Keynesian economics is an economic theory that holds the view of John Maynard Keynes. Keynes holds that the government – through its fiscal budget – has a strategic role in influencing the economy. He believes the government needs to change government spending and taxes to affect output and inflation in the economy.
The main points of Keynesian economics
Keynesian economics is based on two main ideas. First, aggregate demand is more likely to affect the economy in the short run than aggregate supply. The changes make the economy fluctuate and form a business cycle.
Second, Keynesians view wages and prices as being rigid. Thus, in an economic downturn, unemployment can occur.
Unemployment does not necessarily reduce wages. The rigidity of the wage reduction makes businesses do not immediately recruit workers and increase output during a recession. As a result, the economy will not immediately return to its equilibrium when experiencing a recession, as the Classical Economic thought.
In returning the economy to its equilibrium, external stimuli need to be made. In this case, the government takes a role.
Keynesian view about fiscal policy
Keynes advocates an increase in government spending and lower taxes to stimulate demand and pull the global economy out of the depression. This step is effective because, at the same time, the private sector is not enough to drive the economy. Hence, the government should increase its spending or lowers taxes to stimulate economic growth and avoid a recession.
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Keynesians believe aggregate demand is the main driving force in an economy. Changes in aggregate demand have consequences for changes in aggregate output (economic growth), inflation, and unemployment.
In this case, the role of government is needed to influence aggregate demand. From Keynes’s view, the concept of fiscal policy emerged.
The expansionary fiscal policy seeks to stimulate economic growth by increasing aggregate demand. That is done by increasing government spending, reducing taxes, or a combination of both.
In contrast, the contractionary fiscal policy seeks to moderate growth and avoid economic overheating by reducing aggregate demand. In this case, the government uses a combination of decreasing expenditure and increasing taxes.
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Views on the contribution of aggregate demand to aggregate output
Keynesians believe that, because prices are rigid, fluctuation in the expenditure components causes aggregate output to change. Expenditures can be in the form of consumption, investment, or government expenditure.
When the government increases its expenditure, for example, and all other expenditure components remain constant, the output will increase.
Views on the role of government
The government’s role in driving the economy is increasingly important during the recession. The reason is that the contribution of private sector expenditure is not strong enough to stimulate economic growth.
The private sector often bases its decisions on economic conditions. Consumption and investment expenditure are closely related to economic growth. When economic growth falls, consumption and investment also fall. For this reason, economists categorize the two as induced expenditures.
Conversely, government expenditure is an autonomous expenditure. Most components of government spending are independent of economic growth. Instead, they depend on the government’s discretionary decision.
Capitalism according to Keynesian
Keynes said that capitalism is a good economic system. The system allows aggregate demand to work in the economy.
In the capitalist system, people get money from their work. Businesses employ and pay people to work. Then people can spend their money on things they want.
Keynesian unemployment theory
According to Keynesian theory, changes in aggregate demand have the most significant short-term effects on real output and employment, not on prices.
This idea is illustrated, for example, through the Phillips curve, which shows inflation rises when unemployment falls.
Proof of Keynes’s idea: the Great Depression
John Maynard Keynes developed his concept as an attempt to understand the Great Depression. Keynes advocated an increase in government spending and lower taxes to stimulate demand. Increasing demand will eventually pull the global economy out of depression.
Increased US government spending put an end to the Great Depression. An increase in aggregate demand has pushed real GDP beyond potential output. That gives an impressive confirmation of Keynes’s ideas.