What Is Keynesian Economics?

The central tenet of this school of thought is that government intervention can stabilize the economy
Sarwat Jahan, Ahmed Saber Mahmud, and Chris Papageorgiou

DURING THE GREAT DEPRESSION of the 1930s, existing economic consumer spending during a recession. These market failures
theory was unable either to explain the causes of the severe sometimes call for active policies by the government, such as a
worldwide economic collapse or to provide an adequate public fiscal stimulus package (explained below). Therefore, Keynesian
policy solution to jump-start production and employment. economics supports a mixed economy guided mainly by the
British economist John Maynard Keynes spearheaded a revolu- private sector but partly operated by the government.
tion in economic thinking that overturned the then-prevailing • Prices, and especially wages, respond slowly to changes in
idea that free markets would automatically provide full employ- supply and demand, resulting in periodic shortages and surpluses,
ment—that is, that everyone who wanted a job would have one especially of labor.
as long as workers were flexible in their wage demands (see box). • Changes in aggregate demand, whether anticipated or
The main plank of Keynes’s theory, which has come to bear his unanticipated, have their greatest short-run effect on real out-
name, is the assertion that aggregate demand—measured as put and employment, not on prices. Keynesians believe that,
the sum of spending by households, businesses, and the gov- because prices are somewhat rigid, fluctuations in any compo-
ernment—is the most important driving force in an economy. nent of spending—consumption, investment, or government
Keynes further asserted that free markets have no self-balancing expenditures—cause output to change. If government spending
mechanisms that lead to full employment. Keynesian economists increases, for example, and all other spending components
justify government intervention through public policies that aim remain constant, then output will increase. Keynesian models
to achieve full employment and price stability. of economic activity also include a multiplier effect; that is,
output changes by some multiple of the increase or decrease in
The revolutionary idea spending that caused the change. If the fiscal multiplier is greater
Keynes argued that inadequate overall demand could lead than one, then a one dollar increase in government spending
to prolonged periods of high unemployment. An economy’s would result in an increase in output greater than one dollar.
output of goods and services is the sum of four components:
consumption, investment, government purchases, and net Stabilizing the economy
exports (the difference between what a country sells to and buys No policy prescriptions follow from these three tenets alone.
from foreign countries). Any increase in demand has to come What distinguishes Keynesians from other economists is their
from one of these four components. But during a recession, belief in activist policies to reduce the amplitude of the busi-
strong forces often dampen demand as spending goes down. ness cycle, which they rank among the most important of all
For example, during economic downturns uncertainty often economic problems.
erodes consumer confidence, causing them to reduce their Rather than seeing unbalanced government budgets as wrong,
spending, especially on discretionary purchases like a house Keynes advocated so-called that act against the direction of the
or a car. This reduction in spending by consumers can result business cycle. For example, Keynesian economists would advo-
in less investment spending by businesses, as firms respond cate deficit spending on labor-intensive infrastructure projects
to weakened demand for their products. This puts the task of to stimulate employment and stabilize wages during economic
increasing output on the shoulders of the government. Accord- downturns. They would raise taxes to cool the economy and
ing to Keynesian economics, state intervention is necessary to prevent inflation when there is abundant demand-side growth.
moderate the booms and busts in economic activity, otherwise Monetary policy could also be used to stimulate the economy—
known as the business cycle. for example, by reducing interest rates to encourage investment.
There are three principal tenets in the Keynesian description The exception occurs during a liquidity trap, when increases in
of how the economy works: the money stock fail to lower interest rates and, therefore, do not
• Aggregate demand is influenced by many economic deci- boost output and employment.
sions—public and private. Private sector decisions can sometimes Keynes argued that governments should solve problems in
lead to adverse macroeconomic outcomes, such as reduction in the short run rather than wait for market forces to fix things

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over the long run, because, as he wrote, “In the long run, we the short run but believed that in the long run, expansionary
are all dead.” This does not mean that Keynesians advocate monetary policy leads to inflation only. Keynesian economists
adjusting policies every few months to keep the economy at largely adopted these critiques, adding to the original theory a
full employment. In fact, they believe that governments cannot better integration of the short and the long run and an under-
know enough to fine-tune successfully. standing of the long-run neutrality of money—the idea that a
change in the stock of money affects only nominal variables in
Keynesianism evolves the economy, such as prices and wages, and has no effect on
Even though his ideas were widely accepted while Keynes was real variables, like employment and output.
alive, they were also scrutinized and contested by several con-
temporary thinkers. Particularly noteworthy were his arguments
with the Austrian School of Economics, whose adherents believed
that recessions and booms are a part of the natural order and
The main plank of Keynes’s theory
that government intervention only worsens the recovery process. is that aggregate demand is the
Keynesian economics dominated economic theory and pol-
icy after World War II until the 1970s, when many advanced most important driving force in an
economies suffered both inflation and slow growth, a condition
dubbed “stagflation.” Keynesian theory’s popularity waned then
economy.
because it had no appropriate policy response for stagflation.
Monetarist economists doubted the ability of governments to Both Keynesians and monetarists came under scrutiny with
regulate the business cycle with fiscal policy and argued that the rise of the new classical school during the mid-1970s. The
judicious use of monetary policy (essentially controlling the new classical school asserted that policymakers are ineffective
supply of money to affect interest rates) could alleviate the crisis because individual market participants can anticipate the changes
(see “Monetarism,” p. 16). Members of the monetarist school from a policy and act in advance to counteract them. A new
also maintained that money can have an effect on output in generation of Keynesians that arose in the 1970s and 1980s
argued that even though individuals can anticipate correctly,
aggregate markets may not clear instantaneously; therefore,
KEYNES THE MASTER fiscal policy can still be effective in the short run.
Keynesian economics gets its name, theories, and principles The global financial crisis of 2007–08 caused a resurgence
from British economist John Maynard Keynes (1883–1946), in Keynesian thought. It was the theoretical underpinnings of
who is regarded as the founder of modern macroeconomics. economic policies in response to the crisis by many governments,
His most famous work, The General Theory of Employment, including in the United States and the United Kingdom. As the
Interest and Money, was published in 1936. But its 1930 precur- global recession was unfurling in late 2008, Harvard professor
sor, A Treatise on Money, is often regarded as more important N. Gregory Mankiw wrote in the New York Times, “If you were
to economic thought. Until then economics analyzed only
going to turn to only one economist to understand the problems
static conditions—essentially doing detailed examination of
a snapshot of a rapidly moving process. Keynes, in Treatise, facing the economy, there is little doubt that the economist would
created a dynamic approach that converted economics into be John Maynard Keynes. Although Keynes died more than a
a study of the flow of incomes and expenditures. He opened half-century ago, his diagnosis of recessions and depressions
up new vistas for economic analysis. remains the foundation of modern macroeconomics. Keynes
In The Economic Consequences of the Peace in 1919, Keynes wrote, ‘Practical men, who believe themselves to be quite exempt
predicted that the crushing conditions the Versailles peace from any intellectual influence, are usually the slave of some
treaty placed on Germany to end World War I would lead defunct economist.’ In 2008, no defunct economist is more
to another European war. prominent than Keynes himself.”
He remembered the lessons from Versailles and from the But the 2007–08 crisis also showed that Keynesian theory
Great Depression when he led the British delegation at the had to better include the role of the financial system. Keynesian
1944 Bretton Woods conference—which set down rules to
economists are rectifying that omission by integrating the real
ensure the stability of the international financial system and
facilitated the rebuilding of nations devastated by World War and financial sectors of the economy.
II. Along with US Treasury official Harry Dexter White,
Keynes is considered the intellectual founding father of the SARWAT JAHAN is a senior economist in the IMF’s Asia and Pacific
International Monetary Fund and the World Bank, which Department, AHMED SABER MAHMUD is the associate director of the
were created at Bretton Woods. Applied Economics Program at Johns Hopkins University, and CHRIS
PAPAGEORGIOU is a deputy division chief in the IMF’s Research Department.

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