Keynesian Economics Definition
Keynesian Economics is a theory that relates the total spending with inflation and output in an economy, and therefore, suggests that increasing government expenditure and reducing the taxes will result in increased demand in the market and pull up the economy out of depression. This theory is named after a UK-based economist John Maynard Keynes who came up with this concept when the global economy was going through the great depression in the 1930s.
Thus, the concept concluded that an optimum level of economic performance can be achieved and the downfalls can be avoided through the stimulation in market demand using the economic or monetary policies of the government. Since the theory focuses on stabilizing the economy by concentrating on demand, it is considered as ‘demand-side’ theory.
Examples of Keynesian Economics
- Great Depression: To mitigate the effects of the Great Depression, President Roosevelt introduced measures to revive US economy that included the Social Security scheme, minimum wage program, and child labor laws
- Reaganomics: During his tenure as President, Ronald Reagan increased government spending and reduced the taxes to provide stimulus to the economy. The budget was increased at 2.5% every year and income taxes, as well as corporate taxesCorporate TaxesCorporate tax is a tax levied by the government on the profits earned by a company at a fixed rate each year and is calculated in accordance with specific tax regulations., were reduced. These measures helped in recovering from the 1981 recession
- Great Recession: Barack Obama introduced the Economic Stimulus Act to end the 2008 recession. Under this act, the US Government provided benefits to the unemployed and for education and healthcare. Obama also introduced healthcare policy, widely known as Obamacare.
Keynesian vs Classical Economics
- Classical economic theory is of the view that the economy is self-regulating. It means that the cyclical upward and downward movement of employment and output adjust by itself.
For example, suppose that the economy is going through a downturn so the demand in the market has fallen. Lower demand will lead to lower production levels which in turn will reduce the salaries and wages. It will provide extra capital to the company and they will be able to recruit a number of people at lower salaries. It will stimulate employment and demand in the market and thus, economic growth will be restored as well.
- Contrary to this, Keynesian economics is of the view that if the government does not interfere then the economic conditions can even deteriorate further and demand may plunge even more. It is of the view that when demand is reduced, the companies will not be willing to hire more people.
The unemployment will rise and it will further reduce the market demand. The situation was witnessed during the Great Depression. The production of the companies reduced and unemployment increased which compelled Keynes to come up with new thoughts about economics.
Thus, there are two key differences between Keynesian vs classical economics:
|Keynesian Economics||Classical Economics|
|Government spending on infrastructure, education, and benefits for unemployed people will boost the demand||Businesses will keep growing which will grow the economy too|
|Full employment can be assured by government intervention only||Government policies should take into account the companies and not the consumers|
- Supply-side economists: They believe that growth in businesses is necessary to boost the economy instead of demand from the consumer side. They agree that government intervention can be helpful but it should target businesses.
- Trickle-down economics: They believe that the benefits should be passed on to the wealthy people. Since wealthy people mainly comprise of business owners, benefitting them will benefit the whole economy.
- Monetarists: People who believe that monetary policy alone can drive the economy are called Monetarists. They believe that increasing the money supply in an economy can bring it out of depression.
- Socialists: Socialists do not support the inference that comes out of Keynesian economics theory. They hold the view that the advantages of the policies that the government undertake to revive economy should favor each and everyone irrespective of their social status
- Communists: Communists are of the view that supports minimal intervention by the government. As per them, people should have control of the economy in their hands
- Keynesian economics theory suggests increasing government expenditure at the time of recession. But to do that, the government will have to borrow more capital which will increase the interest rates. Rising interest rates will discourage investments from private held companies
- Government borrowing can lead to resource crunch because the government will borrow from the market and it may not leave banks with enough capital to provide to other corporate entities
- At times, fiscal expansion can lead to inflation as well because it is often introduced quite late when the economy is already in recovery mode.
- It is difficult to predict the magnitude of the demand that needs to be increased in order to raise production levels.
- The government raises spending during the recession but once the economy has recovered, it becomes difficult for the governments to reduce the spending because people get accustomed to it and the government faces political pressure
- The time lag between the introduction of new expansionary policies by the government and the impact of those policies on market demand leads to inflationDemand Leads To InflationDemand-Pull Inflation is a type of inflation that occurs when the economy's aggregate demand outweighs the economy's aggregate supply, causing prices to rise.
Alternatives to Keynesian Economics
- Modern Monetary Theory: As per this theory, the government does not need to borrow the capital to increase the spending in order to revive the market demand. It can simply print more money
- Austrian school: This school of thought suggests that the private sector should cope up with the market disequilibrium on its own, without government’s intervention
Keynesian economics supports intervention from the government in the economy in order to revive it from recession in the form of increased spending and tax cuts in order to provide stimulus to market demand which in turn will increase production and bring back the economy to an equilibrium state.
However, there are other key factors that are needed to be taken care of when the government devises such schemes, such as, inflation, employment, and liquidity. The economic measures related to monetary policy and fiscal policyFiscal PolicyFiscal policy is a government policy that is used to control a country's finances and revenue, and it includes various taxes on goods, services, and individuals, i.e., revenue collection. It has an impact on spending levels, so it is referred to as monetary policy's sister policy. can backfire if provisions for these other factors are not considered beforehand.
This has been a guide to Keynesian Economics Theory and its definition. Here we discuss the difference between Keynesian vs classical economics along with the example. You can learn more from the following articles –