Keynesian economics is an economic theory based on the ideas of John Maynard Keynes (Jackson 29). First published in 1936, Keynes's theory suggests that general trends may overwhelm the micro-level behavior of individuals. He stated," This book is chiefly addressed to my fellow economists ... I myself held with conviction for many years the theories which I now attack, and I am not, I think, ignorant of their strong points" (Keynes). Keynes asserted the importance of the aggregate demand for goods as the driving factor, especially in downturns. From this he argued that government policies could be used to promote demand at a macro level, to fight high unemployment and deflation of the sort seen during the 1930s. Keynes thought that the economy was the most important issue of the time as evidenced by his statement, "The ideas of economists . . . are more powerful than is commonly understood. Indeed the world is ruled by little else" (Keynes). To further defend this point, he stated, "It is better that a man should tyrannize over his bank balance than over his fellow-citizens and whilst the former is sometimes denounced as being but a means to the latter, sometimes at least it is an alternative" (Keynes). A central conclusion of Keynesian economics is that there is no strong automatic tendency for output and employment to move toward full employment levels. This conflicts with classical economics, which assumes a general tendency towards equilibrium in a restrained money creation economy (Banguero 25).
John Maynard Keynes was one who perceived increasing cracks in the assumptions and theories that held sway at that time. He believed that his book on economic theory would "largely revolutionize not, I suppose, at once but in the course of the next ten years change the way the world thinks about economic problems" (Keynes). Keynes questioned two of the pillars of economic theory dominant: the need for a solid basis for money, generally a gold standard, and the theory, expressed as Say's Law which stated that decreases in demand would only cause price declines, rather than affecting real output and employment (Banguero 26). In his political views, Keynes was not revolutionary, but pro-business and pro-entrepreneur. He often argued that "... The importance of money essentially flows from its being a link between the present and the future" (Keynes).
Several principles are central to Keynesianism (Kant 109). The first principle suggests that aggregate demand is influenced by a host of economic decisions and sometimes behaves erratically. The public decisions include those on monetary and fiscal policy. A few economists, however, believe in what is called debt neutrality, the doctrine that substitutions of government borrowing for taxes have no effects on total demand. Keynes once stated, "The avoidance of taxes is the only intellectual pursuit that still carries any reward" (Keynes).
Next, changes in aggregate demand have their greatest short-run impact on real output and employment, not on prices. Keynesians believe the short run lasts long enough to matter, a principle Keynes coined as "short-run expectations." Keynes's once stated, "In the long run, we are all dead" to make the point (Keynes).
The third principle of Keynesian economics is the belief that anticipated monetary policy can produce real effects on output and employment only if some prices are rigid. Otherwise, an injection of new money would change all prices by the same percentage. Keynesian models generally typically assume or try to explain rigid prices or wages. Rationalizing rigid prices is hard to do because, according to standard microeconomic theory, real supplies and demands do not change if all nominal prices rise or fall proportionally (Banguero 26).
Keynesians believe that, because prices are somewhat rigid, fluctuations in any component of spending, i.e. consumption, investment, or government expenditures, cause output to fluctuate (Jackson 32). 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 "multiplier effect" (Keynes). That is, output increases by a multiple of the original change in spending that caused it. For example, a $10 billion increase in government spending could cause total output to rise by $15 billion (a multiplier of 1.5) or by $5 billion (a multiplier of 0.5). Contrary to many widespread beliefs, Keynesian analysis does not require that the multiplier exceed 1.0. For Keynesian economics to work, however, the multiplier must be greater than 0 (Kant 115).
The fourth principle of Keynesian economics is that prices and, especially wages, respond slowly to changes in supply and demand, resulting in shortages and surpluses, especially of labor. Even though monetarists are more confident than Keynesians in the ability of markets to adjust to changes in supply and demand, many monetarists accept the Keynesian position on this matter. Milton Friedman, for example, the most prominent monetarist, has written: "Under any conceivable institutional arrangements, and certainly under those that now prevail in the United States, there is only a limited amount of flexibility in prices and wages" (Friedman 58). In current dialect, that would certainly be called a Keynesian position.
Keynesians do not think that the typical level of unemployment is ideal, partly because unemployment is subject to the impulse of aggregate demand, and partly because they believe that prices adjust only gradually. 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 efficient market responses to unattractive opportunities.
Many Keynesians advocate activist stabilization policy to reduce the amplitude of the business cycle, which they rank among the most important of all economic problems (Banguero 29). This does not mean that Keynesians advocate what used to be called fine-tuning, or 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 cannot know enough soon enough to fine-tune successfully. Three "lags" (Keynes) make it unlikely that fine-tuning will work (Jackson 27).
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 is often 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. Many Keynesians still believe that more modest goals for stabilization policy are not only defensible, but also sensible.
Finally, many Keynesians are more concerned about combating unemployment than about conquering inflation. They have concluded from the evidence that the costs of low inflation are small. Contrarily, Keynes once stated, "By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens" (Keynes). Views on the relative importance of unemployment and inflation heavily influence the policy advice that economists give and that policymakers accept. Keynesians typically advocate more aggressively expansionist policies than non-Keynesians. Keynesians' belief in aggressive government action to stabilize the economy is based on value judgments and on the beliefs that (a) macroeconomic fluctuations significantly reduce economic well-being, (b) the government is knowledgeable and capable enough to improve upon the free market, and (c) unemployment is a more important problem than inflation (Kant 124).
Keynesian theory was much denigrated in academic circles from the mid-1970's until the mid-1980's. However, it has staged a strong comeback since then because Keynesian economics was better able to explain the economic events of the 1970's and 1980's than its principal intellectual competitor, new classical economics. New classical economic theory emphasizes the ability of a market economy to cure recessions by downward adjustments in wages and prices. The new classical economists of the mid-1970's attributed economic downturns to people's misperceptions about what was happening to relative prices. Misperceptions would arise, they argued, if people did not know the current price level or inflation rate. Therefore, economic downturns, by the new classical view, should be mild and brief. During the 1980's, most of the world's industrial economies endured deep and long recessions.
According to new classical theory, a correctly perceived decrease in the growth of the money supply should have only small effects, if any, on real output (Ingham 81). An offshoot of new classical theory formulated by Harvard's Robert Barro is the idea of debt neutrality. Barro argues that inflation, unemployment, real GNP, and real national saving should not be affected by whether the government finances it's spending with high taxes and low deficits or with low taxes and high deficits (Kant 108). Because people are rational, he argues, they will correctly perceive that low taxes and high deficits today must mean higher future taxes for them. Barro argues…