FLASH SALE! - "FINANCIAL MODELING COURSE BUNDLE AT 60% OFF" Enroll Now

Keynesian Economics

Updated on January 29, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Keynesian Economics?

Keynesian economics refers to the economic theory that advocates the impact of total spending on the economy as it drives the aggregate demand. It states how the introduction of certain monetary policies could positively affect employment, inflation, and other outcomes, thereby keeping the economy active.

What Is Keynesian Economics

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Keynesian Economics (wallstreetmojo.com)

Keynesian economics is different from classical economics, which claims that aggregate supply and not aggregate demand keeps an economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more strong and going. The theory also believes that increasing government spending and lowering taxes help prevent financial struggles for an economy by raising people’s purchasing power and enhancing consumer demands.

Key Takeaways

  • Keynesian economics refers to the economic school of thought advocating the impact of aggregate demand in shaping an economy.
  • It establishes a cyclical connection between consumer demand, total spending, increased production, more employment, and inflation in taking an economy out of depression.
  • Since the theory stabilizes the economy by concentrating on demand, it is considered the ‘demand-side’ theory.
  • While the laissez-faire policy drives classical economics, Keynesian economics is a completely demand-driven approach.

Understanding Keynesian Economics Theory

Keynesian economics was introduced by British economist John Maynard Keynes in the 1930s while he deeply studied the Great DepressionGreat DepressionThe Great Depression refers to the long-standing financial crisis in the history of the modern world. It began in the United States on October 29, 1929, with the Wall Street Crash and lasted till 1939.read more. The scholar analyzed the possible factors responsible for the economic depression and concluded the impact of aggregate demand on the economic outcomes achieved.

To understand the exact Keynesian economics definition, it is important to be aware of the interrelation between total spending, aggregate demand, and inflation. The increasing demand for products and services available in the market shows how active the economy is. This is because the demand for consumer goods and services automatically increases when the population is ready to spend. And the population is only prepared to pay when it has money. Thus, the aggregate demand signifies an economy’s financial strength, depending on the increase and decrease in purchasing power. 

When the demand in the market for consumer goods is high, the economy remains stable. Hence, Keynesian or post Keynesian economics is considered a “demand-side” theory. Moreover, the continuous increase in the demand for products leads to an increase in prices, causing inflation. Though inflation makes goods pricey for a portion of the population, it still indicates the dominance of wealth, representing financial stability in an economy.

During an economic turmoil, when inflation is low, and people receive lower wages, employers opt for capital investment. As a result, they employ more people to regain their productivity. As a result, more people get jobs, ending up spending more, increasing the demands for consumer goods, thereby retaining the economic stability.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Examples

Let us consider the following Keynesian economics examples to understand how it works:

Example 1

The first instance that gave rise to the Keynesian theory was the Great Depression of the 1930s. To mitigate the effects, especially unemploymentUnemploymentUnemployment refers to a situation where individuals capable of working seek active opportunities for work but cannot find any for various reasons.read more, U.S. President Franklin D. Roosevelt introduced measures to revive the U.S. economy, including the Social Security scheme, minimum wage program, and child labor laws. 

Example 2

Former President Barack Obama introduced the Economic Stimulus Act to end the 2008 recession. Under this act, the U.S. Government provided benefits to the unemployed, including education. He also initiated a healthcare policy, widely known as Obamacare.

Criticisms

Keynesian economics has been critical of governments’ increasing expenditure on welfare assignments, thereby raising the taxes levied on the citizens. Plus, the theory never favored people believing in saving more and more. On the contrary, the principle advocated for proportionate spending and saving habits to help the economy flow without interruption.

The new Keynesian economics, however, establishes a link between employment, wages, and aggregate demand. The critics state that the aggregate demand is not the only factor that makes employers hire workers, increasing the employment rate. In addition, the macro-level economy adjusts slowly with the aggregate demand, given the sticky wages that do not change as per the change in demand.

The classical theory supporters believe that it is not the aggregate demand that impacts the economic outcomes but the business performance and growth that boosts the economy. In addition, there have been thinkers who vouched for strong fiscal policiesFiscal PoliciesFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more. In contrast, a few supported the introduction of effective monetary policies Monetary Policies Monetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more by the government to ensure the stabilization of the economy. 

While socialists want the Keynesian theory to allow more governmental intervention, communists desire to transfer complete control to the people. 

Classical vs Keynesian Economics

The two schools of thought in economics are classical and Keynesian theories. While the laissez-faire policy drives the former, the latter is a completely demand-driven approach. 

Classical vs Keynesian Economics

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Keynesian Economics (wallstreetmojo.com)

The classical economics concept states that the economy is stable only when the business performance is up to the mark. The believers of this economic approach believe in no external interference from the administrative authorities. Instead, they advocate for self-regulated market entities that work independently and grow, stabilizing the economy. It also states that it is the aggregate supply that impacts the economy.

On the contrary, Keynesian economics is the demand-side theory, specifying how aggregate demand makes people spend, impacting the economy effectively. It keeps room for government intervention in different forms. It could be through an increase in the tax rate and interest rate and a decrease in the social programs spending at the time of economic boom, and exactly opposites if economic turmoil is indicated. 

Frequently Asked Questions (FAQs)

What is the Keynesian theory of economics?

Keynesian economics is a theory that relates total spending with inflation and output in an economy. It states that increasing government expenditure and reducing taxes may increase demand in the market and pull the economy out of depression. This theory is named after a British economist, John Maynard Keynes, who came up with this concept when the global economy witnessed the Great Depression in the 1930s.

Does Keynesian economics work?

Keynesian economics works well when it comes to increasing the rate of employment with the increase in the demand for the product. The enhanced demand calls for an increase in the supply, and to meet the supply requirements, production paces up, leading to the employment of more workers. But, on the contrary, it also witnesses the loophole as the aggregate demand is not the only factor determining the economy’s productivity. Rather, other parameters play a key role.

Moreover, the theory works better for developed nations that are wealthier than developing ones.

Is Keynesian economics socialism?

As the theory advocates the government’s intervention in making expenditures and lowering taxes to enhance the purchasing power of the citizens, it could be linked with socialism, given its socialist approach to some extent.

This article is a guide to what is Keynesian Economics & its definition. Here, we explain the theory, criticism, example & difference with classical economics. You can learn more from the following articles: –