Keynesian economics

Keynesian economics

Overview
Keynesian economics is a school of macroeconomic
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

 thought based on the ideas of 20th-century English economist John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

.

Keynesian economics argues that private sector
Private sector
In economics, the private sector is that part of the economy, sometimes referred to as the citizen sector, which is run by private individuals or groups, usually as a means of enterprise for profit, and is not controlled by the state...

 decisions sometimes lead to inefficient
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...

 macroeconomic outcomes and, therefore, advocates active policy responses by the public sector
Public sector
The public sector, sometimes referred to as the state sector, is a part of the state that deals with either the production, delivery and allocation of goods and services by and for the government or its citizens, whether national, regional or local/municipal.Examples of public sector activity range...

, including monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

 actions by the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

 and fiscal policy
Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

 actions by the government to stabilize output over the business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...

. The theories forming the basis of Keynesian economics were first presented in The General Theory of Employment, Interest and Money, published in 1936.
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Encyclopedia
Keynesian economics is a school of macroeconomic
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

 thought based on the ideas of 20th-century English economist John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

.

Keynesian economics argues that private sector
Private sector
In economics, the private sector is that part of the economy, sometimes referred to as the citizen sector, which is run by private individuals or groups, usually as a means of enterprise for profit, and is not controlled by the state...

 decisions sometimes lead to inefficient
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...

 macroeconomic outcomes and, therefore, advocates active policy responses by the public sector
Public sector
The public sector, sometimes referred to as the state sector, is a part of the state that deals with either the production, delivery and allocation of goods and services by and for the government or its citizens, whether national, regional or local/municipal.Examples of public sector activity range...

, including monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

 actions by the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

 and fiscal policy
Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

 actions by the government to stabilize output over the business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...

. The theories forming the basis of Keynesian economics were first presented in The General Theory of Employment, Interest and Money, published in 1936. The interpretations of Keynes are contentious and several schools of thought claim his legacy.

Keynesian economics advocates a mixed economy
Mixed economy
Mixed economy is an economic system in which both the state and private sector direct the economy, reflecting characteristics of both market economies and planned economies. Most mixed economies can be described as market economies with strong regulatory oversight, in addition to having a variety...

 — predominantly private sector, but with a significant role of government and public sector — and served as the economic model during the later part of the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

, World War II
World War II
World War II, or the Second World War , was a global conflict lasting from 1939 to 1945, involving most of the world's nations—including all of the great powers—eventually forming two opposing military alliances: the Allies and the Axis...

, and the post-war economic expansion
Post-World War II economic expansion
The post–World War II economic expansion, also known as the postwar economic boom, the long boom, and the Golden Age of Capitalism, was a period of economic prosperity in the mid 20th century, which occurred mainly in western countries, followed the end of World War II in 1945, and lasted until the...

 (1945–1973), though it lost some influence following the stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...

 of the 1970s. The advent of the global financial crisis in 2007 has caused a resurgence in Keynesian thought
2008–2009 Keynesian resurgence
In 2008 and 2009, there was a resurgence of interest in Keynesian economics among policy makers in the world's industrialized economies. This has included discussions and implementation of economic policies in accordance with the recommendations made by John Maynard Keynes in response to the Great...

.

Overview


According to Keynesian theory, some individually-rational microeconomic-level
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

 actions — if taken collectively by a large proportion of individuals and firms — can lead to inefficient aggregate macroeconomic
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

 outcomes, wherein the economy operates below its potential output
Potential output
In economics, potential output refers to the highest level of real Gross Domestic Product output that can be sustained over the long term. The existence of a limit is due to natural and institutional constraints...

 and growth rate. Such a situation had previously been referred to by classical economists
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....

 as a general glut
General glut
In macroeconomics, a general glut is when supply exceeds demand, specifically, when there is more production in all fields of production in comparison with what resources are available to consume said production....

. There was disagreement among classical economists on whether a general glut was possible. Keynes contended that a general glut would occur when aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

 for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

, which results from the defensive (or reactive) decisions of the producers. In such a situation, government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation
Deflation (economics)
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% . This should not be confused with disinflation, a slow-down in the inflation rate...

. Most Keynesians advocate an activist stabilization policy to reduce the amplitude of the business cycle, which they rank among the most serious of economic problems. For example, when the unemployment rate is very high, a government can use a dose of expansionary monetary policy.

Keynes argued that the solution to the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

 was to stimulate the economy ("inducement to invest") through some combination of two approaches: a reduction in interest rates and government investment in infrastructure. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

A central conclusion of Keynesian economics is that, in some situations, no strong automatic mechanism moves output and employment towards full employment
Full employment
In macroeconomics, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so....

 levels. This conclusion conflicts with economic approaches that assume a strong general tendency towards equilibrium
Economic equilibrium
In economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...

. In the 'neoclassical synthesis
Neoclassical synthesis
Neoclassical synthesis is a postwar academic movement in economics that attempts to absorb the macroeconomic thought of John Maynard Keynes into the thought of neoclassical economics...

', which combines Keynesian macro concepts with a micro foundation, the conditions of general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...

 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
New classical macroeconomics
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics...

 movement, which began in the late 1960s and early 1970s, criticized Keynesian theories, while New Keynesian economics
New Keynesian economics
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...

 has sought to base Keynes' 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
War
War is a state of organized, armed, and often prolonged conflict carried on between states, nations, or other parties typified by extreme aggression, social disruption, and usually high mortality. War should be understood as an actual, intentional and widespread armed conflict between political...

 or could promote peace.

Precursors


Keynes' work was part of a long-running debate within economics over the existence and nature of general glut
General glut
In macroeconomics, a general glut is when supply exceeds demand, specifically, when there is more production in all fields of production in comparison with what resources are available to consume said production....

s. While a number of the policies Keynes advocated (the notable one being government deficit spending) and the theoretical ideas he proposed (effective demand, the multiplier, the paradox of thrift) were advanced by various authors in the 19th and early 20th centuries, Keynes' unique contribution was to provide a general theory of these, which proved acceptable to the political and economic establishments.

Schools



An intellectual precursor of Keynesian economics was underconsumption
Underconsumption
In underconsumption theory in economics, recessions and stagnation arise due to inadequate consumer demand relative to the amount produced. The theory has been replaced since the 1930s by Keynesian economics and the theory of aggregate demand, both of which were influenced by...

 theory in classical economics
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....

, dating from such 19th-century economists as Thomas Malthus
Thomas Malthus
The Reverend Thomas Robert Malthus FRS was an English scholar, influential in political economy and demography. Malthus popularized the economic theory of rent....

, the Birmingham School
Birmingham School (economics)
The Birmingham School was a school of economic thought that emerged in Birmingham, England during the Post-Napoleonic depression that affected England following the end of the Napoleonic wars in 1815....

 of Thomas Attwood
Thomas Attwood
Thomas Attwood was a British economist, the leading figure of the underconsumptionist Birmingham School of economists, and, as the founder of the Birmingham Political Union, a leading figure in the public campaign for the Great Reform Act of 1832.He was born in Halesowen, and attended Halesowen...

, and the American economists William Trufant Foster
William Trufant Foster
William Trufant Foster , was an American educator and economist, whose theories were especially influential in the 1920s. He was the first president of Reed College.- Career :...

 and Waddill Catchings, who were influential in the 1920s and 1930s. Underconsumptionists were, like Keynes after them, concerned with failure of aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

 to attain potential output
Potential output
In economics, potential output refers to the highest level of real Gross Domestic Product output that can be sustained over the long term. The existence of a limit is due to natural and institutional constraints...

, calling this "underconsumption" (focusing on the demand side), rather than "overproduction
Overproduction
In economics, overproduction, oversupply or excess of supply refers to excess of supply over demand of products being offered to the market...

" (which would focus on the supply side), and advocating economic interventionism
Economic interventionism
Economic interventionism is an action taken by a government in a market economy or market-oriented mixed economy, beyond the basic regulation of fraud and enforcement of contracts, in an effort to affect its own economy...

. Keynes specifically discussed underconsumption (which he wrote "under-consumption") in the General Theory, in Chapter 22, Section IV and Chapter 23, Section VII.

Numerous concepts were developed earlier and independently of Keynes by the Stockholm school
Stockholm school (economics)
The Stockholm school, or Stockholmsskolan, is a school of economic thought whose antithesis is the gold standard centered Austrian School of Economics. It refers to a loosely organized group of Swedish economists that worked together, in Stockholm, Sweden primarily in the 1930s...

 during the 1930s; these accomplishments were described in a 1937 article, published in response to the 1936 General Theory, sharing the Swedish discoveries.

Concepts


The multiplier
Multiplier (economics)
In economics, the fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. More generally, the exogenous spending multiplier is the ratio of a change in national income to any autonomous change in spending In economics, the fiscal...

 dates to work in the 1890s by the Australian economist Alfred De Lissa, the Danish economist Julius Wulff, and the German American
German American
German Americans are citizens of the United States of German ancestry and comprise about 51 million people, or 17% of the U.S. population, the country's largest self-reported ancestral group...

 economist Nicholas Johannsen
Nicholas Johannsen
Nicholas August Ludwig Jacob Johansen was a German-American amateur economist, today best known for his influence on and citation by John Maynard Keynes. He wrote under two pen names: A. Merwin and J.J.O...

, the latter being cited in a footnote of Keynes. Nicholas Johannsen also proposed a theory of effective demand
Effective demand
In economics, effective demand in a market is the demand for a product or service which occurs when purchasers are constrained in a different market. It contrasts with notional demand, which is the demand that occurs when purchasers are not constrained in any other market...

 in the 1890s.

The paradox of thrift
Paradox of thrift
The paradox of thrift is a paradox of economics, popularized by John Maynard Keynes, though it had been stated as early as 1714 in The Fable of the Bees, and similar sentiments date to antiquity...

 was stated in 1892 by John M. Robertson in his The Fallacy of Savings, in earlier forms by mercantilist economists since the 16th century, and similar sentiments date to antiquity:

Today these ideas, regardless of provenance, are referred to in academia under the rubric of "Keynesian economics", due to Keynes's role in consolidating, elaborating, and popularizing them.

Keynes and the classics


Keynes sought to distinguish his theories from and oppose them to "classical economics," by which he meant the economic theories of David Ricardo
David Ricardo
David Ricardo was an English political economist, often credited with systematising economics, and was one of the most influential of the classical economists, along with Thomas Malthus, Adam Smith, and John Stuart Mill. He was also a member of Parliament, businessman, financier and speculator,...

 and his followers, including John Stuart Mill
John Stuart Mill
John Stuart Mill was a British philosopher, economist and civil servant. An influential contributor to social theory, political theory, and political economy, his conception of liberty justified the freedom of the individual in opposition to unlimited state control. He was a proponent of...

, Alfred Marshall
Alfred Marshall
Alfred Marshall was an Englishman and one of the most influential economists of his time. His book, Principles of Economics , was the dominant economic textbook in England for many years...

, Francis Ysidro Edgeworth
Francis Ysidro Edgeworth
Francis Ysidro Edgeworth FBA was an Irish philosopher and political economist who made significant contributions to the methods of statistics during the 1880s...

, and Arthur Cecil Pigou
Arthur Cecil Pigou
Arthur Cecil Pigou was an English economist. As a teacher and builder of the school of economics at the University of Cambridge he trained and influenced many Cambridge economists who went on to fill chairs of economics around the world...

. A central tenet of the classical view, known as Say's law
Say's law
Say's law, or the law of market, is an economic principle of classical economics named after the French businessman and economist Jean-Baptiste Say , who stated that "products are paid for with products" and "a glut can take place only when there are too many means of production applied to one kind...

, states that "supply creates its own demand
Supply creates its own demand
"Supply creates its own demand" is the formulation of Say's law by John Maynard Keynes, and is considered by him one of the defining characteristics of classical economics...

." Say's Law can be interpreted in two ways. First, the claim that the total value of output is equal to the sum of income earned in production is a result of a national income accounting identity, and is therefore indisputable. A second and stronger claim, however, that the "costs of output are always covered in the aggregate by the sale-proceeds resulting from demand" depends on how consumption and saving are linked to production and investment. In particular, Keynes argued that the second, strong form of Say's Law only holds if increases in individual savings exactly match an increase in aggregate investment.

Keynes sought to develop a theory that would explain determinants of saving, consumption, investment and production. In that theory, the interaction of aggregate demand and aggregate supply determines the level of output and employment in the economy.

Because of what he considered the failure of the “Classical Theory” in the 1930s, Keynes firmly objects to its main theory—adjustments in prices would automatically make demand tend to the full employment level.

Neo-classical theory supports that the two main costs that shift demand and supply are labor and money. Through the distribution of the monetary policy, demand and supply can be adjusted. If there were more labor than demand for it, wages would fall until hiring began again. If there were too much saving, and not enough consumption, then interest rates would fall until people either cut their savings rate or started borrowing.

Wages and spending


During the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

, the classical theory defined economic collapse as simply a lost incentive to produce, and the mass unemployment as a result of high and rigid real wages.

To Keynes, the determination of wages is more complicated. First, he argued that it is not real but nominal wages that are set in negotiations between employers and workers, as opposed to a barter relationship. Second, nominal wage cuts would be difficult to put into effect because of laws and wage contracts. Even classical economists admitted that these exist; unlike Keynes, they advocated abolishing minimum wages, unions, and long-term contracts, increasing labor-market flexibility. However, to Keynes, people will resist nominal wage reductions, even without unions, until they see other wages falling and a general fall of prices.

He also argued that to boost employment, real wages had to go down: Nominal wages would have to fall more than prices. However, doing so would reduce consumer demand
Consumption (economics)
Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...

, so that the aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

 for goods would drop. This would in turn reduce business sales revenues and expected profits. Investment in new plants and equipment—perhaps already discouraged by previous excesses—would then become more risky, less likely. Instead of raising business expectations, wage cuts could make matters much worse.

Further, if wages and prices were falling, people would start to expect them to fall. This could make the economy spiral downward as those who had money would simply wait as falling prices made it more valuable—rather than spending. As Irving Fisher
Irving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...

 argued in 1933, in his Debt-Deflation Theory of Great Depressions, deflation
Deflation (economics)
In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% . This should not be confused with disinflation, a slow-down in the inflation rate...

 (falling prices) can make a depression deeper as falling prices and wages made pre-existing nominal debts more valuable in real terms.

Excessive saving


To Keynes, excessive saving, i.e. saving beyond planned investment, was a serious problem, encouraging recession
Recession
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...

 or even depression
Depression (economics)
In economics, a depression is a sustained, long-term downturn in economic activity in one or more economies. It is a more severe downturn than a recession, which is seen by some economists as part of the modern business cycle....

. Excessive saving results if investment falls, perhaps due to falling consumer demand, over-investment in earlier years, or pessimistic business expectations, and if saving does not immediately fall in step, the economy would decline.

The classical economists
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....

 argued that interest rates would fall due to the excess supply of "loanable funds
Loanable funds
In economics, the loanable funds market is a hypothetical market that brings savers and borrowers together, also bringing together the money available in commercial banks and lending institutions available for firms and households to finance expenditures, either investments or consumption...

". The first diagram, adapted from the only graph in The General Theory, shows this process. (For simplicity, other sources of the demand for or supply of funds are ignored here.) Assume that fixed investment in capital goods falls from "old I" to "new I" (step a). Second (step b), the resulting excess of saving causes interest-rate cuts, abolishing the excess supply: so again we have saving (S) equal to investment. The interest-rate (i) fall prevents that of production and employment.

Keynes had a complex argument against this laissez-faire
Laissez-faire
In economics, laissez-faire describes an environment in which transactions between private parties are free from state intervention, including restrictive regulations, taxes, tariffs and enforced monopolies....

response. The graph below summarizes his argument, assuming again that fixed investment falls (step A). First, saving does not fall much as interest rates fall, since the income
Income effect
In economics, the consumer's preferences, money income and prices play an important role in solving the consumer's optimization problem...

 and substitution effects of falling rates go in conflicting directions. Second, since planned fixed investment
Fixed investment
Fixed investment in economics refers to investment in fixed capital, i.e., tangible capital goods , or to the replacement of depreciated capital goods which have been scrapped....

 in plant and equipment is based mostly on long-term expectations of future profitability, that spending does not rise much as interest rates fall. So S and I are drawn as steep (inelastic) in the graph. Given the inelasticity
Elasticity (economics)
In economics, elasticity is the measurement of how changing one economic variable affects others. For example:* "If I lower the price of my product, how much more will I sell?"* "If I raise the price, how much less will I sell?"...

 of both demand and supply, a large interest-rate fall is needed to close the saving/investment gap. As drawn, this requires a negative interest rate at equilibrium (where the new I line would intersect the old S line). However, this negative interest rate is not necessary to Keynes's argument.

Third, Keynes argued that saving and investment are not the main determinants of interest rates, especially in the short run. Instead, the supply of and the demand for the stock of money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

determine interest rates in the short run. (This is not drawn in the graph.) Neither changes quickly in response to excessive saving to allow fast interest-rate adjustment.

Finally, Keynes suggested that, because of fear of capital losses on assets besides money, there may be a "liquidity trap
Liquidity trap
A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...

" setting a floor under which interest rates cannot fall. While in this trap, interest rates are so low that any increase in money supply will cause bond-holders (fearing rises in interest rates and hence capital losses on their bonds) to sell their bonds to attain money (liquidity). In the diagram, the equilibrium suggested by the new I line and the old S line cannot be reached, so that excess saving persists. Some (such as Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...

) see this latter kind of liquidity trap as prevailing in Japan
Japan
Japan is an island nation in East Asia. Located in the Pacific Ocean, it lies to the east of the Sea of Japan, China, North Korea, South Korea and Russia, stretching from the Sea of Okhotsk in the north to the East China Sea and Taiwan in the south...

 in the 1990s. Most economists agree that nominal interest rates cannot fall below zero. However, some economists (particularly those from the Chicago school
Chicago school (economics)
The Chicago school of economics describes a neoclassical school of thought within the academic community of economists, with a strong focus around the faculty of The University of Chicago, some of whom have constructed and popularized its principles...

) reject the existence of a liquidity trap.

Even if the liquidity trap does not exist, there is a fourth (perhaps most important) element to Keynes's critique. Saving involves not spending all of one's income. Thus, it means insufficient demand for business output, unless it is balanced by other sources of demand, such as fixed investment. Therefore, excessive saving corresponds to an unwanted accumulation of inventories, or what classical economists called a general glut
General glut
In macroeconomics, a general glut is when supply exceeds demand, specifically, when there is more production in all fields of production in comparison with what resources are available to consume said production....

. This pile-up of unsold goods and materials encourages businesses to decrease both production and employment. This in turn lowers people's incomes—and saving, causing a leftward shift in the S line in the diagram (step B). For Keynes, the fall in income did most of the job by ending excessive saving and allowing the loanable funds market to attain equilibrium. Instead of interest-rate adjustment solving the problem, a recession
Recession
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...

 does so. Thus in the diagram, the interest-rate change is small.

Whereas the classical economists assumed that the level of output and income was constant and given at any one time (except for short-lived deviations), Keynes saw this as the key variable that adjusted to equate saving and investment.

Finally, a recession undermines the business incentive to engage in fixed investment
Fixed investment
Fixed investment in economics refers to investment in fixed capital, i.e., tangible capital goods , or to the replacement of depreciated capital goods which have been scrapped....

. With falling incomes and demand for products, the desired demand for factories and equipment (not to mention housing) will fall. This accelerator effect
Accelerator effect
The accelerator effect in economics refers to a positive effect on private fixed investment of the growth of the market economy . Rising GNP implies that businesses in general see rising profits, increased sales and cash flow, and greater use of existing capacity...

 would shift the I line to the left again, a change not shown in the diagram above. This recreates the problem of excessive saving and encourages the recession to continue.

In sum, to Keynes there is interaction between excess supplies in different markets, as unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

 in labor markets encourages excessive saving—and vice-versa. Rather than prices adjusting to attain equilibrium, the main story is one of quantity adjustment
Quantity adjustment
In economics, the concept of quantity adjustment refers to one possible result of supply and demand disequilibrium in a market, either due to or in the absence of external constraints on the market...

 allowing recessions and possible attainment of underemployment equilibrium
Underemployment equilibrium
In Keynesian economics, underemployment equilibrium refers to a situation with a persistent shortfall relative to full employment and potential output so that unemployment is higher than at the NAIRU or the "natural" rate of unemployment. This situation is not seen as solvable via laissez-faire...

.

Active fiscal policy



As noted, the classicals wanted to balance the government budget. To Keynes, this would exacerbate the underlying problem: following either the expansionary policy or the contractionary policy would raise saving (broadly defined) and thus lower the demand for both products and labor. For example, Keynesians see Herbert Hoover
Herbert Hoover
Herbert Clark Hoover was the 31st President of the United States . Hoover was originally a professional mining engineer and author. As the United States Secretary of Commerce in the 1920s under Presidents Warren Harding and Calvin Coolidge, he promoted partnerships between government and business...

's June 1932 tax increase as making the Depression worse and would advise tax cuts instead.

Keynes′ ideas influenced Franklin D. Roosevelt
Franklin D. Roosevelt
Franklin Delano Roosevelt , also known by his initials, FDR, was the 32nd President of the United States and a central figure in world events during the mid-20th century, leading the United States during a time of worldwide economic crisis and world war...

's view that insufficient buying-power caused the Depression. During his presidency, Roosevelt adopted some aspects of Keynesian economics, especially after 1937, when, in the depths of the Depression, the United States suffered from recession yet again following fiscal contraction. But to many the true success of Keynesian policy can be seen at the onset of World War II
World War II
World War II, or the Second World War , was a global conflict lasting from 1939 to 1945, involving most of the world's nations—including all of the great powers—eventually forming two opposing military alliances: the Allies and the Axis...

, which provided a kick to the world economy, removed uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas became almost official in social-democratic
Social democracy
Social democracy is a political ideology of the center-left on the political spectrum. Social democracy is officially a form of evolutionary reformist socialism. It supports class collaboration as the course to achieve socialism...

 Europe after the war and in the U.S. in the 1960s.

Keynes′ theory suggested that active government policy could be effective in managing the economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated what has been called countercyclical
Countercyclical
Countercyclical is a term used in economics to describe how an economic quantity is related to economic fluctuations. It is the opposite of procyclical. However, it has more than one meaning.-Meaning in policy making:...

 fiscal policies, that is, policies that acted against the tide of the business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...

: deficit spending
Deficit spending
Deficit spending is the amount by which a government, private company, or individual's spending exceeds income over a particular period of time, also called simply "deficit," or "budget deficit," the opposite of budget surplus....

 when a nation's economy suffers from recession
Recession
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...

 or when recovery is long-delayed and unemployment is persistently high—and the suppression of inflation in boom times by either increasing taxes or cutting back on government outlays. He argued that governments should solve problems in the short run rather than waiting for market forces to do it in the long run, because, "in the long run, we are all dead."

This contrasted with the classical
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....

 and neoclassical
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...

 economic analysis of fiscal policy. Fiscal stimulus (deficit spending
Deficit spending
Deficit spending is the amount by which a government, private company, or individual's spending exceeds income over a particular period of time, also called simply "deficit," or "budget deficit," the opposite of budget surplus....

) could actuate production. But, to these schools, there was no reason to believe that this stimulation would outrun the side-effects that "crowd out
Crowding out (economics)
In economics, crowding out occurs when Expansionary Fiscal Policy causes interest rates to rise, thereby reducing private spending. That means increase in government spending crowds out investment spending....

" private investment: first, it would increase the demand for labor and raise wages, hurting profitability
Rate of profit
In economics and finance, the profit rate is the relative profitability of an investment project, of a capitalist enterprise, or of the capitalist economy as a whole...

; Second, a government deficit increases the stock of government bonds, reducing their market price and encouraging high interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

s, making it more expensive for business to finance fixed investment
Fixed investment
Fixed investment in economics refers to investment in fixed capital, i.e., tangible capital goods , or to the replacement of depreciated capital goods which have been scrapped....

. Thus, efforts to stimulate the economy would be self-defeating.

The Keynesian response is that such fiscal policy is appropriate only when unemployment is persistently high, above the non-accelerating inflation rate of unemployment
NAIRU
In monetarist economics, particularly the work of Milton Friedman, on which also worked Lucas Papademos and Franco Modigliani in 1975,NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises.It is widely used in...

 (NAIRU). In that case, crowding out is minimal. Further, private investment can be "crowded in": Fiscal stimulus raises the market for business output, raising cash flow and profitability, spurring business optimism. To Keynes, this accelerator effect
Accelerator effect
The accelerator effect in economics refers to a positive effect on private fixed investment of the growth of the market economy . Rising GNP implies that businesses in general see rising profits, increased sales and cash flow, and greater use of existing capacity...

 meant that government and business could be complements
Complement good
A complementary good, in contrast to a substitute good, is a good with a negative cross elasticity of demand. This means a good's demand is increased when the price of another good is decreased. Conversely, the demand for a good is decreased when the price of another good is increased...

rather than substitutes
Substitute good
In economics, one way we classify goods is by examining the relationship of the demand schedules when the price of one good changes. This relationship between demand schedules leads economists to classify goods as either substitutes or complements. Substitute goods are goods which, as a result...

 in this situation. Second, as the stimulus occurs, gross domestic product
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....

 rises, raising the amount of saving, helping to finance the increase in fixed investment. Finally, government outlays need not always be wasteful: government investment in public goods that will not be provided by profit-seekers will encourage the private sector's growth. That is, government spending on such things as basic research, public health, education, and infrastructure
Infrastructure
Infrastructure is basic physical and organizational structures needed for the operation of a society or enterprise, or the services and facilities necessary for an economy to function...

 could help the long-term growth of potential output
Potential output
In economics, potential output refers to the highest level of real Gross Domestic Product output that can be sustained over the long term. The existence of a limit is due to natural and institutional constraints...

.

A Keynesian economist might point out that classical and neoclassical theory does not explain why firms acting as "special interests" to influence government policy are assumed to produce a negative outcome, while those same firms acting with the same motivations outside of the government are supposed to produce positive outcomes. Libertarians
Libertarianism
Libertarianism, in the strictest sense, is the political philosophy that holds individual liberty as the basic moral principle of society. In the broadest sense, it is any political philosophy which approximates this view...

 counter that, because both parties consent, free trade increases net happiness, but government imposes its will by force, decreasing happiness. Therefore, firms that manipulate the government do net harm, while firms that respond to the free market do net good. In theory, in a democracy, the populace consents to or refutes government policy through elections and could thereby be considered a consenting party not subjected unilaterally to the government's will.

In Keynes' theory, there must be significant slack in the labor market before fiscal expansion
Deficit spending
Deficit spending is the amount by which a government, private company, or individual's spending exceeds income over a particular period of time, also called simply "deficit," or "budget deficit," the opposite of budget surplus....

 is justified. Both conservative and some neoliberal
Neoliberalism
Neoliberalism is a market-driven approach to economic and social policy based on neoclassical theories of economics that emphasizes the efficiency of private enterprise, liberalized trade and relatively open markets, and therefore seeks to maximize the role of the private sector in determining the...

 economists question this assumption, unless labor unions or the government "meddle" in the free market
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...

, creating persistent supply-side or classical unemployment. Their solution is to increase labor-market flexibility, e.g., by cutting wages, busting unions, and deregulating business.

Contrary to some critical characterizations of it, Keynesianism does not consist solely of deficit spending
Deficit spending
Deficit spending is the amount by which a government, private company, or individual's spending exceeds income over a particular period of time, also called simply "deficit," or "budget deficit," the opposite of budget surplus....

. Keynesianism recommends counter-cyclical policies. An example of a counter-cyclical policy is raising taxes to cool the economy and to prevent inflation when there is abundant demand-side growth, and engaging in deficit spending on labor-intensive infrastructure projects to stimulate employment and stabilize wages during economic downturns. Classical economics, on the other hand, argues that one should cut taxes when there are budget surpluses, and cut spending—or, less likely, increase taxes—during economic downturns. Keynesian economists believe that adding to profits and incomes during boom cycles through tax cuts, and removing income and profits from the economy through cuts in spending and/or increased taxes during downturns, tends to exacerbate the negative effects of the business cycle. This effect is especially pronounced when the government controls a large fraction of the economy, and is therefore one reason fiscal conservatives advocate a much smaller government.

"Multiplier effect" and interest rates


Two aspects of Keynes' model had implications for policy:

First, there is the "Keynesian multiplier
Multiplier (economics)
In economics, the fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. More generally, the exogenous spending multiplier is the ratio of a change in national income to any autonomous change in spending In economics, the fiscal...

", first developed by Richard F. Kahn in 1931. Exogenous
Exogenous
Exogenous refers to an action or object coming from outside a system. It is the opposite of endogenous, something generated from within the system....

 increases in spending, such as an increase in government outlays, increases total spending by a multiple of that increase. A government could stimulate a great deal of new production with a modest outlay if:
  1. The people who receive this money then spend most on consumption goods and save the rest.
  2. This extra spending allows businesses to hire more people and pay them, which in turn allows a further increase consumer spending.

This process continues. At each step, the increase in spending is smaller than in the previous step, so that the multiplier process tapers off and allows the attainment of an equilibrium. This story is modified and moderated if we move beyond a "closed economy" and bring in the role of taxation: The rise in imports and tax payments at each step reduces the amount of induced consumer spending and the size of the multiplier effect.

Second, Keynes re-analyzed the effect of the interest rate on investment. In the classical model, the supply of funds (saving) determined the amount of fixed business investment. That is, since all savings was placed in banks, and all business investors in need of borrowed funds went to banks, the amount of savings determined the amount that was available to invest. To Keynes, the amount of investment was determined independently by long-term profit expectations and, to a lesser extent, the interest rate. The latter opens the possibility of regulating the economy through money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

 changes, via monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

. Under conditions such as the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

, Keynes argued that this approach would be relatively ineffective compared to fiscal policy. But, during more "normal" times, monetary expansion can stimulate the economy.

Postwar Keynesianism


Keynes' ideas became widely accepted after WWII
World War II
World War II, or the Second World War , was a global conflict lasting from 1939 to 1945, involving most of the world's nations—including all of the great powers—eventually forming two opposing military alliances: the Allies and the Axis...

, and until the early 1970s, Keynesian economics provided the main inspiration for economic policy makers in Western industrialized countries. Governments prepared high quality economic statistics on an ongoing basis and tried to base their policies on the Keynesian theory that had become the norm. In the early era of new liberalism
New liberalism
New Liberalism is a book by Matthew Kalkman that examines the evolution of Liberalism from its early beginnings to its potential future incarnations. The author argues that New Liberalism is the next step in this evolution: the notion that, in order for a society to be maintained and to evolve, it...

 and social democracy
Social democracy
Social democracy is a political ideology of the center-left on the political spectrum. Social democracy is officially a form of evolutionary reformist socialism. It supports class collaboration as the course to achieve socialism...

, most western capitalist
Capitalism
Capitalism is an economic system that became dominant in the Western world following the demise of feudalism. There is no consensus on the precise definition nor on how the term should be used as a historical category...

 countries enjoyed low, stable unemployment and modest inflation, an era called the Golden Age of Capitalism.

In terms of policy, the twin tools of post-war Keynesian economics were fiscal policy and monetary policy. While these are credited to Keynes, others, such as economic historian David Colander
David Colander
David C. Colander is the Christian A. Johnson Distinguished Professor of Economics at Middlebury College. He is known for his study of the economics profession itself, and the sociology of economics. His books The Making of an Economist and its later edition, The Making of an Economist, Redux, have...

, argue that they are, rather, due to the interpretation of Keynes by Abba Lerner
Abba P. Lerner
Abba Ptachya Lerner was an American economist.Lerner was born on October 28, 1903 in Bessarabia . He grew up in a Jewish family, which emigrated to Great Britain when Lerner was three years old. Lerner grew up in the London East End. From the age of sixteen he worked as a machinist, a teacher in...

 in his theory of Functional Finance
Functional finance
Functional finance is an economic theory proposed by Abba P. Lerner, based on effective demand principle and chartalism. It states that government should finance itself to meet explicit goals, such as taming the business cycle, achieving full employment, ensuring growth and low inflation.-...

, and should instead be called "Lernerian" rather than "Keynesian".

Through the 1950s, moderate degrees of government demand leading industrial development, and use of fiscal and monetary counter-cyclical policies continued, and reached a peak in the "go go" 1960s, where it seemed to many Keynesians that prosperity was now permanent. In 1971, Republican US President Richard Nixon
Richard Nixon
Richard Milhous Nixon was the 37th President of the United States, serving from 1969 to 1974. The only president to resign the office, Nixon had previously served as a US representative and senator from California and as the 36th Vice President of the United States from 1953 to 1961 under...

 even proclaimed "we are all Keynesians now". However, with the oil shock of 1973, and the economic problems of the 1970s, modern liberal economics began to fall out of favor. During this time, many economies experienced high and rising unemployment, coupled with high and rising inflation, contradicting the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

's prediction. This stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...

 meant that the simultaneous application of expansionary (anti-recession) and contractionary (anti-inflation) policies appeared to be necessary. This dilemma led to the end of the Keynesian near-consensus of the 1960s, and the rise throughout the 1970s of ideas based upon more classical analysis, including monetarism
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...

, supply-side economics
Supply-side economics
Supply-side economics is a school of macroeconomic thought that argues that economic growth can be most effectively created by lowering barriers for people to produce goods and services, such as lowering income tax and capital gains tax rates, and by allowing greater flexibility by reducing...

, and new classical economics. At the same time, Keynesians began during the period to reorganize their thinking (some becoming associated with New Keynesian economics
New Keynesian economics
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...

); one strategy, utilized also as a critique of the notably high unemployment and potentially disappointing GNP growth rates associated with the latter two theories by the mid-1980s, was to emphasize low unemployment and maximal economic growth at the cost of somewhat higher inflation (its consequences kept in check by indexing and other methods, and its overall rate kept lower and steadier by such potential policies as Martin Weitzman's share economy).

Multiple schools of economic thought that trace their legacy to Keynes currently exist, the notable ones being Neo-Keynesian economics
Neo-Keynesian Economics
Neo-Keynesian economics is a school of macroeconomic thought that was developed in the post-war period from the writings of John Maynard Keynes. A group of economists , attempted to interpret and formalize Keynes' writings, and to synthesize it with the neo-classical models of economics...

, New Keynesian economics
New Keynesian economics
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...

, and Post-Keynesian economics
Post-Keynesian economics
Post Keynesian economics is a school of economic thought with its origins in The General Theory of John Maynard Keynes, although its subsequent development was influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor and Paul Davidson...

. Keynes' biographer Robert Skidelsky writes that the post-Keynesian school has remained closest to the spirit of Keynes' work in following his monetary theory and rejecting the neutrality of money
Neutrality of money
Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption....

.

In the postwar era, Keynesian analysis was combined with neoclassical economics to produce what is generally termed the "neoclassical synthesis
Neoclassical synthesis
Neoclassical synthesis is a postwar academic movement in economics that attempts to absorb the macroeconomic thought of John Maynard Keynes into the thought of neoclassical economics...

", yielding Neo-Keynesian economics
Neo-Keynesian Economics
Neo-Keynesian economics is a school of macroeconomic thought that was developed in the post-war period from the writings of John Maynard Keynes. A group of economists , attempted to interpret and formalize Keynes' writings, and to synthesize it with the neo-classical models of economics...

, which dominated mainstream macroeconomic thought
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...

. Though it was widely held that there was no strong automatic tendency to full employment, many believed that if government policy were used to ensure it, the economy would behave as neoclassical theory predicted. This post-war domination by Neo-Keynesian economics was broken during the stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...

 of the 1970s. There was a lack of consensus among macroeconomists in the 1980s. However, the advent of New Keynesian economics
New Keynesian economics
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...

 in the 1990s, modified and provided microeconomic foundations for the neo-Keynesian theories. These modified models now dominate mainstream economics.

Post-Keynesian economists
Post-Keynesian economics
Post Keynesian economics is a school of economic thought with its origins in The General Theory of John Maynard Keynes, although its subsequent development was influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor and Paul Davidson...

, on the other hand, reject the neoclassical synthesis and, in general, neoclassical economics applied to the macroeconomy. Post-Keynesian economics is a heterodox school
Heterodox economics
"Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...

 that holds that both Neo-Keynesian economics and New Keynesian economics are incorrect, and a misinterpretation of Keynes' ideas. The Post-Keynesian school encompasses a variety of perspectives, but has been far less influential than the other more mainstream Keynesian schools.

Main theories


The two key theories of mainstream Keynesian economics are the IS-LM model of John Hicks and the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

; both of these are rejected by Post-Keynesians.

It was with John Hicks
John Hicks
Sir John Richard Hicks was a British economist and one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics were his statement of consumer demand theory in microeconomics, and the IS/LM model , which...

 that Keynesian economics produced a clear model
Model (economics)
In economics, a model is a theoretical construct that represents economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified framework designed to illustrate complex processes, often but not always using...

 that policy-makers could use to attempt to understand and control economic activity. This model, the IS-LM model is nearly as influential as Keynes' original analysis in determining actual policy and economics education. It relates aggregate demand and employment to three exogenous
Exogenous
Exogenous refers to an action or object coming from outside a system. It is the opposite of endogenous, something generated from within the system....

 quantities, i.e., the amount of money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

 in circulation, the government budget, and the state of business expectations. This model was very popular with economists after World War II
World War II
World War II, or the Second World War , was a global conflict lasting from 1939 to 1945, involving most of the world's nations—including all of the great powers—eventually forming two opposing military alliances: the Allies and the Axis...

 because it could be understood in terms of general equilibrium theory. This encouraged a much more static vision of macroeconomics than that described above.

The second main part of a Keynesian policy-maker's theoretical apparatus was the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

. This curve, which was more of an empirical observation than a theory, indicated that increased employment, and decreased unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

, implied increased inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

. Keynes had only predicted that falling unemployment would cause a higher price, not a higher inflation rate
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...

. Thus, the economist could use the IS-LM model to predict, for example, that an increase in the money supply would raise output and employment—and then use the Phillips curve to predict an increase in inflation.

Monetarist criticisms


One school began in the late 1940s with Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

. Instead of rejecting macro-measurements and macro-models of the economy, the monetarist school
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...

 embraced the techniques of treating the entire economy as having a supply and demand equilibrium. However, because of Irving Fisher
Irving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...

's equation of exchange
Equation of exchange
In economics, the equation of exchange is the relation:M\cdot V = P\cdot Qwhere, for a given period,M\, is the total nominal amount of money in circulation on average in an economy.V\, is the velocity of money, that is the average frequency with which a unit of money is spent.P\, is the price...

, they regarded inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

 as solely being due to the variations in the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

, rather than as being a consequence of aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

. They argued that the "crowding out" effects discussed above would hobble or deprive fiscal policy of its positive effect. Instead, the focus should be on monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

, which was considered ineffective by early Keynesians.

Monetarism
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...

 had an ideological as well as a practical appeal: monetary policy does not, at least on the surface, imply as much government intervention in the economy as other measures. The monetarist critique pushed Keynesians toward a more balanced view of monetary policy, and inspired a wave of revisions to Keynesian theory.

Neoclassical criticisms


Beginning in the late 1950s neoclassical macroeconomists began to disagree with the methodology employed by Keynes and his successors. Keynesians emphasized the dependence of consumption on disposable income and, also, of investment on current profits and current cash flow. In addition, Keynesians posited a Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

 that tied nominal wage inflation to unemployment rate. To buttress these theories, Keynesians typically traced the logical foundations of their model (using introspection) and buttressed their assumptions with statistical evidence. Neoclassical theorists demanded that macroeconomics be grounded on the same foundations as microeconomic theory, profit-maximizing firms and rational, utility-maximizing consumers.

The result of this shift in methodology produced several important divergences from Keynesian Macroeconomics:
  1. Independence of Consumption and current Income (life-cycle permanent income hypothesis
    Permanent income hypothesis
    The permanent income hypothesis is a theory of consumption that was developed by the American economist Milton Friedman. In its simplest form, the hypothesis states that the choices made by consumers regarding their consumption patterns are determined not by current income but by their longer-term...

    )
  2. Irrelevance of Current Profits to Investment (Modigliani-Miller theorem
    Modigliani-Miller theorem
    The Modigliani–Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process , in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is...

    )
  3. Long run independence of inflation and unemployment (natural rate of unemployment
    Natural rate of unemployment
    The natural rate of unemployment is a concept of economic activity developed in particular by Milton Friedman and Edmund Phelps in the 1960s, both recipients of the Nobel prize in economics...

    )
  4. The inability of monetary policy to stabilize output (rational expectations
    Rational expectations
    Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...

    )
  5. Irrelevance of Taxes and Budget Deficits to Consumption (Ricardian Equivalence
    Ricardian equivalence
    The Ricardian equivalence proposition is an economic theory holding that consumers internalize the government's budget constraint: as a result, the timing of any tax change does not affect their change in spending...

    )

Austrian School criticisms


Austrian
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

 economist Friedrich Hayek
Friedrich Hayek
Friedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...

 criticized Keynesian economic policies for what he called their fundamentally collectivist approach, arguing that such theories encourage centralized planning, which leads to malinvestment of capital, which is the cause of business cycles. Hayek also argued that Keynes' study of the aggregate relations in an economy is fallacious, as recessions are caused by micro-economic factors. Hayek claimed that what starts as temporary governmental fixes usually become permanent and expanding government programs, which stifle the private sector and civil society.

Other Austrian school
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

 economists have also attacked Keynesian economics. Henry Hazlitt
Henry Hazlitt
Henry Stuart Hazlitt was an American economist, philosopher, literary critic and journalist for such publications as The Wall Street Journal, The Nation, The American Mercury, Newsweek, and The New York Times...

 criticized, paragraph by paragraph, Keynes' General Theory in The Failure of the New Economics
The Failure of the New Economics
The Failure of the "New Economics" is a book by Henry Hazlitt offering a detailed critique of John Maynard Keynes' work The General Theory of Employment, Interest and Money .-Overview:...

. Murray Rothbard
Murray Rothbard
Murray Newton Rothbard was an American author and economist of the Austrian School who helped define capitalist libertarianism and popularized a form of free-market anarchism he termed "anarcho-capitalism." Rothbard wrote over twenty books and is considered a centrally important figure in the...

 accuses Keynesianism of having "its roots deep in medieval and mercantilist thought."

New Classical Macroeconomics criticisms



Another influential school of thought was based on the Lucas critique
Lucas critique
The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.The basic idea...

 of Keynesian economics. This called for greater consistency with microeconomic theory and rationality, and in particular emphasized the idea of rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...

. Lucas and others argued that Keynesian economics required remarkably foolish and short-sighted behavior from people, which totally contradicted the economic understanding of their behavior at a micro level. New classical economics introduced a set of macroeconomic theories that were based on optimising microeconomic
Microfoundations
In economics, the term microfoundations refers to the microeconomic analysis of the behavior of individual agents such as households or firms that underpins a macroeconomic theory....

 behavior. These models have been developed into the Real Business Cycle Theory
Real business cycle theory
Real business cycle theory are a class of macroeconomic models in which business cycle fluctuations to a large extent can be accounted for by real shocks. Unlike other leading theories of the business cycle, RBC theory sees recessions and periods of economic growth as the efficient response to...

, which argues that business cycle fluctuations can to a large extent be accounted for by real (in contrast to nominal) shocks.

Keynesian responses


The heart of the 'new Keynesian'
New Keynesian economics
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...

 view rests on microeconomic models that indicate that nominal wages and prices are "sticky," i.e., do not change easily or quickly with changes in supply and demand, so that quantity adjustment
Quantity adjustment
In economics, the concept of quantity adjustment refers to one possible result of supply and demand disequilibrium in a market, either due to or in the absence of external constraints on the market...

 prevails. According to economist Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...

, "while I regard the evidence for such stickiness as overwhelming, the assumption of at least temporarily rigid nominal prices is one of those things that works beautifully in practice but very badly in theory." This integration is further spurred by the work of other economists that questions rational decision-making in a perfect information environment as a necessity for micro-economic theory. Imperfect decision-making such as that investigated by Joseph Stiglitz underlines the importance of management of risk in the economy.

Over time, many macroeconomists have returned to the IS-LM model and the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

 as a first approximation of how an economy works. New versions of the Phillips curve, such as the "Triangle Model", allow for stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...

, since the curve can shift due to supply shock
Supply shock
A supply shock is an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good. This sudden change affects the equilibrium price....

s or changes in built-in inflation
Built-in inflation
Built-in inflation is a type of inflation that results from past events and persists in the present.Built-in inflation is one of three major determinants of the current inflation rate. In Robert J. Gordon's triangle model of inflation, the current inflation rate equals the sum of demand-pull...

. In the 1990s, the original ideas of "full employment" had been modified by the NAIRU
NAIRU
In monetarist economics, particularly the work of Milton Friedman, on which also worked Lucas Papademos and Franco Modigliani in 1975,NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises.It is widely used in...

 doctrine, sometimes called the "natural rate of unemployment." NAIRU advocates suggest restraint in combating unemployment, in case accelerating inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

 should result. However, it is unclear exactly what the value of the NAIRU should be—or whether it even exists.

The Crash of 2008 led to a revival of interest in and debate about Keynes. Keynes' biographer, Robert Skidelsky, wrote a book entitled Keynes: The Return of the Master
Keynes: The Return of the Master
Keynes: The Return of the Master is a 2009 book by economic historian Robert Skidelsky. The work discusses the economic theories and philosophy of John Maynard Keynes, and argues about their relevance to the world following the Financial crisis of 2007–2010...

. Other books about Keynes published immediately following the Crash were generally favorable.

See also

  • Constitutional economics
    Constitutional economics
    Constitutional economics is a research program in economics and constitutionalism that has been described as extending beyond the definition of 'the economic analysis of constitutional law' in explaining the choice "of alternative sets of legal-institutional-constitutional rules that constrain the...

  • Functional finance
    Functional finance
    Functional finance is an economic theory proposed by Abba P. Lerner, based on effective demand principle and chartalism. It states that government should finance itself to meet explicit goals, such as taming the business cycle, achieving full employment, ensuring growth and low inflation.-...

  • Job guarantee
    Job guarantee
    A job guarantee is an economic policy proposal aimed at providing a sustainable solution to the dual problems of inflation and unemployment. Its aim is to create full employment and price stability...

  • Keynesian formula
    Keynesian formula
    The Keynesian formula is an economic theory developed by the British economist John Maynard Keynes. Keynes argued that the level of output and employment in the economy was determined by aggregate demand or effective demand. In a reversal of Say's Law, Keynes in essence argued that "man creates his...

  • 2008–2009 Keynesian resurgence
    2008–2009 Keynesian resurgence
    In 2008 and 2009, there was a resurgence of interest in Keynesian economics among policy makers in the world's industrialized economies. This has included discussions and implementation of economic policies in accordance with the recommendations made by John Maynard Keynes in response to the Great...


Further reading

Especially up to p. 26. — This offers a compact summary of the Keynes equations and their interrelation.
  • Donald Markwell
    Donald Markwell
    For the Montgomery, Alabama, talk radio personality, Don Markwell, see Don Markwell Professor Donald John 'Don' Markwell is an Australian social scientist and college president...

    , John Maynard Keynes and International Relations: Economic Paths to War and Peace, Oxford University Press, 2006. — Includes a more concise structured version of Lindahl's summary (in Section 2.1 + Appendix), — a discussion of the 2008 financial-crash, — and comments on J.L.Stein's generalization:-

External links