Keynesian Economics Theory
How It Works with Examples
Keynesian economics is a theory that says the government should increase demand to boost growth. Keynesians believe consumer demand is the primary driving force in an economy. As a result, the theory supports expansionary fiscal policy. Its main tools are government spending on infrastructure, unemployment benefits, and education. A drawback is that overdoing Keynesian policies increases inflation.
The British economist John Maynard Keynes developed this theory in the 1930s. The Great Depression had defied all prior attempts to end it. President Roosevelt used Keynesian economics to build his famous New Deal program. In his first 100 days in office, FDR increased the debt by $4 billion to create 16 new agencies and laws. For example, the Works Progress Administration put 8.5 million people to work. The Civil Works Administration created 4 million new construction jobs.
Keynes described his premise in “The General Theory of Employment, Interest, and Money.” Published in February 1936, it was revolutionary. First, it argued that government spending was a critical factor driving aggregate demand. That meant an increase in spending would increase demand.
Second, Keynes argued that government spending was necessary to maintain full employment.
Keynes advocated deficit spending during the contractionary phase of the business cycle. But in recent years, politicians have used it even during the expansionary phase. President Bush's deficit spending in 2006 and 2007 increased the debt. It also helped create a boom that led to the 2007 financial crisis. President Trump is increasing the debt during stable economic growth. That will also lead to a boom-and-bust cycle.
Keynesian Versus Classical Economic Theories
Classical economic theory promotes laissez-faire policy. It says the free market allows the laws of supply and demand to self-regulate the business cycle. It argues that unfettered capitalism will create a productive market on its own. It will enable private entities to own the factors of production. These four factors are entrepreneurship, capital goods, natural resources, and labor. In this theory, business owners use the most efficient practices to maximize profit.
Classical economic theory advocates for a limited government. It should have a balanced budget and incur little debt. Government spending is dangerous because it crowds out private investment. But that only happens when the economy is not in a recession. In that case, government borrowing will compete with corporate bonds. The result is higher interest rates, which make borrowing more expensive. If deficit spending only occurs during a recession, it will not raise interest rates. For that reason, it also won't crowd out private investment.
Supply-side economists say that increasing business growth, not consumer demand, will boost the economy. They agree the government has a role to play, but fiscal policy should target companies. They rely on tax cuts and deregulation.
Proponents of trickle-down economics say that all fiscal policy should benefit the wealthy. Since the wealthy are business owners, benefits to them will trickle down to everyone.
Monetarists claim that monetary policy is the real driver of the business cycle. Monetarists like Milton Friedman blame the Depression on high-interest rates. They believe expansion of the money supply will end recessions and boost growth.
Socialists criticize Keynesianism because it doesn't go far enough. They believe the government should take a more active role to protect the common welfare. This means owning some factors of production. Most socialist governments own the nation's energy, health care, and education services.
Even more critical are communists. They believe the people, as represented by the government, should own everything. The government completely controls the economy.
The Keynesian multiplier represents how much demand each dollar of government spending generates. For example, a multiplier of two creates $2 of gross domestic product for every $1 of spending. Most economists agree that the Keynesian multiplier is one. Every $1 the government spends adds $1 to economic growth. Since government spending is a component of GDP, it has to have at least this much impact.
The Keynesian multiplier also applies to decreases in spending. The International Monetary Fund estimated that a cut in government spending during a contraction has a multiplier of 1.5 or more. Governments who insist on austerity measures during a recession remove $1.50 from GDP for every $1 cut.
New Keynesian Theory
In the 1970s, rational expectations theorists argued against the Keynesian theory. They said that taxpayers would anticipate the debt caused by deficit spending. Consumers would save today to pay off the future debt. Deficit spending would spur savings, not increase demand or economic growth.
The rational expectations theory inspired the New Keynesians. They said that monetary policy is more potent than fiscal policy. If done right, expansionary monetary policy would negate the need for deficit spending. Central banks don't need politicians’ help to manage the economy. They would merely adjust the money supply.
President Roosevelt ended the Great Depression by spending on job creation programs. He created Social Security, the U.S. minimum wage, and child labor laws. The Federal Deposit Insurance Corporation prevents bank runs by insuring deposits.
President Reagan promised to reduce government spending and taxes. He called these traditional Republican policies, Reaganomics. But instead of cutting spending, Reagan increased the budget 2.5 percent each year. He increased defense spending from $444 billion to $580 billion by the end of his first term. He also cut income taxes and the corporate tax rate. Instead of reducing the debt, Reagan more than doubled it. But that helped end the 1981 recession.
Bill Clinton's expansionary economic policies fostered a decade of prosperity. He created more jobs than any other president. Home ownership was 67.7 percent, the highest rate ever recorded. The poverty rate dropped to 11.8 percent.
Barack Obama's policies ended the Great Recession with the Economic Stimulus Act. This act spent $224 billion in extended unemployment benefits, education, and health care. It created jobs by allocating $275 billion in federal contracts, grants, and loans. It cut taxes by $288 billion. Obamacare slowed the growth of health care costs.