What Is Keynesian Economics?

• Author: Sarwat Jahan, Ahmed Saber Mahmud, and Chris Papageorgiou

Back to Basics

Just how important is money? Few would deny that it plays a key role in the economy.Â

During the Great Depression of the 1930s, existing economic theory was unable either to explain the causes of the severe worldwide economic collapse or to provide an adequate public policy solution to jump-start production and employment.

British economist John Maynard Keynes spearheaded a revolution in economic thinking that overturned the then-prevailing idea that free markets would automatically provide full employment—that is, that everyone who wanted a job would have one as long as workers were flexible in their wage demands (see box). The main plank of Keynes’s theory, which has come to bear his name, is the assertion that aggregate demand—measured as the sum of spending by households, businesses, and the government—is the most important driving force in an economy. Keynes further asserted that free markets have no self-balancing mechanisms that lead to full employment. Keynesian economists justify government intervention through public policies that aim to achieve full employment and price stability.

The revolutionary idea

Keynes argued that inadequate overall demand could lead to prolonged periods of high unemployment. An economy’s output of goods and services is the sum of four components: consumption, investment, government purchases, and net exports (the difference between what a country sells to and buys from foreign countries). Any increase in demand has to come from one of these four components. But during a recession, strong forces often dampen demand as spending goes down. For example, during economic downturns uncertainty often erodes consumer confidence, causing them to reduce their spending, especially on discretionary purchases like a house or a car. This reduction in spending by consumers can result in less investment spending by businesses, as firms respond to weakened demand for their products. This puts the task of increasing output on the shoulders of the government. According to Keynesian economics, state intervention is necessary to moderate the booms and busts in economic activity, otherwise known as the business cycle.

There are three principal tenets in the Keynesian description of how the economy works:

• Aggregate demand is influenced by many economic decisions—public and private.Private sector decisions can sometimes lead to adverse macroeconomic outcomes, such as reduction in consumer spending...