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What Is Classical Economics?
Before Keynes proposed his economic theory, the main school of economic thought was classical economics. The classical theory opted for a laissez-faire policy, meaning that the free market would self-regulate with the laws of supply and demand. Classical economists asserted that aggregate supply, not aggregate demand, was the key focus of a market economy, which would mean that as long as individuals and businesses were producing goods for sale, those goods would be bought. Classical economics also argued that a free market would automatically guarantee full employment, meaning that anyone who wanted a job would have one.
But then came the Great Depression, a severe financial downturn that proved difficult to solve, and classical economists were left fumbling for answers. They observed that most businesses were having trouble selling their products, and they watched “involuntary unemployment” spike.
The Rise of Keynesian Economics
In the middle of the Great Recession of the 1930s, John Maynard Keynes created his economic theory as a direct response to the financial downturn around him. His books (The Economic Consequences of the Peace, A Treatise on Money, and The General Theory of Employment, Interest and Money) solidified his economic theory (often called Keynesianism) on aggregate demand, the business cycle, and involuntary unemployment, and they not only explained how the Great Recession could have happened but also provided a proposed solution: that central banks and government intervention could solve the financial crisis.
Key Keynesian Concepts: The Business Cycle
Keynes recognized a phenomenon classical economists called the “business cycle,” in which at certain times it seemed like almost all businesses were able to sell as much as they wanted, while at other times virtually all business had trouble selling. Classical economists couldn’t explain what caused the business cycle because they were focused on supply, but Keynes’s emphasis on demand finally offered an explanation. According to Keynes, the business cycle works in stages:
- First, people like to have extra money in reserve in case of an emergency.
- If everyone becomes fearful at once, everyone will attempt to increase their reserves at the same time.
- Third, if everyone increases their reserves at the same time, there will not be enough spending to buy all the goods and services for sale.
- Fourth, if there is not enough spending to buy all the goods and services for sale, the level of fear in the economy will increase. This fear will, in turn, cause people to want to increase their reserves of money and the cycle will build on itself.
This cycle is difficult to stop because people cannot get the very thing they want—more money in reserve—because the only way to get money is by selling something to other people. Those people will be reluctant to buy because they too are trying to increase their reserves. This is referred to as the “paradox of thrift.”
Key Keynesian Concepts: Involuntary Unemployment
Keynes explained that even productive economies could get caught in an economic downturn if a lack of demand (and, therefore, a lack of spending) arose. The lack of spending could cause businesses to cut back on production, and the cuts in production would then lead businesses to reduce the number of workers they employed, creating high unemployment. The reduction in employment opportunities would then lead families to cut back on spending—worsening the original problem.
Keynesian Economic Solutions: Fiscal Policy
Keynesian economics offers a solution to lack of spending: fiscal and monetary policies.
Fiscal policy is any financial stimulus implemented by the national government. Fiscal policy can come either in the form of increased government spending on things like infrastructure or in the form of tax cuts. Either of these methods will inject more demand into the private economy and strengthen economic activity. Fiscal policy works because, according to Keynes, reduced aggregate demand causes financial crises, and government spending is part of aggregate demand. Therefore, an increase in government deficit spending means an increase in aggregate demand, which alleviates economic downturns in the short run and promotes economic growth.
Keynesian Economic Solutions: Monetary Policy
Monetary policy is any financial influence implemented by a central bank. Monetary policy usually comes in the form of lowered interest rates, which increase the total money supply within an economy by allowing individuals and businesses more access to loans—and therefore, more accessible spending power.
Keynesian theory argues for something called the “multiplier effect,” which says that each dollar of government spending results in a one-dollar increase of aggregate demand. For instance, if the government spends $100 million on a public-works project, and $50 million of that was for labor costs, those workers would take that money and spend it at businesses—which businesses would then have more money to produce more and hire additional workers, contributing more spending. Thus, according to Keynesian economics, the government’s $100 million would result in approximately $100 million of economic growth.
Real-World Examples of Keynesian Economics
An example of the Keynesian model in action is United States President Barack Obama’s response to the global financial crisis that began in 2007. President Obama implemented significant fiscal policies during the Great Recession of the mid-2000s. In February 2009, President Obama signed the American Recovery and Reinvestment Act, which was a government stimulus package of $787 billion designed to save existing jobs and create new ones. While opinion is divided as to the Recovery Act’s effectiveness, the majority of economists agreed that at the end of 2010, unemployment was lower than it would have been without the stimulus package.
Learn more about economics and society in Paul Krugman’s MasterClass.