds not paid out in wages would be available for investment, perhaps in other sectors. Plant closures and layoffs were a necessary medicine.

In Keynes' view, this analysis offered no way out of a system-wide collapse. Lowering wages would make capital available for investment - but it would also lower consumption, so the total demand for goods would drop. Investment in new production would then become more risky, less likely. There was no reason to imagine that one effect would outrun the other.

{this needs to be explained better... analysis of labour market, sticky prices, liquidity preference theory}

Although Keynes' theory suggested that the economy need not automatically tend towards full employment, it also suggested that active government policy could be effective in managing the economy. Keynes advocated counter-cyclical fiscal policies: deficit spending when a nation's economy was sluggish and the surpression of inflation in boom times by either increasing taxes or cutting back on government. His macroeconomic model offered a way of calculating the equilibrium state of an economy and defining inflation and recession as departures from it; thus policy could proceed from analysis.

This contrasted with the neoclassical analysis of Government intervention in the economy. It was always clear that government work was an alternative. It could increase wages temporarily and therefore increase the demand for goods, stimulating production. But there was no reason to believe that this stimulation would outrun the side effects that discouraged investment - the government, competing with private interests, would be bidding up the wage rate, and so forth, leading to no overall increase in economic activity. The underlying assumption was that capital had to be directed to increasing productive capacity. A public-works program diverted capital from its proper job.

Two details of the model had implications for policy:

First, there is the "Keynesian multiplier." In his way of tracking aggregate national production, Keynes found that increases in consumption do not equal increases in production. The effect on production is always a multiple of the increase in spending. Thus a government could stimulate a great deal of new production with each modest outlay.

Second, Keynes re-analyzed the effect of the interest rate on investment. In the standard model, the interest rate determined the supply of funds available for investment. For Keynes, the supply depends on the productivity of the system, the very thing that his fiscal proposals were intended to affect. (In this re-definition, the interest rate depends on the preference that people have about holding onto money, the ratio of money held to the total amount of money in circulation. This view opens the possibility of regulating the economy through changes in the money supply, but Keynes argued that this approach would be relatively ineffective compared to the use of fiscal policy.)

Subsequent developments in Keynesian thought

In the post war years, these policy ideas were widely accepted. For the first time, governments prepared good quality economic statistics on an ongoing basis, and attempted to use fiscal and monetary policy to manage the economy. These policies were apparently successful, with most western countries enjoying low, stable unemployment and modest inflation.

Keynesian analysis was combined with neoclassical economics in mainstream economic thought. A widely held view was that there was indeed no strong automatic tendency to full employment, but that if government policy were used to ensure full employment, the economy would behave as neoclassical theory predicted. This combination of Keynesian and Neoclassical ideas, sometimes called the Neoclassical Synthesis, became the standard textbook analysis and came to dominate mainstream economic thought.

These ideas began to lose favour in the 1970s. During this time, many economies experienced high and rising unemployment, coupled with high and rising inflation. The typical textbook Keynesian analysis suggested that government policy should be used to stimulate demand in response to the unemployment, but reduce it in response to inflation, leading to a contradiction. Attempts to resolve this led to Keynesian ideas losing favour to new ideas based upon neoclassical analysis, including monetarism and new classical economics.

More recently, there has been a revival in Keynesian ideas, with particular emphasis on giving the Keynesian macroeconomic analysis theoretically sound foundations in microeconomics. These theories have been called new Keynesian economics. The Radical journalist and economist Will Hutton[?], regards Gordon Brown, as being the first "real" Keynesian Chancellor of the Exchequer, although an argument could be made for Stafford Cripps[?] and Roy Jenkins.

See also economics, macroeconomics, monetarism