Keynesian Economics

The History of Keynesian economics

Keynesian economics is mainly a macroeconomic theory that describes overall economic spending and its consequences on production, employment, and inflation. And it was established during the 1930s by the British economist John Maynard Keynes in an attempt to understand the Great Depression.

What historical event led to Keynesian economics?

In the 1930s sudden collapse in the economy was started in the United States and afterward it spread to the rest of the world. This substantial economic downfall is known as the Great Depression. During this period unemployment increased significantly and production dropped dramatically and as the classical or neoclassical theories suggested, this situation did not correct automatically. Moreover, the classical economics school was not able to offer an explanation or a solution to this problem. In fact, classical theories were developed by looking at the long-term capitalist economic development in Europe and never had the experience of short-term business cycles. Hence, their theories were not developed to explain such phenomena.

Who founded Keynesian economics?

John Maynard Keynes (1883-1946) emerged at this backdrop. He was initially an advocate of classical economics school and taught classical economics at the University of Cambridge. In 1936 he published his famous book “The General Theory of Employment, Interest, and Money” and gave guidelines to overcome the great depression. This led to the beginning of Keynesian ideology. Keynes and his successor are known as Keynesians School of economics. The period from the late 1930s to the mid-1960s is well-known as the Keynesian revolution or Keynesian era.

According to Ha – Joon Chang Keynesian economics ideas were more suitable in explaining the advanced capitalist economy in the twentieth century than the classical or neoclassical school. The emergence of Keynesian economics had a significant impact on both economics and the real world. Under the Keynesian school, more focus was given to the branch of macroeconomics. Until Keynes macroeconomic policies were not used to achieve growth and stability. With the Keynesian revolution relationship between the government and the economy was also transformed.

Keynesian economics vs classical economics

To a larger extent, Keynesian economics was different from classical ideas.

Long run vs Short run

Keynes acknowledges the uncertainty and highlights the key role of finance in modern capitalist society. Unlike classical or neoclassical schools, Keynesian economics did not focus more attention on long-term issues and paid much attention to short-term issues. This is evident by Keynes’s famous quote “in the long run we are all dead”. Due to this Keynesian theoretical contribution is weak on long-term issues, such as institutional changes and technological progress.

In the long run we are all dead

John Maynard Keynes

Uncertainty and Investment

Another point worth noting is Keynesian ideas on uncertainty and investment decision-making. According to Keynes investment decisions of firms are dependent on expected probability (Marginal Efficiency of Capital). Expected probability is subject to the expected income or else the firm’s ability to generate income in the future. Hence, the expected income is associated with risk and uncertainty. Therefore, Keynes argued that investment decisions are dependent upon psychological factors rather than rational calculation because the future is full of uncertainty. Here, Keynes acknowledges the uncertainty in the economy. This was an alternative to the Classical idea about the economy is certain.

Savings – Investment equality

Under the classical idea of Savings – investment equality, total savings are used for investment purposes therefore, savings are equal to the investment at full employment level. On contrary, Keynes did not guarantee that these two would be equal at full employment level because investors and people who save are not the same people. Hence there can be a shortage of surplus in savings. Keynes asserts that in an economy if saving is higher than investment, it will cause a recession whereas investment is higher than the saving, it will cause inflation. Suppose, due to the uncertainty investors are pessimistic about the future and they reduce the investment which then leads to excess savings. According to classical assumptions this excess saving is temporary because the decline in demand for savings reduces the interest rate and makes investment more attractive (Classical assume that the rate of interest depends on the saving and investment). According to Keynesian theory, this will not happen. It is because when investment reduces, overall spending declines, and then due to this income falls. This reduction in income then reduces the savings. And this vicious cycle leads to recession. Furthermore, Keynesians claimed that Savings and investment were determined by a complex host of factors in addition to the interest rate, and the rate of interest depends on the money supply and demand for money

Price and Wage rigidities

Another point to consider is price and wage rigidities. According to Keynes price and wages are not flexible as mentioned by classical economists. There are rigidities in the economy such as monopolies and labor unions which prevent the flexible movement of wages and prices. Therefore, a classical automatic adjustment mechanism through prices is not possible. When the market is in a disequilibrium prices cannot change freely and remove the deficit or surplus and push the economy towards equilibrium. Thereby Keynesian economics suggested the adjustment through output. So, when there is excess demand or excess supply, the output would change automatically making adjustment mechanism possible.

Employment and Aggregate Supply

When considering the employment and Aggregate supply, the Keynesian aggregate supply curve is upward sloping until the economy reaches full employment output. This is because wages are not flexible and involuntary unemployment exists in the short run. This idea is totally different from the Classical Aggregate Supply curve which is vertical at the full-employment level. However, it is important to note that there is the time difference between Keynesian and classical. The classical aggregate supply curve is in the long run and the Keynesian aggregate supply curve is in the short run.

The level of output and employment in an economy is determined by the aggregate demand.

Role of Finance

Keynesian school of economics stresses the role of government in demand management for stable growth of the economy. Keynes believed that quantity adjustment through fiscal and monetary policies is effective in achieving economic growth. Alternative to the idea of the crowding-out effect of classical school Keynes stress that government spending can have a favorable impact on national income and employment through the multiplier effect. Further, Keynes argued the effectiveness of the expansionary monetary policy. This is favorable because money is not neutral under the Keynesian assumptions. So when the money supply increase, the interest rate goes down then investment, and consequently aggregate demand goes up. The Keynesian conclusion was government intervention is a must for demand management. However, the classical economists argued that neither of these policies is not effective because they will only change the prices, not the output.

Important of Finance

In addition, Keynes recognized the importance of finance. Keynes rejected the quantity theory of money and came up with the Liquidity preference theory. According to that people hold cash balances for three motives, transactions motive, precautionary motive, and speculative motive.

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