Economics, Keynesian
Economics, Keynesian
Keynesian economics is the approach to macroeconomics that grew out of John Maynard Keynes’s work, especially his The General Theory of Employment, Interest and Money (1936) written during the Great Depression. Since Keynes’s work has been interpreted in different ways and inspired various formulations of macroeconomics, it is defined in a number of different ways, including the approach to macroeconomics in which: aggregate demand plays a major role in determining output and employment; involuntary unemployment can persist; and fiscal and monetary policy can affect the level of output and employment. Keynes himself recognized that he had a number of predecessors, and it has been suggested that major elements of his approach were anticipated by others (most notably, Michal Kalecki).
In The General Theory Keynes argued that employment is determined by the aggregate demand for goods, which is in turn determined (in a closed economy) by consumption demand and investment demand. Consumption depends mainly on the level of real income while investment demand depends on the interest rate, which is determined by money supply and the demand for money, and by business expectations. Given expectations and monetary conditions, employment is determined so that output produced is equal to aggregate demand. The level of employment thus determined may be less than the full employment level at which the supply and demand for labor (which depend on the real wage) become equal. He also examined the aggregate supply side of the economy with a given money wage, and a production function relating output to employment, which determined the average price level. Keynes argued that the wages are likely to be rigid downward when unemployment exists because of the concern of workers with their wage relative to that of others: however, even if wages (and hence the price level) fall, it is unlikely to increase the level of aggregate demand in the face of uncertainty and the negative effect of falling prices on the demand for goods by debtors. Keynes therefore recommended expansionary monetary and especially fiscal policy to increase the level of aggregate demand, employment, and output to reduce unemployment.
Keynes’s analysis is most simply depicted with the income-expenditure model of Figure 1, in which the axes
measure income and output, Y, and expenditures or demand, E. The line marked C is the consumption function that shows the relation between consumption and real income, and the line marked C + I + G is aggregate demand that adds (planned) investment, I, and government expenditure, G, both assumed to be exogenously given, to it. Equilibrium output, YE, is determined where the aggregate expenditure line intersects the 45° line so that output equals expenditure. The level of output determines employment, which may imply unemployment. Fiscal and monetary expansion, by increasing G or I, can increase output and reduce employment.
Economists such as John Hicks and Franco Modigliani, who were persuaded by Keynes’s theory, tried to relate it to pre-Keynesian neoclassical macroeconomic theory in which the economy was generally thought to be at full employment. A series of models, including the IS-LM and later the aggregate demand–aggregate supply (AD-AS) models, were developed to produce what has come to be called the neoclassical synthesis approach to Keynesian economics. This approach, which uses different types of demand and supply curves and equilibrium condition as in neoclassical theory, implies that unemployment can exist, due to wage rigidity, in the short run, but in the medium and long runs, in which the wage is flexible, the economy is at full employment. When unemployment exists, over the medium and longer runs the money wage falls, which reduces the costs of firms and hence the price level, which reduces the nominal demand for money. The resulting excess supply of money is used to increase spending on goods (by what is called the real balance effect), or is lent out, implying a fall in the interest rate and a rise in investment (and possibly consumption) demand. This increase in aggregate demand increases out put and employment and takes the economy to full employment. With rigid wages in the short run, however, this mechanism does not work itself out, and unemployment can exist. Expansionary fiscal and monetary policy can increase output in the short run, but only increases the price level in the medium and long runs when the economy is at full employment.
In the 1960s, after most advanced countries experienced low unemployment for long periods (arguably due to the success of Keynesian macroeconomic policies), and inflationary pressures began to mount, alternative approaches to macroeconomics began to emerge. Three of them adopted positions opposed to Keynesian economics and can be briefly discussed to show what it is not. The first, monetarist, approach developed by Milton Friedman in 1968 and others returned to the pre-Keynesian idea of flexible wages in the short run, so that full employment always prevails, but allows changes in aggregate demand to affect the level of output and employment, because of misperceptions about the effects of aggregate demand changes, to make it consistent with the facts regarding business cycles. For instance, when money supply increases, workers find their money wage to be higher, but by not taking into account that the price of goods is higher too, they supply more labor, which leads to an increase in output. In the longer run, as workers revise their price expectation, this expansionary effect disappears. According to this approach, although full employment always prevails due to the flexibility of wages, macro policy has a temporary effect on real variables due to the misperceptions of the workers. The second also maintains the assumption of flexible, labor-market clearing wages, but assumes that economic agents do not make systematic expectational errors as they do in the earlier monetarist approach, and assumes rational expectations. This new classical approach developed by Robert Lucas in 1983 and others points out that with agents having rational expectations in the sense that they use all relevant information about the economy to calculate price expectations, fiscal and monetary policy (apart from tax policy changes that affect the supply of labor) are not effective even in the short run, unless the policies’ changes are random and hence unanticipated. The third approach, called the real business cycle approach, continues in this tradition, but explains business cycle fluctuations in terms of technology shocks that affect investment demand and the interest rate and bring about the intertemporal substitution of labor to explain changes in employment.
In addition to real-world phenomena mentioned earlier, Keynesian economics lost ground to these new classical approaches because of its alleged problem in providing proper microfoundations to macroeconomics. The neoclassical synthesis Keynesian approach explained unemployment in terms of wage rigidity, but did not relate the analysis to optimizing microfoundations. The new Keynesian approach tries to develop Keynesian economics to address this problem. An early branch of this approach merely introduced fixed prices and wages into the standard micro-founded general equilibrium model, examining disequilibrium situations in which actual transactions occurred at the “short” side of the market and the effects of such deviations from market clearing in one market spilled over into other markets. Another branch of the approach responded directly to the monetarist and rational expectations approaches, introducing wage price stickiness (such as staggered or sticky wage adjustment) into models with rational expectations to show that it is complete wage flexibility, rather than the assumption about expectations, that produced the policy ineffectiveness result. A final, and most popular new Keynesian branch, provided optimizing microfoundations to wage, price, and interest rate rigidity. Efficiency wages (which prevent the wage from falling when unemployment exists because of its adverse effect on labor efficiency) and wage bargaining, imperfect competition and the “menu” costs of price changes, and asymmetric information in credit markets have been used to explain these rigidities. Some models, such as those that distinguish the role of insiders and outsiders in the wage determination process, imply that aggregate demand changes can have long-term effects on output due to what are called hysteresis effects. While some new Keynesian models imply involuntary unemployment in equilibrium, others do not, but imply only that aggregate demand policies can have effects on output.
The central feature of both the neoclassical synthesis and new Keynesian approach is the rigidity of wages and prices. While wage rigidity is an important element of Keynes’s theory, we have seen that according to Keynes the wage flexibility is no guarantee for full employment. The fact that flexible wages may exacerbate rather than solve unemployment problems has been stressed by another approach to Keynesian economics, called the post-Keynesian approach, which emphasizes the implications of decision-making under uncertainty, monetary institutions, and the effect of income distribution on aggregate demand. According to this approach when the wage and price falls due to the existence of unemployment, the interest rate and real balance effects need not work to increase aggregate demand because an excess supply of money may just lead to a fall in money supply as loans are repaid in a credit money economy with no further effects on the interest rate, because even if the interest rate falls asset holders may wish to hold more money and firms unwilling to increase investment in an uncertain environment, and because falling real wages redistribute income from workers to profit recipients who save a larger proportion of their income. Greater wage flexibility also tends to increase uncertainty in the economy given the importance of wages for both firm costs and profits and household income. These ideas add to Keynes’s own discussion on the implications of wage flexibility, and are also corroborated by some optimizing models with a new Keynesian flavor.
Keynesian economics has generally been thought to be valid for short-run macroeconomics, but ignored in the analysis of long-run growth analysis. However, if wage flexibility does not automatically take the economy to full employment or at least the natural level of output consistent with price stability, and governments are unwilling or unable to do the same over the medium run, and if technology responds to aggregate demand and output, Keynesian economics may be relevant for the longer run as well. Post-Keynesians and other heterodox economists have, in fact, followed Joan Robinson and others in applying Keynesian economics to the study of long-run growth.
SEE ALSO Economics, New Keynesian; Economics, Post Keynesian; Kalecki, Michal; Keynes, John Maynard
BIBLIOGRAPHY
Clower, Robert. 1965. The Keynesian Counterrevolution: A Theoretical Appraisal. In The Theory of Interest Rates, ed. F. Hahn and F. P. R. Brechling. London: Macmillan.
Dutt, Amitava Krishna, and Edward J. Amadeo. 1990. Keynes’s Third Alternative? Aldershot: Edward Elgar.
Friedman, Milton. 1968. The Role of Monetary Policy. American Economic Review (March): 1–17.
Hahn, Frank, and Robert M. Solow. 1995. A Critical Essay on Modern Economic Theory. Cambridge, MA: MIT Press.
Hicks, John R. 1937. Mr. Keynes and the Classics. Econometrica. 5 (2), 147–159
Kalecki, Michal. 1971. Selected Essays on the Dynamics of the Capitalist Economy. Cambridge, U.K.: Cambridge University Press.
Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money. London: Macmillan.
Lucas, Robert E. B. 1973. Some International Evidence on Output-Inflation Tradeoffs. American Economic Review 63 (June): 326–334.
Mankiw, N. Gregory, and David Romer, eds. 1991. New Keynesian Economics. 2 vols. Cambridge: MA: MIT Press.
Modigliani, Franco. 1944. Liquidity Preference and the Theory of Interest and Money. Econometrica. 12 (1):45–88.
Robinson, Joan. 1961. Essays in the Theory of Economic Growth. London: Macmillan.
Amitava Krishna Dutt
Keynesian Economics
KEYNESIAN ECONOMICS
John Maynard Keynes (1883–1946) was a brilliant, well-born British economist who during the Great Depression laid the foundations for an alternative to classical economics, which dominated economic thought and policy in the Western democracies from the late 1930s through the end of the century. In the public mind, Keynes is most commonly thought of as offering the rationale for a compensatory fiscal policy to regulate the swings of economic cycles. The centrality of his thought is underscored by the efforts of scholars only in the last decade of the twentieth century to evolve what they call a post-Keynesian economics.
In the conclusion to his General Theory of Employment, Interest, and Money (1936) Keynes maintained that "the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else." The twists and turns in the story of the role of Keynesian economics during the Great Depression and its enduring connection to that crisis in the public mind are fascinating and revealing.
Though he became well-known early in the century through his critique of the Treaty of Versailles and considered his major work to be his two volume A Treatise on Money (1930), Keynes is best known for his General Theory, an uncharacteristically turgid and poorly organized tome that explained in highly theoretical language how a calamity such as the Great Depression could have happened and what policies governments might employ in countering the extremes of business cycles.
From the beginning of his career Keynes was keenly interested in the practical world and quick to offer advice to politicians and public officials. He did so frequently and eloquently during the 1920s and the Great Depression. He was particularly concerned about the state of the American economy, which seemed more fragile than the British economy and which was more sharply affected by the stock market crash of 1929.
In April 1931 Keynes made a radio address to the people of the United States, warning that businessmen and financiers were too optimistic and that the Depression could easily last another five years. A month later he came to the United States to deliver a lecture at the University of Chicago in which he argued that in the United States regulation of credit would be more effective than public works spending in countering the Depression. In December 1933 Keynes wrote for the New York Times a somewhat condescending open letter to President Franklin Roosevelt, warning him to avoid such reform measures as those undertaken by the National Recovery Administration, that, as Keynes saw it, were shaking business confidence and thus impeding recovery. In June 1934 Keynes came to the United States again, this time meeting personally with Roosevelt, presenting calculations on the level of spending needed to achieve recovery. Accounts of the meeting suggest that the two were mutually unimpressed.
Clearly, advice from Keynes was abundant. Yet hardly anyone formulating policy at the time was listening. Nevertheless, the essential components of both his analytical framework and policy recommendations were developed independently by administration officials, especially presidential advisors Stuart Chase and Harry L. Hopkins, several of their staff, and Reserve Board Chairman Marriner S. Eccles. All drew from their practical experience, the work of a broad range of economists and advisors, and most importantly, all were pressed by an imperative to respond to the obvious human needs that the crisis engendered. As Eccles later put it, "we came out at about the same place in economic thought and policy by very different roads." Thus, one might be understandably suspicious of Keynes's conclusion concerning the ideas of academics that "the world is ruled by little else."
Nonetheless, Keynesian economics ultimately became, in the minds of some, almost synonymous with the New Deal. Why so? Because Keynes offered a powerful theoretical analysis of the economic conditions underlying the crisis of the 1930s at precisely the moment when Western democracies were desperately in need of an authoritative and coherent explanation of the Depression, and of hope that there was a way out consistent with their ideology.
Of initial concern was the duration and depth of the Depression. Prevailing business cycle theory, offered by eminent scholars such as Jacob Viner and Wesley C. Mitchell, proposed that cycles were an inevitable, even necessary, part of the progression of capitalist economies. During downturns the decline in prices, wages, and interest rates would reach a point where investors could not resist the potential profits these conditions offered and would start borrowing, investing, and propelling the economy back onto an upward trajectory. Similarly, in upturns, high prices, wages, and interest rates would restrict investment and lead to a downturn. The implication for policy was that governments should intervene as little as possible and let "natural" forces right the economy in their own due time. Yet during the Great Depression the downturn went deeper and lasted longer than anyone had imagined, and still no "natural" forces were leading to recovery. It seemed that the economy might not be self-correcting and could reach equilibrium at levels far below full employment and adequate living standards.
The use of public works to offer jobs to the unemployed and build public infrastructures at minimal cost had become legitimized during the 1920s. Herbert Hoover had implemented such programs before leaving office and the policy was continued in the New Deal under Harold Ickes's Public Works Administration. Yet federal spending for relief was regarded by both Hoover and Roosevelt as an expedient to mitigate suffering, a galling necessity (and hence a symbol) of bad times. It was difficult for them to accept spending, other than on well-planned and needed public works, as a deliberate and continuing instrument of economic policy. Moreover, how could one reasonably argue that tax money given back to taxpayers, who would have spent it had the government not taken it in taxes, could provide a stimulus to the economy?
These concerns could be pushed to the background as long as there seemed to be progress, however halting, towards recovery. But when the recession of 1937 struck, the nation was faced with not a Hoover but a "Roosevelt Recession," which had to be addressed. The domestic political implications were clear to New Dealers, but so also were the implications for the worldwide ideological struggle among fascism, communism, and liberal democracy.
As the recession deepened during the winter of 1937 and 1938 there were widespread complaints in the press that the administration was adrift and had no coherent policy, a criticism that could justly be applied to the various pragmatic, need-driven programs of the early New Deal. Secretary of the Treasury Henry Morgenthau, Jr., urged a return to a balanced budget. Eccles, Hopkins, and others urged a resumption of spending. The president finally resumed spending, but only after being presented with arguments that the policy was consistent with American historical experience and with liberalism, and that the resulting growth would bring in enough to pay back the deficits incurred.
That decision was announced in April 1938. By August there were clear signs of recovery and it was assumed by all that the renewed spending program had caused the recovery. But by the time the recession struck, the General Theory was being read and avidly embraced by young American economists within and outside of the administration. Several addressed the recession crisis by restating Keynes's ideas in a brief, accessible manifesto, An Economic Program for American Democracy, published in November 1938. The book was, in effect, a simplified, policy-oriented, Americanized distillate of Keynes's General Theory. It immediately became a best seller. Eccles was so impressed with its argument that he used his personal funds to buy copies for every member of the U.S. Congress. The Washington Star called it "the first authentic attempt to tell compactly and in simple language the complete economic and social ideology of the New Deal." The Boston Globe concluded that "for the first time the effects of haphazard spending and investment policies of the New Deal are dispassionately analyzed and given academic sanction."
Of course, as economists and other policy makers were beginning to understand, the base of that academic sanction was Keynes's General Theory. In it Keynes provided elaborate explanations for why it was possible for the economy to reach equilibrium at levels well below full employment. His analysis of "liquidity preference" explained that in some circumstances potential investors might wish to retain rather than invest their resources. Thus, contrary to classical economic theory, interest rates could fall to zero without attracting new investment. His description of the "propensity to consume" explained what proportion of incomes citizens would, under various circumstances, re-inject into the economy through consumption. His "multiplier" concept borrowed from economist R. F. Kahn to offer clearer answers to the question of how much stimulus would be given by a specific amount of public investment as it moved through the economy. The multiplier concept offered the possibility of predicting levels of increased economic activity and tax yields, and thus assurance that an invigorated economy could eventually pay the deficits such investment created.
None of these ideas appeared early enough in analytical form to affect New Deal policy, including even the resumption of spending in 1938. They did, however, as the Boston Globe reporters understood, provide academic sanction and legitimization of that policy. Informed observers quickly came to conflate Keynesian economics and the later New Deal. As Eccles put it, New Deal policies, now bolstered by Keynes's academic sanction, offered "some assurance that we can go forward in the future."
Keynes, the economic theorist, had little direct influence on the formulation of policy. The world, in fact, was ruled by others. But his work suggested that the United States was on the right path and thus brought hope and promise to a generation of young academics disheartened by the ideological choices that leaders of Italy, Germany, Spain, and Japan had made in their efforts to cope with the Great Depression. As the United States spiraled into recession in 1937, Western civilization seemed to hang in the balance. And in the minds of those persuaded by Keynes, the "academic scribbler," by explaining what was happening, had tipped that balance in the direction of the liberal democracies. Having thus grasped a hand of rescue at so critical a time, it is understandable that over six decades later Keynesian economics continued to be the predominant paradigm for economic thought and policy in much of the world, including even most societies that had once embraced fascism and Marxism.
See Also: ECONOMISTS; KEYNES, JOHN MAYNARD.
BIBLIOGRAPHY
Feis, Herbert. The Fiscal Revolution in America. 1969.
Hamouda, O. F., and B. B. Price, eds. Keynesianism and the Keynesian Revolution in America: A Memorial Volume in Honour of Lorie Tarshis. 1998.
May, Dean L. From New Deal to New Economics: The American Liberal Response to the Recession of 1937. 1981.
Pasinetti, Luigi L., and Bertram Schefold, eds. The Impact of Keynes on Economics in the 20th Century. 1999.
Wells, Paul, ed. Post-Keynesian Economic Theory. 1995.
Dean L. May
Keynesian Economics
Keynesian Economics
What It Means
Keynesian economics is a school of thought based on the ideas of the British economist John Maynard Keynes (1883–1946). It emphasizes a balance between the private sector’s freedom to conduct business and the government’s role as a stabilizing force in the economy. In Keynesian economics the intervention of government is important to the overall growth of an economy, as well as in pulling an economy out of downturns known as recessions and depressions.
Generally, Keynesian economics advocates using government spending and tax breaks to stimulate the economy when it is in a slump. Likewise, it says that cutting government spending and increasing taxes will help curb inflation (the rising of prices in general, which makes currency, such as the U.S. dollar, worth less) during periods of economic growth. This approach is known as fiscal policy.
The economic policies of industrialized nations (such as the United States) have been greatly influenced by the theories of Keynesian economics. In fact, evidence of Keynesian theory is prevalent in everyday life. For example, when the federal government introduces new tax breaks, it is essentially letting more money remain in the hands of consumers so that they can spend it on goods and services. This increased spending will stimulate the national economy. But if it is too high, consumer spending itself can cause problems for the economy by increasing inflation. Whether the government is acting to rein in an economy that is growing too rapidly or injecting financial life into a slow economy, when it attempts to manipulate overall economic growth through taxes and spending, it is drawing upon Keynesian theories.
Keynesian theory contrasts greatly with classical economics, which emphasizes the idea of laissez-faire, the belief that economies will operate most effectively without government intervention.
When Did It Begin
After World War I ended in 1918, the world economic system did not regain stability as quickly as economists expected it would. Global production of goods and services dropped, and capitalism (the economic system in which production and prices are determined by buyers and sellers interacting freely) came under scrutiny. Some people argued that other economic systems, such as planned economies, worked better. For instance, the Soviet Union embraced socialism, a system inspired by the ideas of Karl Marx in which the government controls the economy.
John Maynard Keynes entered this debate as a supporter of capitalism who nevertheless rejected the laissez-faire approach. In his seminal 1936 work, The General Theory of Employment, Interest, and Money, he argued that the national government of a country needed to intervene in the economy, especially when unemployment (joblessness) was chronic. Keynes stated that a government could prevent economic depression by increasing government spending on public works (the construction of such things as highways, bridges, and dams). He explained that such projects would stimulate employment by giving more people jobs, and as a result, national purchasing power would be increased. This, in turn, would lead to more consumer spending, more investment in business, and new jobs beyond the public-works projects.
Keynesian thinking greatly influenced U.S. economic policy at the beginning of World War II (1939–45). After the war many European countries drew upon Keynesian theories as they developed social-democratic economic models (which try to operate according to ideas of equality and fairness rather than unregulated market forces) to stabilize their damaged economies.
More Detailed Information
Today the field of economics is divided into two main branches: one examining economies from the bottom up (studying how individual decisions add up to larger economic trends), the other looking at them from the top down (studying how large-scale factors affect an economy). Keynes was largely responsible for bringing about the top-down view.
The bottom-up approach is called microeconomics; it is the study of how individuals, households, and firms, for example, make decisions about spending, saving, or investing their limited resources. Microeconomics examines how decisions and behaviors on the part of individuals affect the overall supply and demand for goods and services, which, in turn, determine prices.
Macroeconomics is the term used to describe the top-down approach, the study of the overall features and activities of a national economy. Macroeconomic concerns include such broad subjects as employment, inflation, the total size of the economy and how fast it is growing, and overall economic patterns (for example, the cycle of economic growth and then economic slowdown that is an ordinary part of capitalist economies). In Keynesian theory, macro-level, or general, economic trends can outweigh the micro-level decisions and behaviors of individuals. It is for this reason that Keynesians believe that government should intervene to influence these large-scale factors.
Two major indicators of the health of an economy are unemployment (the percentage of the workforce that cannot find jobs) and inflation (the general rising of prices). The first usually indicates a declining economy, and the second is usually a sign of economic growth (because rising prices are a side effect of such growth). Both can spell trouble for an economy if they increase too quickly. Inflation makes the currency worth less (for instance, decades ago a candy bar might have cost 5 cents, but today there is not much that a person could buy for 5 cents). A certain amount of inflation is normal and manageable, but it is problematic when it rises too quickly, causing people to lose purchasing power.
The Keynesian approach stresses the role of demand in an economy. Keynesians hold that low consumer demand for goods and services is the primary cause of unemployment and that the opposite situation, excessive consumer demand, causes inflation. Therefore, they argue, government has a responsibility to manage the total demand for goods and services, known as aggregate demand, by adjusting how much it spends and how much it taxes its citizens.
Keynesians tend to consider fighting unemployment more important than attempting to overcome inflation. Many Keynesians believe that the problems caused by high levels of inflation are comparatively insignificant. For Keynesians the key to economic stability is to keep the country’s employment rate as close to full as possible (primarily by raising government spending but also by lowering taxes and increasing the money supply).
Keynes divided the causes of inflation into two types: cost-push inflation and demand-pull inflation. Cost-push inflation results from the rising cost of what are called inputs, the resources that must be used to produce goods and services. Inputs could be the wages that must be paid to workers or the price of the raw materials for a product or service. In cost-push inflation the increased price of inputs causes an increased cost for companies to produce goods and services. When companies across the economy try to protect their existing profits by raising their own prices, prices overall in the economy rise, thus causing inflation. In this sense, increased costs have pushed the economy into higher inflation.
Demand-pull inflation, as the name suggests, results from an increase in the overall demand for goods and services in an economy. The total amount of goods and services demanded by consumers, businesses, and government, for any number of reasons, goes up, but the total supply of these goods and services in the economy does not rise as quickly. This might happen from a sudden increase in government spending or, in a more complicated example, when a country’s currency (such as the dollar) falls in value, thus making its goods and services cheaper to foreign countries and increasing their demand for them. Whatever the cause for the increased overall demand, the result is the same: there is now more money being spent by consumers, businesses, and governments, but the supply of goods and services has not increased by the same amount, so producers are able to increase their prices. Increased demand has thus pulled the economy into higher inflation.
Recent Trends
Keynes’s policies were widely accepted in the years following World War II (1939–45). In the 1960s, however, the American economist Milton Friedman (1912–2006) and others began challenging the Keynesian approach. He agreed with the Keynesian idea that government should be involved in stabilizing the economy, but he argued that monetary policy was the only effective way to do so. Monetary policy centers on adjusting the national money supply, and it is carried out by a nation’s central bank (which in the United States is the Federal Reserve).
In the 1970s the United States and other countries suffered from both high unemployment and high inflation, two economic problems that did not usually appear at the same time. The phenomenon, which Keynesian economics could not explain, was dubbed “stagflation.” These problems stretched into the 1980s, causing many economists to blame excessive government intervention for troubles in the economy. It seemed to validate Friedman’s criticisms of Keynesian policies, and his economic theory, called monetarism, gained favor. Supporters of monetary policy point out that it is more efficient because it can be put into action much faster than fiscal policies, which must be reviewed and approved by Congress. Even so, many of Keynes’s ideas—such as stimulating a sluggish economy with tax breaks or increased government spending—remained influential in government policy and in political and economic debates.
Keynesianism
KEYNESIANISM
KEYNESIANISM is a term that identifies both a school of economic theory and a distinctive approach to public policy. Regarding theory, it can be said that the English economist John Maynard Keynes (1883–1946) invented modern macroeconomics with the publication in 1936 of his masterwork The General Theory of Employment, Interest, and Money. That book shifted the focus of attention from the microeconomic actions of individuals and firms to the overall behavior of a capitalist economy.
Keynes argued that, contrary to the conventional wisdom embodied in Say's Law, the capitalist economy did not contain a self-correcting or homeostatic mechanism that would necessarily return it to a healthy equilibrium over the course of the business cycle. Rather, as the contemporaneous Great Depression seemed to demonstrate, a deficiency in effective demand could result in equilibrium at an intolerably high level of unemployment. In the Keynesian model, government policy to bolster aggregate demand, especially fiscal action (spending and taxing) to increase either consumption or the particularly volatile element of investment, could be used to drive an underperforming economy to full employment. Because of the so-called "multiplier effect" that Keynes invoked as a central element in his model, such action could have an ultimate economic impact several times larger than the magnitude of the government's initial corrective intervention.
In the period from World War II through the early 1970s, Keynesianism rose to ever greater influence as both a theory and a guide for public policy. The Keynesian analysis gained a prominent place in textbooks, and its terminology increasingly became the common language of both economists and policymakers. The experience of World War II, with its massive deficit spending, seemed to validate Keynes's approach, and the subsequent Cold War and the later expansion of social spending left the federal government with a sufficiently large presence in the U.S. economy to serve as a Keynesian lever. The size of postwar budgets meant that changes in federal spending and taxing had a powerful impact on the overall economy. Embraced most fervently by Democrats but influential also in Republican circles, the Keynesian policy approach gained its fullest expression in the liberal presidencies of the 1960s, most prominently in the Kennedy-Johnson tax cut of 1964. In 1965, Time magazine put Keynes's picture on its cover in a tribute to the influence of his economic vision.
With the onset of stagflation in the 1970s, Keynesianism began to lose influence both as a theory and as a policy. Unable to explain adequately the economic malaise of simultaneous stagnation and inflation, it came under theoretical assault by the monetarist and the rational expectations schools of economic thought. Suspected of being itself a primary contributor to inflation, Keynesianism was increasingly supplanted by policy approaches aimed more at the supply side of the economy.
At the end of the twentieth century, Keynesianism still provided much of the lingua franca of macroeconomics. However, both as a theory and as a policy, it lived on only in a much chastened and attenuated form, more a limited analysis and a special prescription for particular circumstances than the general theory Keynes had originally proclaimed it to be.
BIBLIOGRAPHY
Collins, Robert M. More: The Politics of Economic Growth in Postwar America. New York: Oxford University Press, 2000.
Keynes, John Maynard. The General Theory of Employment, Interest, and Money. London: Macmillan, 1936.
Skidelsky, Robert. Keynes. Oxford: Oxford University Press, 1996.
Stein, Herbert. The Fiscal Revolution in America. Chicago: University of Chicago Press, 1969.
Robert M.Collins
See alsoEconomics ; Great Depression ; Reaganomics ; Supply-Side Economics .