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What Is Demand-Side Economics?
Demand-side economics is frequently referred to as “Keynesian economics” after John Maynard Keynes, a British economist who outlined many of the theory’s most important attributes in his General Theory of Employment, Interest, and Money.
- According to Keynes’ theories, economic growth is driven by the demand for (rather than the supply of) goods and services. Simply put, producers won’t create more supply unless they believe there’s demand for it.
- Demand-side theory directly counters classical and supply-side economics, which hold that demand is driven by available supply. This may seem like a chicken-and-egg distinction, but it has some major ramifications for how you look at the economy and the government’s role in it.
- In contrast to supply-siders, Keynesians place less emphasis on overall levels of taxation, and believe much more in the importance of government spending, especially during periods of weak demand.
The Main Differences Between Supply-Side and Demand-Side Economics
Here’s how demand-side economics differs from supply-side:
- Demand-side economists argue that instead of focusing on producers, as supply-side economists want to, the focus should be on the people who buy goods and services, who are far more numerous.
- Demand-side economists like Keynes argue that when demand weakens—as it does during a recession—the government has to step in to stimulate growth.
- Governments can do this by spending money to create jobs, which will give people more money to spend.
- This will create deficits in the short-term, Keynesians acknowledge, but as the economy grows and tax revenues increase, the deficits will shrink and government spending can be reduced accordingly.
What Are the Different Demand-Side Policies?
Broadly speaking, there are two-prongs to demand-side economic policies: an expansionary monetary policy and a liberal fiscal policy.
- In terms of monetary policy, demand-side economics holds that the interest rate largely determines the liquidity preference, i.e., how incentivized people are to spend or save money. During times of economic slowness, demand-side theory favors expanding the money supply, which drives down interest rates. This is thought to encourage borrowing and investment, the idea being that lower rates make it more appealing for consumers and businesses to buy goods or invest in their businesses—valuable activities that increase demand or create jobs.
- When it comes to fiscal policy, demand-side economics favors liberal fiscal policies, especially during economic downturns. These might take the form of tax cuts for consumers, like the Earned Income Tax Credit, or EITC, which was an important part of the Obama administration’s efforts to fight the Great Recession.
- Another typical demand-side fiscal policy is to promote government spending on public works or infrastructure projects. The key idea here is that during a recession it’s more important for the government to stimulate economic growth than it is for the government to take in revenue. Infrastructure projects are popular options because they tend to pay for themselves in the long term.
A Brief History of Demand-Side Economics
Before Keynes, the field of economics was dominated by classical economics, based on the works of Adam Smith. Classical economics emphasizes free markets and discourages government intervention, believing that the “invisible hand” of the market is the best way to efficiently allocate goods and resources in a society.
- The dominance of classical economic theory was severely challenged during the Great Depression when a collapse in demand failed to result in increased savings or lower interest rates that might stimulate investment spending and stabilize demand.
- During this time, the U.S. under the Hoover Administration pursued a policy of balanced budgets, leading to massive tax increases and the Smoot-Hawley tariffs of the 1930s. These policies, especially the latter, failed to stimulate demand for domestic industries and provoked retaliatory tariffs from other nations, which led to a further decrease in international trade and likely worsened the crisis.
- Writing in his General Theory of 1936, Keynes argued persuasively that, contrary to classical economics, markets have no self-stabilizing mechanism. According to his account, producers make investment decisions based on expected future demand. If demand appears weak (as it does during a recession), businesses are less likely to produce more goods and services, which in turn results in fewer people with jobs or income that might stimulate economic activity. In cases like this, Keynes argued, governments could stimulate demand by increasing spending.
- Keynes’ policies found advocates in Franklin Roosevelt’s administration, which pursued many of the monetary and fiscal policies advocated by Keynes in the form of the New Deal. This included government spending through programs like the Works Progress Administration (WPA), the Civilian Conservation Corps (CCC), the Tennessee Valley Authority (TVA), and the Civil Works Administration (CWA).
- Though the exact relationship between Franklin’s New Deal policies and the Great Depression is a hotly debated topic among economists, Keynes’ views became economic orthodoxy in the United States and much of the western world until the “stagflation” of the 1970s, when they largely fell out of fashion in favor of supply-side theories.
The Debate Over Demand-Side Economics Today
Although most often associated with FDR and the New Deal, Keynesian economics and its descendants has experienced something of a revival since the 2008 financial crisis.
- During the Great Recession, the Obama administration pursued a number of demand-side policies to stimulate the economy. These included aggressively lowering interest rates, cutting taxes for the middle class, and pushing a $787 billion dollar stimulus package. The administration also intervened in the financial sector, passing the largest overhaul of that sector since the 1930s, in stark contrast to the more laissez-faire attitudes of the 1990s and early 2000s.
- As during the 1930s, these demand-side policies were fiercely contested at the time, and remain controversial even today. The slowness of the recovery prompted criticism from many economists, especially those on the left, who argue that even more aggressive stimulus was needed, while economists on the right criticized the Obama administration for increasing the deficit.
Learn more about economics in Paul Krugman’s MasterClass.