Keynesian economics is a well-known theory of total expenditure (also called aggregate demand economics) and its effects on output and inflation. Although the term is often used to describe several terms, what it is and how it works will be described herein fairly.
Keynesian economics was born from John Maynard Keynes‘s hand with his book “General Theory of Employment, Interest and Money” published in 1936 in the wake of the Great Depression. In this theory, he proposes giving more power and new tools to institutions to avoid economic crises.
The principle of Keynesian economics is that both fiscal and monetary policy affect aggregate demand. However, some economists believe in “debt neutrality“, i.e. the doctrine that substituting taxes for government borrowing does not affect aggregate demand.
How does Keynesian economics work?
Changes in aggregate demand (whether anticipated or unanticipated) tend to have a greater short-run impact on output and jobs (NOT prices). In Keynesian theory, this idea can be exemplified by the Phillips curves, which show that inflation changes slowly when unemployment changes.
On this basis, anticipatory monetary policy can produce real effects on output and employment only if some prices are rigid. So Keynesian economics assumes in its models and tries to explain sticky prices or wages. However, rationalising sticky prices can be a rather difficult task because (according to standard microeconomic theory) real supplies and demands do not change if all nominal prices rise or fall proportionally.
This theory posits that because prices are somewhat rigid, alterations in any of the components of government spending, consumption, investment or expenditure lead to fluctuations in output. For example, if the government increases spending and all other spending components are held constant, then the output will increase.
On the other hand, Keynesian economic activity models also include a so-called “multiplier effect“, in which output increases by a multiple of the original change in the causal expenditure. For example, a 10 billion euro increase in government spending could lead to total output increasing by 15 billion euros (a multiplier of 1.5) or by 5 billion euros (a multiplier of 0.5). Contrary to what many believe, the Keynesian analysis does not need the multiplier to exceed 1.0 to work; the multiplier must be greater than zero.
Another fundamental point of Keynesian economics is the belief that prices and especially wages respond slowly to supply and demand changes, resulting in shortages and surpluses (especially of labour).
Although monetarists are more confident than Keynesians in markets’ ability to adjust to changes in supply and demand, many monetarists accept the Keynesian position. For example, Milton Friedman, winner of the 1976 Nobel Prize in Economics, stated, “Under any conceivable institutional arrangement, and certainly, under those now prevailing in the United States, there is only a limited amount of flexibility in prices and wages”, which is a clearly Keynesian position.
No policy prescription follows the above principles of Keynesian economics. Still, many economists who do not identify themselves as Keynesians (and most monetarists) would accept each of these premises.
