Would Keynesian policies be a more viable method to deal with the economic crisis?


The Keynesian School of economic thought, was developed in the 1930s by the British economist John Maynard Keynes to understand the Great Depression. The scale of Keynesian theory span across the Atlantic in the post war decades, after its adoption in war-time Britain for macroeconomic management. Comprised of various macroeconomic theories, such as how in the short-run – and in recessions – economic output is impacted by aggregate demand (the economies wellbeing). To demonstrate that the total spending in the economy has an effect on output and inflation. The label “Keynesian” should be applied only to macroeconomics having no necessary implications about many microeconomic issues, known as the founder of modern macroeconomics. That “is the study of the economy as a whole, including growth in incomes, changes in prices, and the rate of unemployment.” (Mankiw, 2010) Extending over global, regional and national economies, economists advise on policies for the government regarding important economic indicators. Since Keynesian policies we have seen a subsequent development of Monetarism and New Classical economics, as well as the Real Business Cycle theory, and must include comparisons from the other Schools of economic thought alongside the Keynesian policies in dealing with the economic crisis. Keynesian policies have changed history and will be considered alongside other influences such as individualism factors, environmental factors and market correction.


The nineteenth century had policies taken from Great Britain liberalisation, with limited restrictions for entrepreneurs. “Eternal impediments to the free movement of goods and services were also cut back, enabling countries to specialize. International trade flourished.” (Grawue, 2017, p.30) While, technological and transport innovations drove economic growth, with an increase in production within those countries of deregulation. During the interwar period the category of “crisis” migrated across schools of economic thought. “These include the aggregate wave-like movements of prosperity and depression, as mapped by Schumpeter, the proliferation of business cycle theories in neoclassical and American institutional economics, the distinction between risk and uncertainty offered by Frank Knight, a founding figure of what would come to be called the Chicago School, and perhaps, most prominently, Keynes’s account of expectations as drivers of aggregate investment in periods of economic uncertainty.” (Knight in Goswami, 2018, p.18) The boom and bust cycles of the 1920s followed by the 1930s Great Depression, did allow “crisis” to become a part of economic thought that involved risk, uncertainty and expectation.

This set apart the inter-war economics as the Soviet Union government had began to control their economy at the start of the 1920s. Government spending also excessively rose during World War II, with the government pouring billions into manufacturing military equipment. Other large-scale government programs were implemented such as the New Deal investment in the United States. “Even if the New Deal programs were good policy, they should still, in theory, have required a constitutional amendment before they could be enacted” (Huemer, 2013, p.226) Despite, the New Deal meant to provide jobs in new public projects which created such demand for goods and services. “Public investments and construction of social security systems gave Western European governments a central place in the new economic model.” (Grawue, 2017, p.37) “Yet economic crises, whether then or now, are not exclusively objective phenomena that automatically generate uniform responses.” (Goswami, 2018, p.31)


Previous to Keynes, the Classical School of economic thought had affirmed that shifts in employment and economic output were self-adjusting (equilibrium of output and prices); if aggregate demand decreases, the slump in production and jobs would also decrease prices and wages. Therefore, this now low level of inflation and wages would gradually induce employers to invest in capital and jobs, to simulate employment and restore economic growth. This classical economics was studied by Keynes at Cambridge, despite, the depth and severity of the Great Depression had left this hypothesis unreliable. Demanding a new theory, Keynes published his “General Theory of Employment, Interest and Money” (this book would lay the foundations for his legacy), and other works; all claiming that some characteristics of market economies would cause aggregate demand to plunge further.


The Keynesian theory attributes a depression to: aggregate demand, savings and unemployment. Aggregate demand is a total demand for goods and services, otherwise considered the gross domestic product. It is comprised of (consumption, investment, government spending, and net exports) or C + I + G + NX. Keynes considered a high savings rate as having an extreme impact on the economy as consumption is a major factor in the aggregate demand equation. Keynes did not want GDP to fall if individuals choose to put money in the bank, viewing the unintended consequences as increased unemployment and less capital investment.

Keynes disagreed with classical economics full employment theory, because wages and prices are flexible this makes full employment unattainable. “Keynes further asserted that free markets have no self-balancing mechanisms that lead to full employment.” (Jahan, Mahmud, & Papageorgiou, 2014, p.1) Keynes theorized that if the unemployment rate falls, fewer job seekers are available to expanding businesses, causing higher wages, until the business no longer hires. Therefore, public jobs such as a draft during wartime was favoured in creating full employment.

Another important point Keynes theorized were sticky wages and prices, which responded slowly to changes in supply and demand; again showing that government intervention would be necessary. Real wages account for inflation, unlike nominal wages. Therefore, Keynes thought that businesses would be unable to make workers cut their nominal wages, unless there was deflation and wages or prices fell. Therefore, to increase employment, the real wage rate must fall; despite it decreasing aggregate demand. To make such changes in the economy Keynes theory used the government’s ability through fiscal and monetary policy; its ability to trade government bonds, to alter spending and taxes.


“Keynes’s overthrow of the ‘Ricardian foundations’ consisted in the claim that production and employment could be limited by lack of effective demand; and that in most circumstances, and particularly when unemployment was heavy, could be boosted by government action to increase effective demand.” (Skidelsky, 2010, p.325) Keynes refutes the notion lower wages can restore employment when demand for products are weak, as employers may not take on additional employees and reduce capital investment. Instead, Keynes theorised economies to be in a state of constant change – contracting and expanding – known as the boom bust cycle. In response, Keynes urged for a fiscal policy that during boom periods, taxes ought to be increased or spending cut; whilst during bust periods there should be deficit spending. The critique of Keynes economics leant towards a more centrally planned economy, were popularised by economist Friedrich Hayek in his 1944 publication “The Road to Serfdom”. A clear contrast between the market economy and central planning, would be north and south Korea split after the Korean War in the 1950s, both being equally poor, then the per capita GDP in the 1970s exploded in South Korea, and stagnated in the North. (Grawue, 2017, p.59)

While, such aspects as the standard of living are not taken into account by the Keynesian school that is focused entirely on boosting employment within a crisis. “Wages and employment are discussed as if they had no relation to productivity and output.” (Hazlitt, 1962, p.72) In contrast, the Austrian school of economic thought, states that any short-term increase in revenue would not last and any new employments can only be kept as long as there is continued inflation. While, credit expansion could be confused for real loanable funds, distorting what is available to support current production and consumption levels. Limited to an aggregate production function with only one input – aggregate labour and Keynesian thinking assumes only one price, that is, ‘the price level’ a weighted average of all money prices average out relative prices and changes in such prices. With no concern over long-run capital stocks and counted as given in GDP whether they are profitable or misdirect resources. Representing assets where only exchange has occurred and no new employment has been added. Nor do aggregates count for unsold inventories, underground business, or personal production for direct consumption.

Neoclassical economists thought unemployment was caused by market imperfections (that kept real wages and interest from their natural levels. While, Marxist employment cycles consider that capitalist profits can only be maintained through a ‘reserve army of the unemployed’. (Skidelsky, 2010, p.325) Despite, the Austrian theory suggests that in an unhampered economy unemployment is always voluntary (termed as “catalytic unemployment” my Ludwig von Mises), as job seekers coordinate and make adjustments to choice of occupation or amount of wage rate they and their employer are willing to accept. “Cheaper production methods enable them to cut costs, lower prices, and attract more consumers, again raising profits.” (Grawue, 2017, p.64) These market dynamics led Adam Smith to write “[The rich] consume little more than the poor, […] led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, […]”. (Smith, 1759, pp.184-185)


Keynesian theory were also used in developing the Phillips curve (which examines unemployment), and the ISLM Model shown in Figure 1. The LM curves relationship assumes the interest rate as the liquidity theory of interest. Where the money supply M is exogenous because the central bank indirectly sets it in this model. If the central bank decreases the money supply, M / P is reduced by M and P is fixed, shifting the money supply left. Raising the interest rate, while people hold less money balances. While, an increase in the money supply, decreases the interest rate, while people hold more money. This model assumes greater income greater spending, equals greater money demand: (M / P)d = L(r, Y).

Figure 1


Milton Friedman a critic of Keynes, contributed to the establishment of the monetarist school of thought, focused on the role money supply has on inflation rather than aggregate demand. “The recognition that substantial inflation is always and everywhere a monetary phenomenon is only the beginning of an understanding of the cause and cure of inflation.” (Friedman & Friedman, 1980, p.254) Additionally, that government spending can crowd out investment and spending by private businesses, with less money available in the market for private borrowing. “The combined effect of the aftermath of the stock market crash and the slow decline in the quantity of money during 1930 was a rather severe recession.” (Friedman & Friedman, 1980, p.80) Here the government could increase interest rates or sell treasury securities to beat inflation. Even hyperinflation with the quantity theory of money can show that credit expansion maxes out asset prices, therefore, halting credit expansion, and bond interest elevates as government debt defaults. “[However, Keynesians] do not spend much time worrying about potential inflation; on the contrary, they are obsessed with an irrational fear of even the slightest hint of deflation.” (Higgs, 2009) To prevent malinvestment and misguided policy decisions, one must consider the costs of not accounting for market price distortions, as such misdirected resources and periods of inflation and deflation.


Keynes theorized more government spending, in the aggregate demand function can use up the extra production capacity; its benefits multiplied if employment rises and consumption increases. “[However,] what happens to the quantity of money tends to dwarf what happens to output; hence our reference to inflation as a monetary phenomenon, without adding any qualification about output.” (Friedman & Friedman, 1980, p.255) While, Keynesian economics suggests that government intervention and the business cycle move in opposite direction – spending more in a bust and spending less in a boom. “However, to our knowledge there is no example in history of a substantial inflation that lasted for more than a brief time that was not accompanied by a roughly corresponding rapid increase in the quantity of money; and no example of a rapid increase in the quantity of money that was not accompanied by a roughly correspondingly substantial inflation.” (Friedman & Friedman, 1980, pp.255-256) Milton Friedman and Rose Friedman (1980, p.256) continue to explain the cause and effect, with the quantity of money grows six months earlier than all five of the matching price indexes.

Financial developments are endogenous to the fluctuations.  “The endogenous variables are the price [and] the quantity [exchanged].” (Mankiw, 2010) “Changes in the endogenous variables were brought about only by actual changes in the preferences of laborers and capitalists, by shifts in the supply and demand for present goods reflecting changes in time (or liquidity) preferences.” (Garrison, 1978) While, Hyman Minsky worked on the financial part of the business cycle more than anybody else, because he believed that finance was the cause for capitalisms instability although the capitalist economy had an inherent tendency to speculative booms. “Although Minsky always professed to draw his inspiration from Keynes, this upward instability hypothesis stands in stark contrast to the economy’s tendency, in Keynes’s theory, to gravitate to a state of unemployment equilibrium.” (Leijonhufvud, 2009, p.742) Today, however, many governments use portions of Keynesian theory to smooth out the business cycle, while some economists combine his principles with macroeconomic decisions.


Keynes at the time was critical of the British government, that to balance the national books cut welfare and raised taxes. As this would discourage people to spend. “[Keynes prefered] easy money not only because it lowers the visible cost of financing the government’s deficit spending, but also because it induces individuals to borrow more money and spend it for consumption [goods]” (Higgs, 2009). Keynes discouraged most saving except for retirement or education. The multiplier effect is a major component of Keynesian economic models. The Keynesian multiplier: ones spending is income for another, and that income is spent and the cycle continues. When individuals save less and spend more their marginal propensity to consume increases. One dollar spent from fiscal stimulus, creates more than a dollar in growth. This provided justification for government spending projects on a national scale.


The slow change in prices make possible using the money supply as a way to change interest rates. Keeping rates low Keynes would stimulate the economic cycle by encouraging people to borrow money. Yet would avoid the zero-bound problem, as stimulating the economy becomes more difficult, as demonstrated in the Graph 1. At point MS3, interest rate manipulation may no longer generate new economic stimulus. Japan’s Lost decade in the 1990s can be an example of this liquidity trap, with interest rates being close to zero. The lower boundary of interest rates then can be shown as a means to an end. When Keynesians have to look beyond interest rate manipulation, other interventionist policies would be direct control of the supply of labour/goods and altering fiscal/monetary policy. However, policy changes can sometimes have an uncertain ruling, for example on a tax policy or other policy there can be policy uncertainty. To prevent miscalculation investors compute for inflation increases in prices using the real interest rate, “[the] return to saving and the cost of borrowing after adjustment for inflation.” (Mankiw, 2010)

Graph 1



The Keynesian Cross, shown in Figure 2 is “[a] simple model of income determination, based on the ideas in Keynes’s General Theory, which shows how changes in spending can have a multiplied effect on aggregate income.” (Mankiw, 2010) This however only measures a closed economy and assumes spending provides economic stimulus and spending decreases economic stimulus. “It takes fiscal policy and planned investment as exogenous and then shows that there is one level of national income at which actual expenditure equals planned expenditure.” (Mankiw, 2010) Alternatively, as government spending and taxation both increase, the government purchases multiplier and the tax multiplier both cancel each other out, as long as one is not larger than the other. As government purchases exceed taxes there is a government deficit that increases income, or where taxes exceed government purchases there is a government surplus that decreases income, in this model. This explains that budget deficits are good as spending is more productive than saving.

Figure 2



In conclusion, the Keynesian theory can be considered as outdated when used as absolute in dealing with the economic crisis. As economic crises are not exclusively objective phenomena that the government can apply uniform policy responses to. Additionally, in today’s age economists should look to employ all schools of economic theories when analyzing the correct response to an economic crisis. While, any response of altering aggregate demand, savings and unemployment within a depression would be incomparable (when considering such issues such as policy lags in the economy) to the efficacy of the self regulatory mechanism of the marketplace, that leads to the fulfilment of consumer demand.



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