Keynesian Revolution: Theory, Criticism, and Legacy

Introduction: Before the Keynesian Revolution

"I believe myself to be writing a book on economic theory which will largely revolutionize — not, I suppose, at once, but in the course of the next ten years — the way the world thinks about economic problems."

— John Maynard Keynes, Letter to G.B. Shaw, January 1, 1935

Prior to the Keynesian Revolution, many economists and politicians viewed economics from a "micro" perspective. They saw factors such as unemployment, interest rates, and profit and loss as related to individual organizations and the impact of individual transactions. In modern times, the idea of macroeconomics is much more widespread, and the impact of economic endeavors is viewed as part of an economic whole — a national and global approach. Part of the credit for this broader view belongs to John Maynard Keynes, through his publications and the "Keynesian Revolution."

Though Keynes is often criticized for his theories, it is most important to remember that he represents a true figure of change. Without Keynes, it is uncertain whether economists of today would be considering their transactions and efforts from a national or global perspective, or still from a "micro," transaction-by-transaction basis.

John Maynard Keynes was a pioneer of his time, revolutionizing economic thought and introducing the idea of macroeconomics. Prior to the "Keynesian Revolution" — the period when Keynes's ideas became prevalent in society — classical economists considered economics from a wholly different perspective. Most politicians felt that the government should not be heavily involved in economic affairs, thus allowing individual enterprises maximum freedom and opportunity (IEA). Keynes felt differently, however, and saw the government as a key player in maintaining an equilibrium, or system of checks and balances, as related to the economy as a whole.

History of Economic Theory

"Classical theorists" — people such as Adam Smith — who opposed Keynesian ideas proposed that the market was self-regulating. Classical thought rested upon the idea that the economic system pushes itself toward economic equilibrium (IEA).

Because of this, Keynes faced significant opposition from classical thinkers when he proposed his ideology. One of the most important points to understand when discussing Keynesian ideology is that everything classical economists stood for was, from Keynes's perspective, rendered a "moot point." The whole purpose of the Keynesian Revolution was to press the point that the best government macroeconomic policy was to manage the entire economy as if it were one giant enterprise.

Obviously, this idea must have caused some unease among private enterprises that valued their independence. In any large business organization, accounting mechanisms govern much of the policies and procedures by which the organization runs. Management uses accounting information to analyze operations and performance. Interestingly, Keynes's macroeconomic theory emerged during a period when the development of national economic accounts was actually becoming a realistic concept (IEA, 1997).

The Keynesian Revolution: A Turning Point

The Keynesian Revolution marked a turning point in history — a time of new insight related to governing theories of economics. John Maynard Keynes's idea of economics as a whole, or the overall picture of economics rather than isolated pieces of the puzzle, marks a turning point in intellectual history. He published many works related to his theories on Keynesian economics, one of the most important of which was The General Theory. Since that publication, many people have accepted and converted to Keynesianism, which achieved dominance in both academic and political worlds.

The Keynesian Revolution essentially marks the introduction of the idea of macroeconomics by Keynes in the 1930s. Keynes's ideas changed thinking in several areas, including unemployment, money supply, and inflation. Macroeconomics deals with economic factors like national output and income, unemployment, the rate of inflation, and the balance of payments. Prior to this era, most economists focused on microeconomics, which studies factors like the supply and demand for individual goods and services, trade in markets, and the patterns of pricing individual goods.

Key Concepts of Keynesian Theory

A key concept of the Keynesian Revolution was the idea that the best policy when considering economics is to evaluate the entire governing economic theory of one organization, group, or country as a single unit. This directly supports the idea of macroeconomics. Keynes believed it was appropriate to view the whole economy as if it were one huge business, and argued that the economy should be managed as one.

Keynesian theory puts forth two basic premises that must be understood. The fundamental propositions Keynes advanced are as follows: (1) unemployment results from inadequate demand; and (2) unemployment should be eliminated by government intervention — specifically, governments should increase demand through adjustments in policy (Galbraith).

Keynes viewed the economy in a circular fashion. He saw that in a market economy, demand depended upon income and expenditures, and income in turn depended on expenditure. Essentially, every dollar of income received by one person depends on the expenditure made by someone else. Expenditure, however, also depends on demand, because people will not purchase products for which there is no demand, thus potentially reducing the income of another individual.

One important concept to note is that, though Keynes's ideas made sense for the period in which they were developed, they may not necessarily account for modern phenomena such as the widespread use of consumer credit.

To understand the premise of Keynesian theory, it is helpful to grasp some general ideas about economics. In any economy, a transaction takes place whereby money is exchanged for something of value. The purchaser benefits by gaining something they need or desire, and the seller benefits by gaining income. In economic language, the "expenditure" of the buyer is the "income" of the seller. This simple relationship forms the basis for Keynesian theory, expressed as follows:

Income = Expenditure

Income = Consumption + (Business) Investment + Government Spending

Source: IEA, 1997

By this model, total spending and income should be equal in theory. John Maynard Keynes is credited with introducing the circular flow of income theory, in which money is a "medium of exchange" that is never used up but simply transferred from one individual to another.