Keynesian Economics - Theory

Theory

Prior to the publication of Keynes' General Theory, mainstream economic thought was that the economy existed in a state of general equilibrium, meaning that the economy naturally consumes whatever it produces because the needs of consumers are always greater than the capacity of the economy to satisfy those needs. This perception is reflected in Say's Law and in the writing of David Ricardo, which is that individuals produce so that they can either consume what they have manufactured or sell their output so that they can buy someone else's output. This perception rests upon the assumption that if a surplus of goods or services exists, they would naturally fall in price to the point where they would be consumed.

Keynes' theory was significant because it overturned the mainstream thought of the time and brought about a greater awareness that problems such as unemployment are not a product of laziness, but the result of a structural inadequacy in the economic system. He argued that because there was no guarantee that the goods that individuals produce would be met with demand, unemployment was a natural consequence. He saw the economy as unable to maintain itself at full employment and believed that it was necessary for the government to step in and put under-utilised savings to work through government spending. Thus, according to Keynesian theory, some individually rational microeconomic-level actions such as not investing savings in the goods and services produced by the economy, if taken collectively by a large proportion of individuals and firms, can lead to outcomes, wherein the economy operates below its potential output and growth rate.

Prior to Keynes, a situation in which aggregate demand for goods and services did not meet supply was referred to by classical economists as a general glut, although there was disagreement among them as to whether a general glut was possible. Keynes argued that when a glut occurred, it was the over-reaction of producers and the laying off of workers that led to a fall in demand and perpetuating the problem. Keynesians therefore advocate an active stabilization policy to reduce the amplitude of the business cycle, which they rank among the most serious of economic problems. According to the theory, government spending can be used to increase aggregate demand, thus increasing economic activity, reducing unemployment and deflation.

Keynes argued that the solution to the Great Depression was to stimulate the economy ("inducement to invest") through some combination of two approaches:

1. A reduction in interest rates (monetary policy), and
2. Government investment in infrastructure (fiscal policy).

By reducing the interest rate at which the central bank lends money to commercial banks, the government sends a signal to commercial banks that they should do the same for their customers. In reality, government loans to commercial banks make up a tiny proportion of the overall funding of commercial banks, and as a consequence, it can be ineffective at times when the degree of economic contraction is significant.

Investment by government in infrastructure injects income into the economy by creating business opportunity, employment and demand and reversing the effects of the aforementioned imbalance. Governments source the funding for this expenditure by borrowing funds from the economy through the issue of government bonds, and because government spending exceeds the amount of tax income that the government receives, this creates a fiscal deficit.

A central conclusion of Keynesian economics is that, in some situations, no strong automatic mechanism moves output and employment towards full employment levels. This conclusion conflicts with economic approaches that assume a strong general tendency towards equilibrium. In the 'neoclassical synthesis', which combines Keynesian macro concepts with a micro foundation, the conditions of general equilibrium allow for price adjustment to eventually achieve this goal. More broadly, Keynes saw his theory as a general theory, in which utilization of resources could be high or low, whereas previous economics focused on the particular case of full utilization.

The new classical macroeconomics movement, which began in the late 1960s and early 1970s, criticized Keynesian theories, while New Keynesian economics has sought to base Keynes's ideas on more rigorous theoretical foundations.

Some interpretations of Keynes have emphasized his stress on the international coordination of Keynesian policies, the need for international economic institutions, and the ways in which economic forces could lead to war or could promote peace.