Why is keynesian economics important

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Recommend Tweet Send via mail Print. Keynesianism — then and now. In depth Zoom. John Maynard Keynes — was probably the most important economist of the 20th century. Analysing the Great Depression, which started in , he introduced a new paradigm: governments must borrow money and increase their spending in economic downturns in order to prevent a recession from becoming a self-enforcing depression.

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Keynesian economics was developed by the British economist John Maynard Keynes during the s in an attempt to understand the Great Depression. Keynesian economics is considered a "demand-side" theory that focuses on changes in the economy over the short run. 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 prevented—by influencing aggregate demand through activist stabilization and economic intervention policies by the government.

Keynesian economics represented a new way of looking at spending, output, and inflation. Previously, what Keynes dubbed 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, and in so doing correct the imbalances in the economy.

A lower level of inflation and wages would induce employers to make capital investments and employ more people, stimulating employment and restoring economic growth. Keynes believed that the depth and persistence of the Great Depression, however, severely tested this hypothesis. In his book, The General Theory of Employment, Interest, and Money and other works, Keynes argued against his construction of classical theory, that during recessions business pessimism and certain characteristics of market economies would exacerbate economic weakness and cause aggregate demand to plunge further.

For 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.

Instead he argued that employers will not add employees to produce goods that cannot be sold because demand for their products is weak. Similarly, 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 would also have the effect of reducing overall expenditures and employment. Keynesian economics is sometimes referred to as "depression economics," as Keynes's General Theory was written during a time of deep depression not only in his native land of the United Kingdom but worldwide.

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 in which, during periods of economic woe, the government should undertake deficit spending to make up for the decline in investment and boost consumer spending in order to stabilize aggregate demand. Keynes was highly critical of the British government at the time.

The government greatly increased welfare spending and raised taxes to balance the national books. Keynes said this would not encourage people to spend their money, thereby leaving the economy unstimulated and unable to recover and return to a successful state.

Instead, he proposed that the government spend more money and cut taxes to turn a budget deficit, 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. 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 the more money sitting stagnant, the less money in the economy stimulating growth.

This was another of Keynes's theories geared toward preventing deep economic depressions. Many economists have criticized Keynes's 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, 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 period of deep economic depression, was not as optimistic about the natural equilibrium of the market.

He believed the government was in a better position than market forces when it came to creating a robust economy. According to Keynes's theory of fiscal stimulus, an injection of government spending eventually leads to added business activity and even more spending.

Some decades ago, economists heatedly debated the relative strengths of monetary and fiscal policies, with some Keynesians arguing that monetary policy is powerless, and some monetarists arguing that fiscal policy is powerless.

Both of these are essentially dead issues today. Nearly all Keynesians and monetarists now believe that both fiscal and monetary policies affect aggregate demand.

A few economists, however, believe in debt neutrality—the doctrine that substitutions of government borrowing for taxes have no effects on total demand more on this below. According to Keynesian theory, changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-run effect on real output and employment, not on prices.

This idea is portrayed, for example, in phillips curves that show inflation rising only slowly when unemployment falls. Keynesians believe that what is true about the short run cannot necessarily be inferred from what must happen in the long run, and we live in the short run.

Monetary policy can produce real effects on output and employment only if some prices are rigid—if nominal wages wages in dollars, not in real purchasing power , for example, do not adjust instantly.

Otherwise, an injection of new money would change all prices by the same percentage. So Keynesian models generally either assume or try to explain rigid prices or wages.

Rationalizing rigid prices is a difficult theoretical problem because, according to standard microeconomic theory, real supplies and demands should not change if all nominal prices rise or fall proportionally. But Keynesians believe that, because prices are somewhat rigid, fluctuations in any component of spending—consumption, investment , or government expenditures—cause output to fluctuate. If government spending increases, for example, and all other components of spending remain constant, then output will increase.

Keynesian models of economic activity also include a so-called multiplier effect; that is, output increases by a multiple of the original change in spending that caused it. Thus, a ten-billion-dollar increase in government spending could cause total output to rise by fifteen billion dollars a multiplier of 1. Contrary to what many people believe, Keynesian analysis does not require that the multiplier exceed 1.

For Keynesian economics to work, however, the multiplier must be greater than zero. Keynesians believe that prices, and especially wages, respond slowly to changes in supply and demand, resulting in periodic shortages and surpluses, especially of labor. No policy prescriptions follow from these three beliefs alone. And many economists who do not call themselves Keynesian would nevertheless accept the entire list.

What distinguishes Keynesians from other economists is their belief in the following three tenets about economic policy. Keynesians do not think that the typical level of unemployment is ideal—partly because unemployment is subject to the caprice of aggregate demand, and partly because they believe that prices adjust only gradually. In fact, Keynesians typically see unemployment as both too high on average and too variable, although they know that rigorous theoretical justification for these positions is hard to come by.

Keynesians also feel certain that periods of recession or depression are economic maladies, not, as in real business cycle theory, efficient market responses to unattractive opportunities. Many, but not all, Keynesians advocate activist stabilization policy to reduce the amplitude of the business cycle, which they rank among the most important of all economic problems.

Here, however, even some conservative Keynesians part company by doubting either the efficacy of stabilization policy or the wisdom of attempting it. This does not mean that Keynesians advocate what used to be called fine-tuning—adjusting government spending, taxes, and the money supply every few months to keep the economy at full employment.

Almost all economists, including most Keynesians, now believe that the government simply cannot know enough soon enough to fine-tune successfully. Three lags make it unlikely that fine-tuning will work. First, there is a lag between the time that a change in policy is required and the time that the government recognizes this. Second, there is a lag between when the government recognizes that a change in policy is required and when it takes action.

In the United States, this lag can be very long for fiscal policy because Congress and the administration must first agree on most changes in spending and taxes. The third lag comes between the time that policy is changed and when the changes affect the economy. This, too, can be many months. Yet many Keynesians still believe that more modest goals for stabilization policy—coarse-tuning, if you will—are not only defensible but sensible.

For example, an economist need not have detailed quantitative knowledge of lags to prescribe a dose of expansionary monetary policy when the unemployment rate is very high. Finally, and even less unanimously, some Keynesians are more concerned about combating unemployment than about conquering inflation.