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What Is Keynesian Economics?
FINANCE & DEVELOPMENT, September 2014, Vol. 51, No. 3
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Sarwat Jahan, Ahmed Saber Mahmud, and Chris Papageorgiou
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Economics Back to The central tenet of this school of thought is that government
Basics intervention can stabilize the economy
Just how important is money? Few would deny that it plays a
People in Economics
key role in the economy.
F&D on Facebook During the Great Depression of the 1930s, existing economic
theory was unable either to explain the causes of the severe
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worldwide economic collapse or to provide an adequate
public policy solution to jump-start production and
employment.
Write to us British economist John Maynard Keynes spearheaded a
F&D welcomes comments revolution in economic thinking that overturned the then-
and brief letters, a selection of prevailing idea that free markets would automatically provide
which are posted under full employment—that is, that everyone who wanted a job
Letters to the Editor. Letters would have one as long as workers were flexible in their wage
may be edited. Please send demands (see box). The main plank of Keynes’s theory, which
your letters to has come to bear his name, is the assertion that aggregate
[email protected] demand—measured as the sum of spending by households,
businesses, and the government—is the most important
driving force in an economy. Keynes further asserted that free
F&D Magazine markets have no self-balancing mechanisms that lead to full
About F&D employment. Keynesian economists justify government
intervention through public policies that aim to achieve full
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employment and price stability.
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The revolutionary idea
Information Keynes argued that inadequate overall demand could lead to
prolonged periods of high unemployment. An economy’s
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output of goods and services is the sum of four components:
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consumption, investment, government purchases, and net
Writing Guidelines exports (the difference between what a country sells to and
buys from foreign countries). Any increase in demand has to
come from one of these four components. But during a
recession, strong forces often dampen demand as spending
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goes down. For example, during economic downturns
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uncertainty often erodes consumer confidence, causing them
to reduce their spending, especially on discretionary
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purchases like a house or a car. This reduction in spending by
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consumers can result in less investment spending by
to you.
businesses, as firms respond to weakened demand for their
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products. This puts the task of increasing output on the
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shoulders of the government. According to Keynesian
economics, state intervention is necessary to moderate the
booms and busts in economic activity, otherwise known as
the business cycle.

There are three principal tenets in the Keynesian description

of how the economy works:
• Aggregate demand is influenced by many economic
decisions—public and private. Private sector decisions can
sometimes lead to adverse macroeconomic outcomes, such
as reduction in consumer spending during a recession. These
market failures sometimes call for active policies by the
government, such as a fiscal stimulus package (explained
below). Therefore, Keynesian economics supports a mixed
economy guided mainly by the private sector but partly
operated by the government.
• Prices, and especially wages, respond slowly to
changes in supply and demand , resulting in periodic
shortages and surpluses, especially of labor.
• Changes in aggregate demand, whether anticipated or
unanticipated, have their greatest short-run effect on
real output and employment, not on prices. Keynesians
believe that, because prices are somewhat rigid, fluctuations
in any component of spending—consumption, investment, or
government expenditures—cause output to change. If
government spending increases, for example, and all other
spending components remain constant, then output will
increase. Keynesian models of economic activity also include
a multiplier effect; that is, output changes by some multiple of
the increase or decrease in spending that caused the change.
If the fiscal multiplier is greater than one, then a one dollar
increase in government spending would result in an increase
in output greater than one dollar.

Keynes the master

Keynesian economics gets its name, theories, and principles

from British economist John Maynard Keynes (1883–1946),
who is regarded as the founder of modern macroeconomics.
His most famous work, The General Theory of Employment,
Interest and Money, was published in 1936. But its 1930
precursor, A Treatise on Money, is often regarded as more
important to economic thought. Until then economics
analyzed only static conditions—essentially doing detailed
examination of a snapshot of a rapidly moving process.
Keynes, in Treatise, created a dynamic approach that
converted economics into a study of the flow of incomes and
expenditures. He opened up new vistas for economic analysis.

In The Economic Consequences of the Peace in 1919, Keynes

predicted that the crushing conditions the Versailles peace
treaty placed on Germany to end World War I would lead to
another European war.

He remembered the lessons from Versailles and from the

Great Depression, when he led the British delegation at the
1944 Bretton Woods conference—which set down rules to
ensure the stability of the international financial system and
facilitated the rebuilding of nations devastated by World War
II. Along with U.S. Treasury official Harry Dexter White, Keynes
is considered the intellectual founding father of the
International Monetary Fund and the World Bank, which were
created at Bretton Woods.

Stabilizing the economy

No policy prescriptions follow from these three tenets alone.
What distinguishes Keynesians from other economists is their
belief in activist policies to reduce the amplitude of the
business cycle, which they rank among the most important of
all economic problems.

Rather than seeing unbalanced government budgets as

wrong, Keynes advocated so-called countercyclical fiscal
policies that act against the direction of the business cycle.
For example, Keynesian economists would advocate deficit
spending on labor-intensive infrastructure projects to
stimulate employment and stabilize wages during economic
downturns. They would raise taxes to cool the economy and
prevent inflation when there is abundant demand-side
growth. Monetary policy could also be used to stimulate the
economy—for example, by reducing interest rates to
encourage investment. The exception occurs during a
liquidity trap, when increases in the money stock fail to lower
interest rates and, therefore, do not boost output and
employment.
Keynes argued that governments should solve problems in
the short run rather than wait for market forces to fix things
over the long run, because, as he wrote, “In the long run, we
are all dead.” This does not mean that Keynesians advocate
adjusting policies every few months to keep the economy at
full employment. In fact, they believe that governments
cannot know enough to fine-tune successfully.
Keynesianism evolves
Even though his ideas were widely accepted while Keynes was
alive, they were also scrutinized and contested by several
contemporary 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 that government intervention only
worsens the recovery process.

Keynesian economics dominated economic theory and policy

after World War II until the 1970s, when many advanced
economies suffered both inflation and slow growth, a
condition dubbed “stagflation.” Keynesian theory’s popularity
waned then because it had no appropriate policy response for
stagflation. Monetarist economists doubted the ability of
governments to regulate the business cycle with fiscal policy
and argued that judicious use of monetary policy (essentially
controlling the supply of money to affect interest rates) could
alleviate the crisis (see “What Is Monetarism?” in the March
2014 F&D). Members of the monetarist school also
maintained that money can have an effect on output in the
short run but believed that in the long run, expansionary
monetary policy leads to inflation only. Keynesian economists
largely adopted these critiques, adding to the original theory a
better integration of the short and the long run and an
understanding of the long-run neutrality of money—the idea
that a change in the stock of money affects only nominal
variables in the economy, such as prices and wages, and has
no effect on real variables, like employment and output.
Both Keynesians and monetarists came under scrutiny with
the rise of the new classical school during the mid-1970s. The
new classical school asserted that policymakers are ineffective
because individual market participants can anticipate the
changes from a policy and act in advance to counteract them.
A new 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, fiscal policy can still be effective in the short run.
The global financial crisis of 2007–08 caused a resurgence in
Keynesian thought. It was the theoretical underpinnings of
economic policies in response to the crisis by many
governments, including in the United States and the United
Kingdom. As the global recession was unfurling in late 2008,
Harvard professor N. Gregory Mankiw wrote in the New York
Times, “If you were going to turn to only one economist to
understand the problems facing the economy, there is little
doubt that the economist would be John Maynard Keynes.
Although Keynes died more than a half-century ago, his
diagnosis of recessions and depressions remains the
foundation of modern macroeconomics. Keynes wrote,
‘Practical men, who believe themselves to be quite exempt
from any intellectual influence, are usually the slave of some
defunct economist.’ In 2008, no defunct economist is more
prominent than Keynes himself.”
But the 2007–08 crisis also showed that Keynesian theory
had to better include the role of the financial system.
Keynesian economists are rectifying that omission by
integrating the real and financial sectors of the economy.■

Sarwat Jahan is an Economist and Chris Papageorgiou is a

Deputy Division Chief in the IMF’s Strategy, Policy, and Review
Department. Ahmed Saber Mahmud is the Associate
Director of Applied Economics at Johns Hopkins University.

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