Keynesian Economics: Principles, History, and Modern Evolution

Introduction to Keynesian Economics

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 aggregate demand for goods as the primary driving factor, especially during economic downturns. From this, he argued that government policies could be used to promote demand at a macro level in order to fight high unemployment and deflation of the sort seen during the 1930s.

Keynes believed that the economy was the most important issue of his 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 toward 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 — the way the world thinks about economic problems" (Keynes). Keynes questioned two of the pillars of dominant economic theory: 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 cause only 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).

Core Principles of Keynesianism

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. 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).

The second principle holds that 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." His famous remark — "In the long run, we are all dead" — was made precisely to underscore this 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 assume or attempt to explain rigid prices or wages. Rationalizing rigid prices is difficult 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 — consumption, investment, or government expenditures — cause output to fluctuate (Jackson 32). If government spending increases and all other components of spending remain constant, then output will increase. Keynesian models of economic activity also include a "multiplier effect" (Keynes): 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 zero (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 — particularly of labor. Even monetarists, who are generally more confident than Keynesians in the ability of markets to adjust, often accept the Keynesian position on this matter. Milton Friedman, for example — the most prominent monetarist — wrote: "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 usage, that position would certainly be called Keynesian.

Policy Implications and Stabilization

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 view unemployment as both too high on average and too variable, although they acknowledge that rigorous theoretical justification for these positions is difficult to establish. Keynesians also maintain 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 fine-tuning — that is, 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 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 need. 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 those 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 himself 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. Their 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).