Belief: Aggregate demand determines employment and there is no guarantee that, in a free market, demand will be high enough for full employment.
Policy recommendation: The government must counter the business cycle by managing aggregate demand, and they must do this by, mainly, using fiscal policy.
Keynesian economics asserts that, in a free market, AD (aggregate demand) is likely to fall and cause the macroeconomy to enter a considerable period of disequilibrium and recession, requiring government intervention to boost AD and output.
Keynesian economics was developed by John Maynard Keynes during the 1930s as he analysed the issues surrounding the Great Depression. Keynes postulated that the problem was a combination of a lack of AD and a failure of the free market to automatically restore full employment.
Keynes argued that AD was the driving force of the economy because demand determines how much to produce. AD itself is made up of four components: consumption, investment, government spending and net exports. A fall in any of these components will cause AD, and consequently output, to fall.
Moreover, in a free market economy, AD will inevitably fall at some point in time because of various market failures, and the economy will not be able to self-balance or correct itself if left to do so on it’s own. In a free market economy, a recession will keep getting worse because many forces come into play that continually reduce AD and make the economy shrink further.
For example, during recessions, uncertainty erodes consumer confidence, causing a reduction in consumption. In addition, this negatively affects investors’ animal spirits. As consumption falls, firms’ profits fall and their investment falls. This continues in a downward spiral as a negative multiplier effect damages the economy; that is, the initial decrease in AD has a domino effect that causes AD to fall further so that the final fall in AD is greater than the initial fall. As confidence and expectations become deflated, consumers continue to spend less and firms continue to decrease their investment, unemployment rises and the problem exacerbates.
Resultantly, Keynesian economists contend that government intervention is required to help manage the booms and busts of the business cycle. For instance, in a recession, the government must boost AD through fiscal spending and allow the positive multiplier to take effect, then employment and growth will rise. Keynesian economists insist that this deficit spending should be on labour-intensive projects to ensure that employment and wages rise.
Keynes argued that monetary policy could also be used to stimulate the economy, by decreasing interest rates to boost investment and AD. However, He warned that the government cannot rely solely on using monetary policy to boost AD because of the potential for a liquidity trap. A liquidity trap occurs when interest rates are so low that they cannot fall any further, and if interest rates cannot fall then investment cannot rise.
Keynes insisted that governments must intervene in the short-run and not follow the Classical economics argument of waiting for market forces to fix the economy in the long-run because, as he famously proclaimed, “in the long run, we are all dead.”
Keynesian economics was used to bring the UK and American economies out of the Great Depression when the governments began to boost AD with military spending during the war effort. Keynesian economics continued to dominate the economic policy realm until, in the 1970s, the developed world entered a period of stagflation(rising unemployment and inflation). Keynesian theory had no answer to explain this phenomenon and this left the door open for the Monetarist school of thought to argue that monetary policy must be used to control inflation and manage the economy. However, there was a resurgence in Keynesian economics in the late 2000s after the 2007 global financial crisis. The governments of the Western economies responded to the crisis by using expansionary fiscal policy and loose monetary policy.