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A Primer on Keynesian Economics

By Dr. Hassan Shirvani —Before John Maynard Keynes published his General Theory of Employment, Interest, and Money in 1936, the prevailing view among most economists was that modern economies are characterized by perfectly competitive markets, in which flexible prices and wages cleared all markets and, hence, ensured continuous full employment. Pointing to the Great Depression of the 1930s and its associated mass unemployment, Keynes rejected this conventional wisdom. Instead, he asserted that modern economies are characterized by imperfectly competitive markets, in which giant corporations and labor unions resist any decrease in prices and wages. Under these conditions, any adverse demand shock to the economy will be absorbed by lower output and employment, rather than by reduced prices and wages as stipulated by pre-Keynesian economists. In addition, even if prices and wages are flexible downward, a general price and wage deflation can generate expectations of even lower prices and wages in the future, resulting in delayed spending and hiring by consumers and businesses and, hence, an aggravation of the recessionary conditions in the economy.

As the foregoing shows, Keynes had limited faith in the free play of market forces to restore economic health and to establish full employment. Attributing economic downturns to the failure of aggregate demand to catch up with the productive capacity of modern economies, he recommended the pursuit of policies that will boost total spending to its full employment level. Specifically, Keynes made a distinction between consumer spending, stipulated as a relatively stable function of consumer income, and business investment, considered as a more volatile function of the rate of interest and future earnings expectations. For Keynes, it is mostly fluctuations in business moods that lie behind investment volatility and, hence, the recurring economic booms and busts in capitalist economies. What is more, the richer the economy, the greater the share of private investment in national income and, thus, the greater the risk that the economy will be at the mercy of shocks to business moods and investments.

In principle, governments can fight recessions by encouraging more private investment through an expansionary monetary policy, which involves increasing the money supply and lowering the interest rate. However, as Keynes pointed out, during severe economic and financial crises, many businesses will be reluctant to invest in new plants and equipment, given their existing excess capacities, even at lower interest rates. In addition, given the state of economic and financial anxiety during severe recessions, there will be a flight to the safety of cash assets, resulting in very low interest rates and the emergence of the so-called liquidity traps. Under these conditions, any additional money creation will be hoarded, with no effect on interest rates. This double whammy of business reluctance to invest and ineffective monetary policy can result in extended periods of recession and high unemployment. As it is well known, the Great Depression lasted a whole decade and the Great Recession is currently in its sixth year.

In the light of the foregoing, Keynes recommended the use of fiscal policy as the only effective tool to combat persistently deep recessions. While lower taxes and reduced regulations can somewhat help private spending, Keynes does not consider them sufficiently stimulative in an environment of extreme pessimism. Instead, Keynes recommends government spending, especially on useful infrastructure projects, which can temporarily supplement private spending to pull the economy out of its funk. Once the economic recovery begins, businesses will have greater incentive to invest, thus making it possible for fiscal policy to retract.  The Second World War played this role during the Great Depression, and more socially useful government expenditures can surely do the same for the Great Recession.


Hassan Shirvani, Ph.D.
Professor Cullen Foundation Chair in Economics

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