In economics Keynesian economics (also Keynesianism and Keynesian Theory), is based on the ideas of twentieth-century British economist John Maynard Keynes. The state, according to Keynesian economics, can stimulate economic growth and improve stability in the private sector - through, for example, interest rates, taxation and public projects.
The theories forming the basis of Keynesian economics were first presented in The General Theory of Employment, Interest and Money, published in 1936.
In Keynes's theory, some micro-level actions of individuals and firms can lead to aggregate macroeconomic outcomes in which the economy operates below its potential output and growth. Many classical economists had believed in Say's Law, that supply creates its own demand, so that a "general glut" would therefore be impossible. Keynes contended that aggregate demand for goods might be insufficient during economic downturns, leading to unnecessarily high unemployment and losses of potential output. Keynes argued that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing high unemployment and deflation. Keynes's macroeconomic theories were a response to mass unemployment in 1920s Britain and in 1930s America.
Keynes argued that the solution to depression was to stimulate the economy ("inducement to invest") through some combination of two approaches :
A central conclusion of Keynesian economics is that in some situations, no strong automatic mechanism moves output and employment towards full employment levels. This conclusion conflicts with economic approaches that assume a general tendency towards an equilibrium. In the 'neoclassical synthesis', which combines Keynesian macro concepts with a micro foundation, the conditions of General equilibrium allow for price adjustment to achieve this goal.
The New classical macroeconomics movement, which began in the late 1960s and early 1970s, criticized Keynesian theories, while New Keynesian economics have sought to base Keynes's idea on more rigorous theoretical foundations.
More broadly, Keynes saw his as a general theory, in which utilization of resources could be high or low, whereas previous economics focused on the particular case of full utilization.
Keynes sought to distinguish his theories from "classical economics," by which he meant the economic theories of David Ricardo and his followers, including John Stuart Mill, Alfred Marshall, F.Y. Edgeworth, and A. Cecil Pigou. A central tenet of the classical view, known as Say's law, states that “supply creates its own demand.” Say's Law can be interpreted in two ways. First, the claim that the total value of output is equal to the sum of income earned in production is a result of a national income accounting identity, and is therefore indisputable. A second and stronger claim, however, that the "costs of output are always covered in the aggregate by the sale-proceeds resulting from demand" depends on how consumption and saving are linked to production and investment. In particular, Keynes argued that the second, strong form of Say's Law only holds if increases in individual savings exactly match an increase in aggregate investment. (cf. General Theory, Ch.1,2)
Keynes sought to develop a theory that would explain determinants of saving, consumption, investment and production. In that theory, the interaction of aggregate demand and aggregate supply determines the level of output and employment in the economy.
Because of what he considered the failure of the “Classical Theory” in the 1930s, Keynes firmly objects its main theory--adjustments in prices would automatically make demand tend to the full employment level.
Neo-classical theory supports that the two main costs that shift demand and supply are labor and money. Through the distribution of the monetary policy, demand and supply can be adjusted. If there were more labor than demand for it, wages would fall until hiring began again. If there was too much saving, and not enough consumption, then interest rates would fall until people either cut their savings rate or started borrowing.
To Keynes, the determination of wages is more complicated. First, he argued that it is not real but nominal wages that are set in negotiations between employers and workers, as opposed to a barter relationship. First, nominal wage cuts would be difficult to put into effect because of laws and wage contracts. Even classical economists admitted that these exist; unlike Keynes, they advocated abolishing minimum wages, unions, and long-term contracts, increasing labor-market flexibility. However, to Keynes, people will resist nominal wage reductions, even without unions, until they see other wages falling and a general fall of prices.
He also argued that to boost employment, real wages had to go down: nominal wages would have to fall more than prices. However, doing so would reduce consumer demand, so that the aggregate demand for goods would drop. This would in turn reduce business sales revenues and expected profits. Investment in new plants and equipment—perhaps already discouraged by previous excesses—would then become more risky, less likely. Instead of raising business expectations, wage cuts could make matters much worse.
Further, if wages and prices were falling, people would start to expect them to fall. This could make the economy spiral downward as those who had money would simply wait as falling prices made it more valuable—rather than spending. As Irving Fisher argued in 1933, in his Debt-Deflation Theory of Great Depressions, deflation (falling prices) can make a depression deeper as falling prices and wages made pre-existing nominal debts more valuable in real terms.
The classical economists argued that interest rates would fall due to the excess supply of "loanable funds". The first diagram, adapted from the only graph in The General Theory, shows this process. (For simplicity, other sources of the demand for or supply of funds are ignored here.) Assume that fixed investment in capital goods falls from "old I" to "new I" (step a). Second (step b), the resulting excess of saving causes interest-rate cuts, abolishing the excess supply: so again we have saving (S) equal to investment. The interest-rate fall prevents that of production and employment.
Keynes had a complex argument against this laissez-faire response. The graph below summarizes his argument, assuming again that fixed investment falls (step A). First, saving does not fall much as interest rates fall, since the income and substitution effects of falling rates go in conflicting directions. Second, since planned fixed investment in plant and equipment is mostly based on long-term expectations of future profitability, that spending does not rise much as interest rates fall. So S and I are drawn as steep (inelastic) in the graph. Given the inelasticity of both demand and supply, a large interest-rate fall is needed to close the saving/investment gap. As drawn, this requires a negative interest rate at equilibrium (where the new I line would intersect the old S line). However, this negative interest rate is not necessary to Keynes's argument.Third, Keynes argued that saving and investment are not the main determinants of interest rates, especially in the short run. Instead, the supply of and the demand for the stock of money determine interest rates in the short run. (This is not drawn in the graph.) Neither change quickly in response to excessive saving to allow fast interest-rate adjustment.
Finally, because of fear of capital losses on assets besides money, Keynes suggested that there may be a "liquidity trap" setting a floor under which interest rates cannot fall. (In this trap, bond-holders, fearing rises in interest rates (because rates are so low), fear capital losses on their bonds and thus try to sell them to attain money (liquidity).) Even economists who reject this liquidity trap now realize that nominal interest rates cannot fall below zero (or slightly higher). In the diagram, the equilibrium suggested by the new I line and the old S line cannot be reached, so that excess saving persists. Some (such as Paul Krugman) see this latter kind of liquidity trap as prevailing in Japan in the 1990s.
Even if this "trap" does not exist, there is a fourth element to Keynes's critique (perhaps the most important part). Saving involves not spending all of one's income. It thus means insufficient demand for business output, unless it is balanced by other sources of demand, such as fixed investment. Thus, excessive saving corresponds to an unwanted accumulation of inventories, or what classical economists called a general glut This pile-up of unsold goods and materials encourages businesses to decrease both production and employment. This in turn lowers people's incomes—and saving, causing a leftward shift in the S line in the diagram (step B). For Keynes, the fall in income did most of the job by ending excessive saving and allowing the loanable funds market to attain equilibrium. Instead of interest-rate adjustment solving the problem, a recession does so. Thus in the diagram, the interest-rate change is small.
Whereas the classical economists assumed that the level of output and income was constant and given at any one time (except for short-lived deviations), Keynes saw this as the key variable that adjusted to equate saving and investment.
Finally, a recession undermines the business incentive to engage in fixed investment. With falling incomes and demand for products, the desired demand for factories and equipment (not to mention housing) will fall. This accelerator effect would shift the I line to the left again, a change not shown in the diagram above. This recreates the problem of excessive saving and encourages the recession to continue.
In sum, to Keynes there is interaction between excess supplies in different markets, as unemployment in labor markets encourages excessive saving—and vice-versa. Rather than prices adjusting to attain equilibrium, the main story is one of quantity adjustment allowing recessions and possible attainment of underemployment equilibrium.
As noted, the classicals wanted to balance the government budget. To Keynes, this would exacerbate the underlying problem: following either policy would raise saving (broadly defined) and thus lower the demand for both products and labor. For example, Keynesians see Herbert Hoover's June 1932 tax increase as making the Depression worse .
Keynes's ideas influenced Franklin D. Roosevelt's view that insufficient buying-power caused the Depression. During his presidency, Roosevelt adopted some aspects of Keynesian economics, especially after 1937, when, in the depths of the Depression, the United States suffered from recession yet again following fiscal contraction. Something similar to Keynesian expansionary policies had been applied earlier by both social-democratic Sweden, and Nazi Germany . But to many the true success of Keynesian policy can be seen at the onset of World War II, which provided a kick to the world economy, removed uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas became almost official in social-democratic Europe after the war and in the U.S. in the 1960s.
Keynes's theory suggested that active government policy could be effective in managing the economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated what has been called countercyclical fiscal policies, that is policies which acted against the tide of the business cycle: deficit spending when a nation's economy suffers from recession or when recovery is long-delayed and unemployment is persistently high—and the suppression of inflation in boom times by either increasing taxes or cutting back on government outlays. He argued that governments should solve problems in the short run rather than waiting for market forces to do it in the long run, because "in the long run, we are all dead."
This contrasted with the classical and neoclassical economic analysis of fiscal policy. Fiscal stimulus (deficit spending) could actuate production. But to these schools, there was no reason to believe that this stimulation would outrun the side-effects that "crowd out" private investment: first, it would increase the demand for labor and raise wages, hurting profitability; Second, a government deficit increases the stock of government bonds, reducing their market price and encouraging high interest rates, making it more expensive for business to finance fixed investment. Thus, efforts to stimulate the economy would be self-defeating.
The Keynesian response is that such fiscal policy is only appropriate when unemployment is persistently high, above what is now termed the Non-Accelerating Inflation Rate of Unemployment, or "NAIRU". In that case, crowding out is minimal. Further, private investment can be "crowded in": fiscal stimulus raises the market for business output, raising cash flow and profitability, spurring business optimism. To Keynes, this accelerator effect meant that government and business could be complements rather than substitutes in this situation. Second, as the stimulus occurs, gross domestic product rises, raising the amount of saving, helping to finance the increase in fixed investment. Finally, government outlays need not always be wasteful: government investment in public goods that will not be provided by profit-seekers will encourage the private sector's growth. That is, government spending on such things as basic research, public health, education, and infrastructure could help the long-term growth of potential output.
Invoking public choice theory, classical and neoclassical economists doubt that the government will ever be this beneficial and suggest that its policies will typically be dominated by special interest groups, including the government bureaucracy. Thus, they use their political theory to reject Keynes' economic theory.
A Keynesian economist might point out that classical and neoclassical theory does not explain why firms acting as "special interests" to influence government policy are assumed to produce a negative outcome, while those same firms acting with the same motivations outside of the government are supposed to produce positive outcomes.
In Keynes' theory, there must be significant slack in the labor market before fiscal expansion is justified. Both conservative and some neoliberal economists question this assumption, unless labor unions or the government "meddle" in the free market, creating persistent supply-side or classical unemployment. Their solution is to increase labor-market flexibility, e.g., by cutting wages, busting unions, and deregulating business.
Deficit spending is not Keynesianism. Governments had long used deficits to finance wars. Keynesianism recommends counter-cyclical policies to smooth out fluctuations in the business cycle. For example, raising taxes to cool the economy and to prevent inflation when there is abundant demand-side growth, and engaging in deficit spending on labor-intensive infrastructure projects to stimulate employment and stabilize wages during economic downturns. Classical economics, on the other hand, argues that one should cut taxes when there are budget surpluses, and cut spending—or, less likely, increase taxes—during economic downturns. Keynesian economists believe that adding to profits and incomes during boom cycles through tax cuts, and removing income and profits from the economy through cuts in spending and/or increased taxes during downturns, tends to exacerbate the negative effects of the business cycle.
Two aspects of Keynes' model had implications for policy:
First, there is the "Keynesian multiplier", first developed by Richard F. Kahn in 1931. Exogenous increases in spending, such as an increase in government outlays, increases total spending by a multiple of that increase. A government could stimulate a great deal of new production with a modest outlay if:
This process continues. At each step, the increase in spending is smaller than in the previous step, so that the multiplier process tapers off and allows the attainment of an equilibrium. This story is modified and moderated if we move beyond a "closed economy" and bring in the role of taxation: the rise in imports and tax payments at each step reduces the amount of induced consumer spending and the size of the multiplier effect.
Second, Keynes re-analyzed the effect of the interest rate on investment. In the classical model, the supply of funds (saving) determined the amount of fixed business investment. That is, since all savings was placed in banks, and all business investors in need of borrowed funds went to banks, the amount of savings determined the amount that was available to invest. To Keynes, the amount of investment was determined independently by long-term profit expectations and, to a lesser extent, the interest rate. The latter opens the possibility of regulating the economy through money supply changes, via monetary policy. Under conditions such as the Great Depression, Keynes argued that this approach would be relatively ineffective compared to fiscal policy. But during more "normal" times, monetary expansion can stimulate the economy, mostly by encouraging construction of new housing.
Keynesians and redistributionists tend to associate with each other. Keynes, in the twenties, wrote about a hydro-electric project. In his opinion it would have been better if the rewards of the project had gone to the worker-builders rather than to the investors who had financed the project.
Keynesians believe that fiscal policy should be directed towards the lower-income segment of the population, because that segment is more likely to spend the money, contributing to demand, than to save it.
After Keynes, Keynesian analysis was combined with neoclassical economics to produce what is generally termed the "neoclassical synthesis" which dominates mainstream macroeconomic thought. Though it was widely held that there was no strong automatic tendency to full employment, many believed that if government policy were used to ensure it, the economy would behave as classical or neoclassical theory predicted.
In the post-WWII years, Keynes's policy ideas were widely accepted. For the first time, governments prepared good quality economic statistics on an ongoing basis and had a theory that told them what to do. In this era of new liberalism and social democracy, most western capitalist countries enjoyed low, stable unemployment and modest inflation.
It was with John Hicks that Keynesian economics produced a clear model which policy-makers could use to attempt to understand and control economic activity. This model, the IS-LM model is nearly as influential as Keynes' original analysis in determining actual policy and economics education. It relates aggregate demand and employment to three exogenous quantities, i.e., the amount of money in circulation, the government budget, and the state of business expectations. This model was very popular with economists after World War II because it could be understood in terms of general equilibrium theory. This encouraged a much more static vision of macroeconomics than that described above.
The second main part of a Keynesian policy-maker's theoretical apparatus was the Phillips curve. This curve, which was more of an empirical observation than a theory, indicated that increased employment, and decreased unemployment, implied increased inflation. Keynes had only predicted that falling unemployment would cause a higher price, not a higher inflation rate. Thus, the economist could use the IS-LM model to predict, for example, that an increase in the money supply would raise output and employment—and then use the Phillips curve to predict an increase in inflation.
Through the 1950s, moderate degrees of government demand leading industrial development, and use of fiscal and monetary counter-cyclical policies continued, and reached a peak in the "go go" 1960s, where it seemed to many Keynesians that prosperity was now permanent. However, with the oil shock of 1973, and the economic problems of the 1970s, modern liberal economics began to fall out of favor. During this time, many economies experienced high and rising unemployment, coupled with high and rising inflation, contradicting the Phillips curve's prediction. This stagflation meant that the simultaneous application of expansionary (anti-recession) and contractionary (anti-inflation) policies appeared to be necessary, a clear impossibility. This dilemma led to the end of the Keynesian near-consensus of the 1960s, and the rise throughout the 1970s of ideas based upon more classical analysis, including monetarism, supply-side economics and new classical economics. At the same time Keynesians began during the period to reorganize their thinking (some becoming associated with New Keynesian economics); one strategy, utilized also as a critique of the notably high unemployment and potentially disappointing GNP growth rates associated with the latter two theories by the mid-1980s, was to emphasize low unemployment and maximal economic growth at the cost of somewhat higher inflation (its consequences kept in check by indexing and other methods, and its overall rate kept lower and steadier by such potential policies as Martin Weitzman's share economy).
The impact of Keynesianism can be seen by the wave of economists who have based their analysis on a criticism of Keynesianism.
One school began in the late 1940s with Milton Friedman. Instead of rejecting macro-measurements and macro-models of the economy, the monetarist school embraced the techniques of treating the entire economy as having a supply and demand equilibrium. However, they regarded inflation as solely being due to the variations in the money supply, rather than as being a consequence of aggregate demand. They argued that the "crowding out" effects discussed above would hobble or deprive fiscal policy of its positive effect. Instead, the focus should be on monetary policy, which was largely ignored by early Keynesians.
Monetarism had an ideological as well as a practical appeal: monetary policy does not, at least on the surface, imply as much government intervention in the economy as other measures. The monetarist critique pushed Keynesians toward a more balanced view of monetary policy, and inspired a wave of revisions to Keynesian theory.
Another influential school of thought was based on the Lucas critique of Keynesian economics. This called for greater consistency with microeconomic theory and rationality, and particularly emphasized the idea of rational expectations. Lucas and others argued that Keynesian economics required remarkably foolish and short-sighted behavior from people, which totally contradicted the economic understanding of their behavior at a micro level. New classical economics introduced a set of macroeconomic theories which were based on optimising microeconomic behavior, for instance real business cycles.
Keynesian ideas were criticized by free market economist and philosopher Friedrich Hayek. Hayek's most famous work The Road to Serfdom, was written in 1944. Hayek taught at the London School of Economics from 1931 to 1950. Hayek criticized Keynesian economic policies for what he called their fundamentally collectivist approach, arguing that such theories, no matter their presumptively utilitarian intentions, require centralized planning, which Hayek argued leads to totalitarian abuses. Keynes seems to have noted this concern, since, in the foreword to the German version of the 'The General Theory of Employment Interest and Money', he declared that "the theory of aggregated production, which is the point of ['The General Theory of Employment Interest and Money'], nevertheless can be much easier adapted to the conditions of a totalitarian state [eines totalen Staates] than the theory of production and distribution of a given production put forth under conditions of free competition and a large degree of laissez-faire."
Another criticism leveled by Hayek against Keynes was that the study of the economy by the relations between aggregates is fallacious, and that recessions are caused by micro-economic factors. Hayek claimed that what starts as temporary governmental fixes usually become permanent and expanding government programs, which stifle the private sector and civil society. Keynes himself described the critique as "deeply moving", which was quoted on the cover of the Road to Serfdom.
Beginning in the late 1950s New Classical Macroeconomists began to disagree with the methodology employed by Keynes and his successors. Keynesians emphasized the dependence of consumption on disposable income and, also, of investment on current profits and current cash flow. In addition Keynes posited a Phillips curve that tied nominal wage inflation to unemployment rate. To buttress these theories Keynesians typically traced the logical foundations of their model (using introspection) and buttressed their assumptions with statistical evidence. New Classical theorists demanded that Macroeconomic be grounded on the same foundations as Microeconomic theory, profit-maximizing firms and utility maximizing consumers.
The result of this shift in methodology produced several important divergences from Keynesian Macro economics:
The heart of the 'new Keynesian' view rests on microeconomic models that indicate that nominal wages and prices are "sticky," i.e., do not change easily or quickly with changes in supply and demand, so that quantity adjustment prevails. This is a practice which, according to economist Paul Krugman "never works in theory, but works beautifully in practice." This integration is further spurred by the work of other economists which questions rational decision-making in a perfect information environment as a necessity for micro-economic theory. Imperfect decision making such as that investigated by Joseph Stiglitz underlines the importance of management of risk in the economy.
Over time, many macroeconomists have returned to the IS-LM model and the Phillips Curve as a first approximation of how an economy works. New versions of the Phillips Curve, such as the "Triangle Model", allow for stagflation, since the curve can shift due to supply shocks or changes in built-in inflation. In the 1990s, the original ideas of "full employment" had been modified by the NAIRU doctrine, sometimes called the "natural rate of unemployment." NAIRU advocates suggest restraint in combating unemployment, in case accelerating inflation should result. However, it is unclear exactly what the value of the NAIRU should be—or whether it even exists.