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What is Keynesian economics?

Keynesian economics definition

Keynesian economics, or Keynesianism, is a macroeconomic theory about how economic output is affected by aggregate demand, or total spending. The theory was introduced by British economist John Maynard Keynes in the 1930s in an effort to analyse and conquer the Great Depression. Keynes believed that lower taxes and increased government expenditure could spur demand and pull the economy out of the depression.

Keynesian economics was later used to bolster the concept that effective economic performance with no economic slumps can be built by affecting aggregate demand with the help of economic intervention and stabilisation policies by the government.

According to Keynesian theory, activist fiscal and monetary policy are the major tools to fight unemployment and manage the economy.

Keynesian economics explained

Keynesian economics provided a new way of looking at output, spending and inflation. Classic economic thinking presupposed that cyclical fluctuations in economic output and unemployment would be self-adjusting and modest. However, the severity of the Great Depression led Keynes and his supporters to question this theory.

According to Keynes, certain characteristics of market economies and structural rigidities could exaggerate economic weakness and trigger aggregate demand to fall further. Keynesian economists usually argue that as aggregate demand is unstable and volatile, market economies often experience inefficient outcomes in the form of inflation and recessions. They believe that these effects can be mitigated by monetary policy actions by central banks and fiscal policy actions by the government, stabilising output over the business cycle.

Generally, Keynesians advocate a managed market economy with a predominantly private sector, supported by active government intervention during depressions and recessions.

There are three major principles in the Keynesian theory, which describes how the economy works:

  • Aggregate demand is affected by many economic decisions, private and public. For example, a reduction in consumer spending during a recession can call for active government intervention, such as a stimulus package.

  • Prices and salaries slowly respond to changes in supply and demand. This may result in surpluses and shortages of labour from time to time.

  • Anticipated or not, aggregate demand changes have a greater effect on employment and real output, rather than on prices.

Keynesian ideas dominated after World War Two until the 1970s, when they were often criticised by modern economists.  However, the global financial crisis of 2008 gave a second birth to Keynesian thought, with many governments, including those of the United Kingdom and the United States, engaging actively in the economy. These policies have also been employed throughout the current coronavirus-inspired global recession.

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