Keynesian Economics Explained

Keynesian theory in economics is named after the British economist, John Maynard Keynes. He provided the framework for this theory after deeply analyzing the Great Depression. The theory is associated with the determination of equilibrium real GDP, employment, and prices. It focuses on the relationship between aggregate income and expenditure. It accounts for the total spending in the economy and its effects on output and inflation.

It is also a proposal which says that the government should increase demand to boost growth as consumer demand is the primary driving force in an economy. Owing to this, the theory comes according to the expansionary fiscal policy.

Introduction

According to the Keynesian view of economics, the aggregate demand isn’t always necessarily equivalent to the productive capacity of the economy. Instead, it is influenced by a host of factors and sometimes behaves erratically, affecting production, employment, and inflation.  

Analysis Of The Theory

Let’s discuss some facts and key takeaways of the theory.

  1. The classical theory demonstrates that even the slightest fall in investment leads to lower interest rates. This fall in interest rates reduces savings. It further increases investment and causes the economy to return to a new equilibrium of full employment. However, Keynesian analysis suggests this is highly unlikely, owing to a number of factors, such as a liquidity trap and the general glut of savings.
  2. Now what is liquidity trap? A liquidity trap takes place when low-interest rates fail to surge demand. For instance, if confidence is very low, people will not borrow – even though it is cheap. Also, meagre-interest rates can make banks unprofitable, so they reduce lending.
  3. Negative multiplier effect: The Keynesian theory brings out the idea that a fall in injections into the economy results in a significant knock-on effect and the final impact is usually greater than the initial one. If a firm reduces investment, people lose their jobs, and this higher unemployment leads to lower spending and affects everyone in the economy.
  4. A paradox of thrift: During recession, consumers adopt a rational approach which is risk-averse – fearing a possible recession, they increase savings and spend less. When this lower spending is aggregated, it leads to lower overall demand in the economy.
  5. According to the Keynesian view, modifications in the aggregate demand, whether anticipated or unanticipated, have their greatest short-run effect on real output and employment, not on prices.
  6. Keynesian theory demonstrates that prices, and especially wages, respond rather slowly to changes in supply and demand, resulting in periodic shortages and surpluses, especially of labor.
  7. Keynesian theory does not stand for the fact that the typical level of unemployment is ideal. This is probably because unemployment is subject to the caprice of aggregate demand, but at the same time it holds the belief that prices adjust only gradually.
Fig: Keynesian Economics

Keynesian Economics and Monetary Policy

Keynesian theory concentrates on demand-biased solutions for recessionary periods. The intervention of government in economics is an important part of the Keynesian arsenal for battling unemployment, underemployment, and low economic demand. The emphasis on direct government intervention in the economy places Keynesian theorists at odds with those who argue for limited government involvement in the markets.

Lowering the interest rates is one of the many effective ways that the governments use to intervene in economic systems meaningfully. Thus, generating active market demand.

Conclusion

Keynesian theorists argue that economies do not stabilize themselves very quickly and require active intervention that boosts short-term demand in the economy. Wages and employment, they argue, are slower to respond to the needs of the market and require governmental intervention to stay on track.

Prices also do not react quickly, and only gradually change when monetary policy interventions are made. This slow change in prices, then, makes it possible to use money supply as a tool and change interest rates to encourage borrowing and lending.

Fig: Economics

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