Keynesian Economics Explained: Sticky Wages, the Multiplier and the Keynesian Cross

Keynesian economics is the theory, set out by the British economist John Maynard Keynes, that total spending in the economy determines output and employment in the short run. Because wages and prices adjust slowly, a fall in spending can leave an economy producing below full employment for a long time. Keynesians conclude that government should raise spending or cut taxes in a slump, and do the reverse in a boom.

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The AD-AS model in long-run equilibrium at full-employment output. Tap it to drag the curves, open the full version, or put it on your own site free, or turn it into a five-minute class activity.

The short definition lives in the Keynesian economics glossary entry.

The three core claims of Keynesian economics

1. Aggregate demand drives output in the short run

Aggregate demand is total planned spending on final goods and services: C + I + G + NX. Firms produce what they expect to sell. When households and businesses cut spending, unsold goods pile up, firms cut production and workers lose jobs. Output falls because demand fell, not because the economy lost any ability to produce.

The classical economists leaned on Say's law, the idea that supply creates its own demand. Keynes argued that in the short run the causation often runs the other way: demand decides how much of the economy's capacity gets used.

2. Wages and prices are sticky

If wages and prices dropped instantly whenever spending fell, cheaper goods would bring buyers back and cheaper labor would bring hiring back. Keynesians argue wages do not fall quickly. Pay is set by contracts, minimum wage laws put a floor under some wages, and firms avoid pay cuts because they hurt morale, so they lay people off instead. This is the sticky-wage theory behind the upward-sloping short-run aggregate supply curve.

3. An economy can settle below full employment

Put the first two claims together and you get the third. If spending falls and wages will not drop, an economy can sit with idle factories and unemployed workers for years. Keynes argued that even if wages did fall, the adjustment could be slow and might not restore full employment on its own, so waiting costs too much. His line "In the long run we are all dead" is often quoted to make the same point.

Keynes also stressed that investment swings with business confidence, which he called "animal spirits." The paradox of thrift is a related idea: if every household tries to save more at once, spending and incomes fall, and total saving may not rise at all.

The multiplier: why one dollar of spending moves GDP by more than one dollar

One person's spending is another person's income. When the government spends a dollar, the person paid spends part of it, the next person spends part of that, and the rounds add up. The share of each extra dollar that households spend is the marginal propensity to consume, or MPC. The share they save is the MPS, and MPC + MPS = 1.

• Spending multiplier = 1 / (1 - MPC) = 1 / MPS
• Tax multiplier = -MPC / (1 - MPC)

Worked example: closing a hypothetical $150 billion gap

All numbers are invented. An economy is producing $500 billion of real GDP. Full-employment output is $650 billion. MPC = 0.6.

1. Gap: 650 - 500 = $150 billion.

2. MPS: 1 - 0.6 = 0.4.

3. Spending multiplier: 1 / 0.4 = 2.5.

4. Purchases needed: 150 / 2.5 = $60 billion.

5. Check: 60 x 2.5 = 150.

The later rounds add 7.776 / 0.4 = 19.44, and 130.56 + 19.44 = 150.

A tax cut works out differently. The tax multiplier is -0.6 / 0.4 = -1.5, so the tax change needed is 150 / -1.5 = -100, a $100 billion tax cut. It must be bigger because households save 40 percent of it first: 0.6 x 100 = $60 billion reaches the first round, the same first round the $60 billion purchase delivered directly. Check the tax version on the tax multiplier calculator.

The multiplier effect guide covers the balanced-budget multiplier and common traps. Get MPC and MPS from data with the MPC and MPS calculator, then test your own numbers on the spending multiplier calculator.

The Keynesian cross

The Keynesian cross is the diagram that finds equilibrium output when prices are fixed. It goes beyond the AP Macroeconomics course, which uses the AD-AS model instead, but it shows the multiplier directly on a graph.

• Horizontal axis: real GDP, which also equals total income, Y.
• Vertical axis: planned aggregate expenditure (AE).
• The 45-degree line: every point where planned spending equals output.
• The AE line: AE = autonomous spending + MPC x Y. Its slope is the MPC, less than 1, so it is flatter than the 45-degree line.

Equilibrium is where the AE line crosses the 45-degree line. Take AE = 200 + 0.6Y, in billions. Set Y = 200 + 0.6Y, so 0.4Y = 200 and Y = $500 billion. At Y = 600, planned spending is 200 + 360 = 560, so 40 of output goes unsold and firms cut back. At Y = 400, spending is 440, shelves empty and firms expand.

Raise government purchases by $60 billion and the AE line shifts up to AE = 260 + 0.6Y. Then 0.4Y = 260 and Y = $650 billion, a rise of 150, which is 2.5 times 60. That is the multiplier read off the graph. Nothing in the diagram pulls output toward full employment: $500 billion is a stable equilibrium even if full employment is $650 billion. That is Keynes's central claim drawn as two lines.

The Keynesian policy prescription: countercyclical fiscal policy

If spending drives output and the economy repairs itself slowly, the remedy is to manage spending. Keynesians call for countercyclical policy, leaning against the business cycle:

• In a recession: expansionary fiscal policy. Raise purchases, cut taxes or raise transfers. A budget deficit is acceptable in a slump.
• In a boom: contractionary fiscal policy. Cut purchases or raise taxes to hold down inflation, and run a budget surplus.

Some of this happens with no new law, as tax collections fall and benefits rise in a downturn; see the automatic stabilizers guide. Monetary policy follows the same logic, though Keynes doubted it could work in a deep slump with rates near zero, the case called a liquidity trap.

Critics point to policy lags, to rising debt, and to government borrowing that pushes up interest rates and crowds out private investment, traced in the crowding out guide. Keynesians answer that crowding out is weakest in a deep recession, when private investment is already low. Economists in the supply-side economics school take a different route, focusing on the incentives that raise the economy's capacity.

Keynesian vs classical economics

See the classical economics entry and the Keynesian vs classical comparison. The AD-AS model in AP Macro blends the two: Keynesian in the short run, where sticky wages give an upward-sloping SRAS, and classical in the long run, where a vertical LRAS means output returns to potential.

Keynesian economics on the AD-AS graph

Put the price level on the vertical axis and real GDP on the horizontal axis. AD slopes down, SRAS slopes up and LRAS is vertical at full-employment output.

Start in long-run equilibrium. Pessimism cuts investment and AD shifts left. The new short-run equilibrium sits left of LRAS at a lower price level: a recessionary gap, with unemployment above the natural rate. With the numbers above, output is $500 billion against $650 billion of potential.

• The classical answer: wait. Nominal wages fall, SRAS shifts right, and output returns to LRAS at a lower price level, as the long-run self-adjustment guide shows.
• The Keynesian answer: sticky wages make that wait too long. Shift AD right with a $60 billion increase in purchases, which with MPC = 0.6 shifts AD right by $150 billion.

With an upward-sloping SRAS, part of any AD shift shows up as a higher price level, so the gap divided by the multiplier is the minimum spending change, which is how AP questions treat it. Practice more in the guide to closing recessionary and inflationary gaps, and shift AD yourself on the interactive AD-AS graph.

Keynesian economics on the AP exam

No AP Macroeconomics topic title uses the word Keynesian, but the ideas run through Unit 3: Topic 3.2, Multipliers (see the AP Macro 3.2 topic page), Topic 3.7, Long-Run Self-Adjustment, and Topic 3.8, Fiscal Policy.

Common mistakes:

• Using the spending multiplier for a tax change. Taxes use -MPC / (1 - MPC).
• Multiplying the gap by the multiplier. Divide the gap by the multiplier.
• Shifting LRAS to show stimulus. Demand policy moves AD only.
• Saying Keynesians always want more spending. In an inflationary gap the Keynesian answer is contractionary policy.

For a full unit review, work through the fiscal policy module.