Keynesian Economics
What is Keynesian Economics?
Keynesian economics holds that aggregate demand drives output in the short run and that government should use fiscal and monetary policy to fight recessions.
Developed by John Maynard Keynes, it argues that economies can get stuck below full employment, so active demand management (spending and tax policy) is needed. It underpins the use of stimulus during downturns and the AD-AS model's short run.
Keynesian Economics: a worked example
Take an invented economy sitting $200 billion below full-employment output, where households spend 75 cents of each extra dollar of income, so MPC = 0.75. The spending multiplier is 1 ÷ (1 - 0.75) = 4, so government purchases of $200 ÷ 4 = $50 billion would close the gap. That first $50 billion becomes someone's income, they spend 0.75 × $50 = $37.5 billion of it, the next round spends 0.75 × $37.5 = $28.1 billion, and the rounds sum to $200 billion. A tax cut is weaker: its multiplier is 0.75 ÷ 0.25 = 3, so the same gap takes about $66.7 billion.
The mistake students make with keynesian economics
Students shorten Keynes to 'government spending is always good' and then apply the multiplier to any economy at any time. The prescription is conditional on idle resources. When workers and factories are already fully employed, extra demand mostly raises the price level, and government borrowing bids up interest rates and crowds out private investment, so real output barely moves. Keynes prescribed restraint and surpluses in booms for that reason. The shorthand sticks because the recession half of the argument is the half that gets taught.
Keynesian Economics questions
What is the difference between Keynesian and classical economics?
Keynesian and classical economics disagree about how fast wages and prices adjust. Classical economists hold that they move quickly enough for the economy to return to full employment on its own, so demand policy mainly shifts the price level. Keynesians hold that wages are sticky downward, so a fall in demand becomes lost output and unemployment that can persist, which is what makes fiscal and monetary action worth taking.
Why do Keynesians say wages are sticky?
Keynesians say wages are sticky downward because of contracts, legal minimums, and the way pay cuts hit workers. A firm that cuts wages tends to lose its best people first and damages the morale of everyone who stays, so it lays workers off instead. If the wage will not fall, a drop in demand turns into a drop in employment, and the economy does not bounce back on its own.
What is the paradox of thrift?
The paradox of thrift is the Keynesian idea that saving more can backfire when everyone does it at once. One household that cuts its spending clearly saves more. If every household cuts spending, total spending falls, and spending is somebody's income, so incomes fall too and the group may save no more than before. It is the sharpest illustration of demand driving output in the short run.
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