Keynesian Economics 101

The Decoder is here to explain thorny theories, prickly policies, complicated issues, and complex arguments.

Keynesian Economics refers to a set of theories designed to explain the determination of overall output and employment in an economy. The British economist John Maynard Keynes (after whom the set of ideas is named) provided the basis for these ideas in his 1936 book, The General Theory of Employment, Interest and Money.  Before the advent of his work, the prevailing point of view among economists and policy makers was that recessions in a private capitalist economy were  essentially self-correcting. They argued that if there were more goods and services in the economy than could be sold, prices and wages would fall and restore balance. Keynes’s insight was that  for a host of reasons this need not be (and often was not) the case.   He suggested that fluctuations in output and employment were the consequence of changes in aggregate demand, and that it was possible for an economy to be trapped in an sustained period where private investment and consumption remained very low even with falling prices.

Keynes provided several reasons as to why the actions of individuals and firms could yield outcomes in which the economy operated below its potential output and growth. Inherent institutional features of the system made prices adjust too slowly downwards;  businesses and households maintained pessimistic expectations, thereby holding back investment and consumption; individuals wanted to keep their assets in the most liquid of forms, thereby preventing long term investments from occurring, and so on. In establishing these relationships, Keynes enabled the creation of the field of macroeconomics. But it was in the arena of policy and the role of the state in managing the economy that his ideas had the most public impact. In order to counter the tendencies that prolonged recessions and created depressions, Keynes proposed an active role for government intervention through monetary and fiscal policies to control the business cycle. When private spending was too low, governments could take up the slack and spend in order to maintain aggregate demand. Such policies greatly enabled the moderation of business cycles in the post-war period.

Keynes’s work and ideas continue to animate and inform the issues of today (see ND20 on a recent debate between Braintruster Jeff Madrick and Niall Ferguson). His theories have been updated and have led to further questions and debates,  but there is no doubting that they have been among the  most influential ideas in the social sciences in the last one hundred years.