Keynesian economics

Named after the English economist John Maynard Keynes (1883-1946), Keynesian economics has influenced post-1945 economic management, particularly in its advocacy of government management of the economy.

Adherents believe that the macro-economy tends towards extended business cycles, with high levels of unemployed factors.

They assert that government management or stimulation of the economy to influence demand (through monetary or fiscal policy) can alleviate this problem of high unemployment. Monetary and fiscal policies thus stimulate the economy in times of slump by generating employment, and slow the economy down in times of inflation.

Also see: business cycle, equilibrium theory, general equilibrium theory, classical macroeconomic model

J M Keynes, The General Theory of Employment, Interest and Money (New York, 1936);
J Hicks, The Crisis in Keynesian Economics (Oxford, 1974)

Historical context

Pre-Keynesian macroeconomics

Macroeconomics is the study of the factors applying to an economy as a whole. Influential economic factors include the overall price level, the interest rate, and the level of employment (or equivalently, of income/output measured in real terms).

The classical tradition of partial equilibrium theory had been to split the economy into separate markets, each of whose equilibrium conditions could be stated as a single equation determining a single variable. The theoretical apparatus of supply and demand curves developed by Fleeming Jenkin and Alfred Marshall provided a unified mathematical basis for this approach, which the Lausanne School generalized to general equilibrium theory.

For macroeconomics, relevant partial theories included the Quantity theory of money determining the price level and the classical theory of the interest rate. In regards to employment, the condition referred to by Keynes as the “first postulate of classical economics” stated that the wage is equal to the marginal product, which is a direct application of the marginalist principles developed during the nineteenth century (see The General Theory). Keynes sought to supplant all three aspects of the classical theory.

Precursors of Keynesianism

Although Keynes’s work was crystallized and given impetus by the advent of the Great Depression, it was part of a long-running debate within economics over the existence and nature of general gluts. A number of the policies Keynes advocated to address the Great Depression (notably government deficit spending at times of low private investment or consumption), and many of the theoretical ideas he proposed (effective demand, the multiplier, the paradox of thrift), had been advanced by various authors in the 19th and early 20th centuries. Keynes’s unique contribution was to provide a general theory of these, which proved acceptable to the economic establishment.

An intellectual precursor of Keynesian economics was underconsumption theories associated with John Law, Thomas Malthus, the Birmingham School of Thomas Attwood,[8] and the American economists William Trufant Foster and Waddill Catchings, who were influential in the 1920s and 1930s. Underconsumptionists were, like Keynes after them, concerned with failure of aggregate demand to attain potential output, calling this “underconsumption” (focusing on the demand side), rather than “overproduction” (which would focus on the supply side), and advocating economic interventionism. Keynes specifically discussed underconsumption (which he wrote “under-consumption”) in the General Theory, in Chapter 22, Section IV and Chapter 23, Section VII.

Numerous concepts were developed earlier and independently of Keynes by the Stockholm school during the 1930s; these accomplishments were described in a 1937 article, published in response to the 1936 General Theory, sharing the Swedish discoveries.[9]

The paradox of thrift was stated in 1892 by John M. Robertson in his The Fallacy of Saving, in earlier forms by mercantilist economists since the 16th century, and similar sentiments date to antiquity.[10][11]

Keynes’s early writings

In 1923 Keynes published his first contribution to economic theory, A Tract on Monetary Reform, whose point of view is classical but incorporates ideas that later played a part in the General Theory. In particular, looking at the hyperinflation in European economies, he drew attention to the opportunity cost of holding money (identified with inflation rather than interest) and its influence on the velocity of circulation.[12]

In 1930 he published A Treatise on Money, intended as a comprehensive treatment of its subject “which would confirm his stature as a serious academic scholar, rather than just as the author of stinging polemics”,[13] and marks a large step in the direction of his later views. In it, he attributes unemployment to wage stickiness[14] and treats saving and investment as governed by independent decisions: the former varying positively with the interest rate,[15] the latter negatively.[16] The velocity of circulation is expressed as a function of the rate of interest.[17] He interpreted his treatment of liquidity as implying a purely monetary theory of interest.[18]

Keynes’s younger colleagues of the Cambridge Circus and Ralph Hawtrey believed that his arguments implicitly assumed full employment, and this influenced the direction of his subsequent work.[19] During 1933, he wrote essays on various economic topics “all of which are cast in terms of movement of output as a whole”.[20]

Development of The General Theory

At the time that Keynes’s wrote the General Theory, it had been a tenet of mainstream economic thought that the economy would automatically revert to a state of general equilibrium: it had been assumed that, because the needs of consumers are always greater than the capacity of the producers to satisfy those needs, everything that is produced would eventually be consumed once the appropriate price was found for it. This perception is reflected in Say’s law[21] and in the writing of David Ricardo,[22] which states that individuals produce so that they can either consume what they have manufactured or sell their output so that they can buy someone else’s output. This argument rests upon the assumption that if a surplus of goods or services exists, they would naturally drop in price to the point where they would be consumed.

Given the backdrop of high and persistent unemployment during the Great Depression, Keynes argued that there was no guarantee that the goods that individuals produce would be met with adequate effective demand, and periods of high unemployment could be expected, especially when the economy was contracting in size. He saw the economy as unable to maintain itself at full employment automatically, and believed that it was necessary for the government to step in and put purchasing power into the hands of the working population through government spending. Thus, according to Keynesian theory, some individually rational microeconomic-level actions such as not investing savings in the goods and services produced by the economy, if taken collectively by a large proportion of individuals and firms, can lead to outcomes wherein the economy operates below its potential output and growth rate.

Prior to Keynes, a situation in which aggregate demand for goods and services did not meet supply was referred to by classical economists as a general glut, although there was disagreement among them as to whether a general glut was possible. Keynes argued that when a glut occurred, it was the over-reaction of producers and the laying off of workers that led to a fall in demand and perpetuated the problem. Keynesians therefore advocate an active stabilization policy to reduce the amplitude of the business cycle, which they rank among the most serious of economic problems. According to the theory, government spending can be used to increase aggregate demand, thus increasing economic activity, reducing unemployment and deflation.

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