The Keynesian economy was named after its founder, British economist John Maynard Keynes. The core principles were developed in the 1930s as a reaction to the Great Depression. The framework of the theory was set in the book written by Keynes in 1936, The General Theory of Employment, Interest, and Money. The theory is primarily focused on the total amount of money in the economy and its effect on key macroeconomic variables such as output (gross domestic product), inflation, and employment. The theory argues that government intervention can stabilize the economy, which is in contradiction with traditional classical economics, which was the main doctrine before the Great Depression.
Keynes augmented that the economy can be stimulated by the aggregate demand side in the case of recessions and depressions. According to the theory, the aggregate demand shock is more likely to cause the recession than the aggregate supply shock. In addition to that, prices and wages are considered to be "sticky" in the short run, so the equilibrium is hard to reach via an immediate decrease in wages and prices. Companies would rather lay off employees than decrease wages, so the increase in unemployment is a sign of the recession. The prices are also not decreased immediately, as the market participants do not have perfect information, and the change of prices is also connected to the costs (called "menu costs"). Due to the stickiness of wages and prices, it is harder to bring the economy to full employment and potential output in the short run. The government should therefore act as the activist that manages the economy via the conduct of proper monetary and fiscal policy. There are two key tools in fiscal policy considered to stimulate aggregate demand: the increase of government expenditures and the decrease of taxes. Monetary policy is conducted via monetary expansion, where different tools are used, such as the interest rate setting, purchases and sales of treasuries (or other bonds) performed by central banks, and additional less important tools. Monetary expansion is achieved via a decrease in interest rates by the central bank or via bond buying programs that increase bond prices, resulting in lower interest rates in the economy (inverse relationship between bond prices and interest rates). However, Keynesians remain skeptical about the effective use of monetary policy. They stressed an indirect link between the money supply and real economic output, while classical economists believed in a direct link between these two variables. Based on that, Keynesians tend to prefer the use of fiscal policy to monetary policy. Keynesian economic theory is thus often compared with the economic theory of monetarists.
Aggregate demand can be defined as:
Aggregate demand (AD) = Consumption (C) + Investments (I) + Government expenditures (G) + (Export (X) – Import (M))
The increase in government expenditures (G) is spread throughout the economy, which also increases other components. The effect is thus multiplied and larger than the original increase in government expenditures (G). A rise in aggregate demand temporarily boosts output (Y), employment, and the price level (PL). The supply side of the economy, called aggregated supply, is unchanged.
Chart 1: Increase in aggregate demand as a result of expansionary fiscal policy (increased government spending or tax cuts)
Table 1: A comparison of Keynesian and Monetary Theories
Mankiw, N. G. (2016). Principles of microeconomics (8th ed.). Cengage Learning; 8th edition (January 1, 2017).ISBN-10: 1305971493.
John Maynard Keynes (2010). The General Theory Of Employment Interest And Money (1936) Hardcover – August 31, 2010. Kessinger Publishing, LLC; 30109th edition (August 31, 2010). ISBN-10: 1162559551.
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