Unit 9: Keynesian Theory

Economists can only build models or theories to explain the economies we observe. When the structure of the economy changes, it sometimes means that the assumptions upon which economic models/theories were built are no longer valid. This means that the macro-economic theories that may have adequately described or predicted economic performance for years or decades suddenly no longer work very well. When this happens, it’s time for economists to “go back to the drawing board” and either modify existing models or create new ones that explain things better.

In the last two units we developed a tool, the AD-AS model, to help us analyze how an economy reacts to changes in price levels (inflation/deflation). Using the AD-AS model, we identified two situations when the economy is not achieving our goals: the recessionary gap and the inflationary gap. We also looked at a specific theory, the Classical Theory, of how the economy responds to these recessionary and inflationary situations.

In this unit, we are going to look at a different theory of how the economy responds to these recessionary and inflationary gaps: the Keynesian theory (pronounced Canes-ee-in). The Keynesian Theory leads to very different conclusions about the ideal role of government in the macroeconomy. Where the Classical theory advocated small government, balanced budgets, and a hands-off approach, the Keynesian theory will advocate a strong active role for the national government including occasional government budget deficits and surpluses.

So, in this unit, we have three main objectives:

  • Explain verbally and graphically and apply the aggregate demand-aggregate suppy (AD-AS) model toKeynesian fiscal policy.
  • Explain and analyze the Keynesian theory of macroeconomic equilibrium and the resulting implications for the role of government.
  • List and explain the tools of government fiscal policy and describe how those tools can beused to achieve macroeconomic goals.

Disruption, Structure, and Change in Economic History

Macroeconomic theories are important because they form the foundation of virtually all the recommendations and proposals that politicians make. What starts as an academic theory in economics can often become actual government policy. And government policy affects actual lives. For example, in the 1860’s an intellectual in London named Karl Marx wrote a theory of how economies evolve. His theory logically led to certain recommendations for government policy. In 1917, Nicolai Lenin adopted this theory and began to put it into policy and practice in Russia. The Soviet Union was born. Seventy-four years and millions of deaths later, the Soviet Union collapsed because parts of the theory and policies didn’t work. If the theory and it’s assumptions of macroeconomics aren’t valid, then the proposals made by politicians will be misguided and ineffective. The most famous macroeconomist of the 20th century, John Maynard Keynes, observed that most so-called “practical men of affairs” are actually the “intellectual slaves of some defunct academic scribbler”.

The Classical theory that we discussed in the last unit had been developed in the 19th century as a way for economists to explain how countries could grow if government would allow free markets. The Classical theory recommended that governments adopt a laissez-faire approach to the economy: keep government small,balance the government budget every year, and keep the govvernment out of markets. At the time, the alternatives to Classical theory policy recommendations were either Mercantilism or Marxism/Socialism. During the 19th century, nations in Europe began to increasingly adopt the Classical theory policy recommendations and move away from Mercantilism. Marxism was never really tried until the 20th century. As nations began to adopt Classical theory-inspired policies and loosened government restrictions on markets, they began to grow.  Those nations that adopted the policies recommended by Classical economists grew fastest.

Jim’s Observation:  Caution is advised before concluding that Classical laissez-faire policies produced the growth. A strong argument is made by some historians that the growth produced the Classical theory. The growth was largely the outcome of the industrial, banking, and political revolutions. In fact, the industrial revolution tended to precede the writings of the Classical economists.  The Classical economists were trying to explain what was already happening.  The industrial revolution produced a new very wealthy and politically influential class of industrialists and bankers whose interests coincided nicely with the laissez-faire recommendations of Classical theory.

The 19th and early 20th centuries never really experienced the kind of steady-state full employment with no inflation equilibrium that Classical theory suggests is the “natural state” of the economy. There were numerous and frequent financial panics and deep depressions interspersed with wild booms, not only in the U.S. but also in England, France, Germany and any other industrialized economy.  They also experienced periods of wild inflation and deflation. But, each depression or inflationary period each came to an end.  The long-run growth path appeared strongest for those nations that liberalized their economies the most. And each period seemed to follow the dynamics described by Classical economics: wild booms produced inflation and depressions ended when deflation had occurred.  It seemed that although they fluctuated wildly, economies would, after price level adjustments, return to full employment — exactly as Classical theory predicts. It appeared that the Classical theory did, in fact, represent how a market economy works. By the early 20th century, most politicians and economic advisers were convinced of the Classical theory.

However, any macroeconomic theory is only a theory of how a specific economy works. Theories rely upon assumptions about how people make decisions and how the markets themselves are structured. The Classical theory assumes that all markets are competitive, that prices go up and down to reach equilibrium, and that households only save money when the interest rate is high. These assumptions may have been a reasonable approximation of the agricultural and small-business economies of the 19th century, but by 1920 economies had changed. By the 1920’s, large industrial corporations came to dominate the economy. Many of these large corporations were very monopolistic and didn’t face competition. By the 1920’s there was a growing middle-class and a dramatic lengthening of lifespans. Middle-class households often choose to save money in anticipation of possible retirement, even if the interest rate on their savings was low. By the 1920’s, the structure of the economy had changed, yet macroeconomic theory had not changed. Yes, there were many economists in the early 20th century who began to realize that the real-life economy wasn’t necessarily the same as that pictured in their Classical theories, but their alternative theories were largely only parts and failed to attractive widespread attention. Besides, Classical theory still seemed to work. Until 1929.

1929: The Great Depression

The 1920’s in the United States were a period of rapid and dramatic growth in real GDP. Incomes soared. Unfortunately, the new-found riches were not evenly distributed. The gains in income in the 1920’s distinctly favored the rich and upper middle class. Nonetheless, the stock market and real GDP reached new heights by 1928 and early 1929. The the bottom fell out. In 1929 the stock market in the United State crashed. Thousands of investors were wiped out. Many people had their savings totally destroyed. The economy slid into a serious recession. Prices of many goods began to decline. Classical theory, you may recall predicts that prices will decline in a recession. Classical theory also predicts that lower prices will encourage greater profitability and SRAS will shift to the right, restoring full employment equilibrium. It appeared to many in 1930, that this was just another recession. A bad one, but just another recession and the economy should soon “right itself”. As unemployment rose, government officials and many economists argued for the government to “tighten it’s belt also” to reduce government debt and to just let the economy fix the contraction on it’s own.

The economy did not “right itself”. Instead of increasing production and lowering wages in response to lower prices, businesses laid off workers. Unemployment grew. Real GDP continued to decline even though the price level was also declining. Deflation continued but so did unemployment. The economy was experiencing both deflation AND increasing unemployment. What started as a stock market crash had turned into a full-fledged severe depression and a financial crisis.  Banks began failing in large numbers. Three years later, in 1932, unemployment continued at a very high level. Unemployment at it’s worst point reached 25-33%. Try to imagine that level of unemployment. One out of every four households was unemployed. To make things even harder, there was no unemployment compensation. If you lost your job, then you had no support except your savings. But your savings were likely wiped out in the stock market crash or the numerous bank failures. Over one in four banks in the U.S. failed – wiping out the savings of even working class citizens. Even worse, this severe downturn spread to other countries. Britain, France, Germany, Italy and others experienced the same severe recession.

Classical theory said this couldn’t happen. Classical theory suggests the economy should “right itself” through lower prices and unemployment would soon end. It didn’t. The recession had become The Great Depression. And The Great Depression, with it’s high unemployment was to last for over 10 years, something Classical theory could not explain. Many people questioned the very viability of a market economy. Many people began to wonder if perhaps socialism or Marxism was the “way to go”. Particularly in European countries, voters increasingly turned to fascist/Nazi or Communist parties, abandoning hope in market-based capitalism. If democratic market-based economies were to continue, a new theory was needed that explained how The Great Depression could happen and what policies could fix it.

J.M. Keynes Offers a New Theory to Explainss the Great Depression

In 1936, John Maynard Keynes, a British economist at Cambridge University published a book called The General Theory of Employment, Interest, and Money. The book revolutionized macroeconomics. It presented an alternative theory of how a modern industrial market economy works. The theories it presents eventually came to be described as Keynesian economics, or the Keynesian theory. Many of the ideas had been proposed by earlier economists, but nobody had presented such a comprehensive alternative to and critique of Classical theory before. Economists in both the U.S. and the U.K. took to the new theory quickly, largely because it explained how The Great Depression was possible. Politicians were much slower and reluctant to adopt the Keynesian policy recommendations. Eventually, though, the development of World War II in 1939-1945 forced politicians to unwittingly adopt the type of government budgets that Keynes recommended. As soon as they did, The Great Depression ended. Full employment quickly returned. It appeared that the Keynesian theory had been validated.

By 1948, government policy in the United States and other nations had clearly become Keynesian. Most non-communist industrialized nations were strongly guided by Keynesian theory for the period from the late 1940’s until the late 1970’s, a period economic historians call the “golden age” because it’s high growth rates and mild recessions. Since 1978-80, most industrialized nations have been guided more by resurgent Neo-classical/Monetarist theory which, although strongly Classical, still retains some aspects or lessons from Keynesian.

Revisiting the AD-AS Model, particularly AD.

To understand the Keynesian theory, we need to re-visit our AD-AS model. The Great Depression was 10 year period of very, very high unemployment combined with very severe deflation in the first 3 years. The most disturbing part (for economists, that is), was that by 1932, it seemed that the economy had indeed reached an “equilibrium” in the sense that the price level stopped falling and unemployment stopped rising, but it certainly wasn’t a full-employment equilibrium. Somehow, the economy had managed to put many people out of work, and yet markets and market price changes weren’t putting those people back to work. In AD-AS terms, we were deep into a recessionary gap and stuck there.

Keynes took a closer look at Aggregate Demand (AD) and spending decisions. The assumption of Say’s Law in the Classical Model implies that households will prefer to spend (C) all of their income unless the interest rate is high enough to persuade them to save (S) some of the money. But although household savings might reduce spending on consumption (C) by households, that same money eventually does get spent. Whatever money gets saved from households, gets borrowed by firms and spent as investment spending (I). So, in total our national income gets completely spent every year, either as C or as I. In Classical theory, the AD curve only moves under two circumstances: the government chooses to spend more than it taxes (a deficit) or the population grows (more people=more demand).

Keynes disputes this view. Keynes observes that spending decisions are complex and subject to many influences beyond just our income. Keynes suggests that the AD curve actually shifts a lot. It was shifts in AD that created the Great Depression and allowed the economy to get “stuck” in a recessionary gap according to Keynes.

In looking closer at spending decisions (demand), Keynes actually builds an entire separate model called the Income-Expenditure model to help explain how spending on GDP is determined.

We will not go into the details of how the Income-Expenditure model in this course. Your textbook does go into some detail about the model, including graphs of Income vs. Spending and discussions of “marginal propensities”. Some books refer to the Income-Expenditure model as the “Keynes Cross” because of a graph that this involved. We are interested primarily in the logic of how households and firms decide how much to spend on C and I. You do not need to be concerned here with Income-Spending graphs or “marginal propensities” and the related math.

We will primarily study Keynesian ideas in the context of the AD-AS model we have already learned.

Aggregate Demand (AD): What Determines Our Spending?

Keynes acknowledges that in any given year we spend most all of our income. Further, our income is the greatest determinant of how much we spend, regardless of whether we are looking at household spending on C or firm spending on I. But Keynes looks closer and examines the changes in our spending when our income changes. In other words, suppose you are a the “average” household. If your income increased by $1000 this year, how much would your spending change? Would you spend the entire $1000 additional income? Would you save part of it and increase spending by less than $1000? If you save part of it, how do decide how much to save and how much to spend?

Remember that real GDP can be considered as both the aggregate of all spending in the economy AND as the aggregate of all income. Let’s look then at what happens to spending decisions when real GDP rises and increases our income. We’ll also consider what happens when real GDP declines resulting in a lower income. In other words, how does Aggregate Demand (spending) change? To do this, let’s look at each of the components: C, I, G, and (X-M). Of these, the most interesting and most important are C and I.

Key Word: Autonomous
Much of the Keynesian analysis of spending involves the word autonomous, as in “some part of consumption spending is autonomous”. Autonomous means that the amount being spent is determined independently of current income. The existence or non-existence of income is irrelevant to the spending decision. For example, if you are unemployed and have no income at all, yet you decide to spend money to buy food to eat anyway, we would call that autonomous spending. Your decision to buy food was independent of whether you had any income. Of course, this brings to mind the question of how did you get the money to spend if you didn’t have any income. Well there are other sources of spending power: you could use up your wealth & savings, somebody could give you money, you could steal money, etc., but you don’t necessarily have to have income in order to spend.

The contrast to autonomous spending is when your spending decision is based upon your income. If you just got a raise at work and decide to go out to a more expensive restaurant than you normally do, then your spending decision was based upon income. It was not autonomous.


Keynes identifies three key issues related how consumers determine C. They all involve changes – changes in income,in wealth, and in expectations,.

The biggest influence on how much consumers spend is their income. If we have more income, we spend more. When we have less income we spend less. It doesn’t sound really earth-shattering at first. In fact, it seems like a statement of the obvious. But the significant part is that when our income increases, we will increase our spending, but we won’t increase our spending as much as the increase in income! In other words, as we get more income, we tend to save a small piece of each increase in income. The portion of additional income that we spend is called the “marginal propensity to consume” and the portion of additional income that we save is called the “marginal propensity to save”. The implication of this insight is that as an economy produces more real GDP and therefore produces more income, consumption will not rise as fast as the income (real GDP) rose. In other words, as incomes rise in an economy, people choose to save more and more. As an economy becomes richer (higher real GDP), there is likely to be a growing pool of savings available in the financial markets – much like what happened in the 1920’s.

The second insight is that changes in wealth will change people’s willingness to spend. For example, if you discover that some asset of yours, say your house, your car, or your retirement funds have suddenly become more valuable, you will be willing to increase your spending, even if your income doesn’t go up. Understanding this concept depends on the understanding the difference between “flows” and “stock” variables. The value of your wealth or your assets is a “stock variable”. Your income and spending are flow variables. If you think you are richer (more wealth), then you’ll spend more even if your income hasn’t gone up. In the U.S. in the period 1999-2006 this happened a lot. House prices rose. Many people found that the house they owned became more valuable – their wealth increased. So, they increased spending and reduced savings even though their income did not change. Keynes most significant insight here was that the phenomenon works in reverse also. If you suddenly perceive your wealth has declined, then most people start saving more of their income and spending less of their income. They attempt to rebuild their wealth by saving more money. In 1929 stock market crashed and many people who owned corporate stocks were suddenly less wealthy. They immediately responded by cutting back their spending and saving more of their income.

The last insight is that expectations affect savings and spending. In particular, if we become more pessimistic about the future we will save more of our income now. This is the phenomenon of “saving for a rainy day (or a retirement, or a serious illness, or a loss of job)”. If we think the likelihood of needing the our saved money in the future is greater, we increase savings now and reduce spending. For example, if I become afraid that I will lose my job later this year, I am likely to cut back on casual spending and save more money now. The same works in reverse. If I perceive the future to be bright and risk-free, I am likely to spend more and save less.

Any of these changes in Consumption spending brought on by changes in income, wealth, or expectations will have the effect of shifting the AD curve.


Classical theory suggested that interest rates pretty much determined the level of Investment spending (I) by firms. The idea was that interest rates are the “price” of borrowing the money households saved. If the price of borrowed money was low enough, then it was profitable for firms to borrow and invest in capital equipment and inventory. If the price of borrowed money (interest rates) is too high, then it is not profitable to invest and firms won’t spend on I. Classical theory says interest rates go up and down and bring equilibrium to financial markets so that this year’s savings (S) is equal to this year’s investment spending (I).

Keynes suggests that investment spending decisions by firms are more complicated in a modern industrial economy. First, firms actually decide how much investment spending well in advance. It isn’t always a year-to-year phenomenon. For example, Acme Corp may decide to build a new factory in year 1. But it takes 3 years to build the factory. In year 3 Acme is still spending money (I) based on a decision two-years earlier. The interest rate in year 3 doesn’t really determine the year 3 spending. The year 3 spending decision was already committed. While interest rates in year 1 may have influenced Acme’s original decision, the interest rates in year 3 don’t really affect year 3 spending. Even if interest rates went up, it would hardly make sense to leave a new factory only 2/3 built! In this sense, investment spending in year 3 is autonomous – it doesn’t depend on interest rates or income in year 3.

Next, Keynes observes that firms only invest if they expect to expand their business. In other words, I only happens if firms expect to grow in the future. If firms don’t expect to grow, then there’s no need to invest. Why spend to expand if you don’t think you’ll need it? The implication here is that firms might not borrow and spend on I even when the interest rate is low. Think of it this way: Would you borrow money, even at 1%, if you really believed there was nothing useful you could do with the borrowed money? Of course not. The implication for the overall economy then is that when real GDP declines significantly, as it did in 1929-1931, firms will cut back on investment spending because they don’t see any need to expand.

Keynes did not necessarily think that firms accurately predicted future economic conditions. Indeed, he thought that often firms got into overly pessimistic and overly optimistic moods, both of which affected Investment spending. He described firms as acting as if they were possessed of “some animal spirits” instead of rational analysis of economic opportunities. He further made the point that the future is unavoidably uncertain and unknowable.  We base our plans and investment decisions based on expectations of the future. Yet often things don’t work out right and we are stuck with paying for debt for bad investment decisions. The key point is that a decline in real GDP today could cause firms to think the future looks grim and therefore they would cut investment spending. Of course a cut in I further reduces real GDP, so a downward spiral could begin.


Keynes perceives the third component of spending on real GDP, government spending, as autonomous. In the past governments had tried to balance their budgets and have taxes equal government spending. Taxes reduce the income available to households to spend on C. When the government budget is balanced, then C is reduced by the same amount, T, that government spends, G. The government neither increases nor decreases real GDP spending if it has a balanced budget.

But Keynes observes that a balanced budget is simply a choice of government. Government could spend whatever amount it wants, regardless of whether the government collects enough taxes to cover the spending. It could always borrow or even just print new money to cover the deficit. In other words, the government always has the option to spend whatever it wants since it has unchallenged power to tax,borrow, and print money. G is therefore autonomous. Now strictly speaking, this is only true for a large economically-strong national government with a good credit rating. In other words, government spending is only autonomous (not dependent on taxes or income) as long as the government in question can borrow from financial markets. For nations like the U.S. or the U.K. in the 20th century,this was a reasonable assumption.

For many small nations or unstable governments, though, this is not a safe assumption. Often times, small or unstable governments cannot borrow from the financial markets because lenders and banks won’t lend to them. For small or unstable nations, many of the government spending-based macroeconomic policies we will discuss in this book are not a realistic option.

Net Exports

The balance of trade, or net exports, is also subject to changes that can shift AD. Including net exports in the theory significantly complicates it, but doesn’t change it’s conclusions. Therefore, in this course we are going to assume a relatively closed economy where net exports and trade with R.O.W., if it exists, is relatively small. We will ignore it for now, much as U.S. policymakers did for much of the 20th century.

Putting It Together: C + I + G + (X-M) = real GDP

If we put together all of Keynes’s insights into how people make spending decisions, it changes how the AD-AS model behaves in recessionary and inflationary gaps. Classical theory suggests the AD stays relatively fixed and SRAS shifts in response to changing firm perceptions of price changes, with the result that eventually full employment equilibrium is restored.

In contrast, Keynes’s analysis of spending decisions suggests that AD shifts. In particular, if the economy moves into a recessionary gap and real GDP declines, Keynes suggests that AD will shift left, making further declines in real GDP likely. If a recession happens and real GDP declines, Keynes observes that households will become fearful for their future and begin to save more, reducing C. Likewise, if real GDP is declining, firms are likely to see no reason to borrow and spend on expansion. I will drop. With C and I both dropping, real GDP will decline even further. Keynes observes that instead of dropping wages and product prices, modern industrial firms are likely to lay-off workers, increasing unemployment even further and preventing the kind of adjustment that Classical theory promises. In short, Keynes offered an explanation of how a modern, industrial economy with large monopolistic firms can become “stuck” in a deep recessionary gap. He offered an explanation for The Great Depression. He also offered a cure: Fiscal Policy.

For an example of the Keynesian theory using AD-AS graphs,see the Keynesian AD-AS Closer Look tutorial.

After World War II, Keynes’ theories and models were quickly adopted by both “mainstream” economists and government politicians after World War II.

The Keynesian “Cure”:
Fiscal Policy (or Government to the Rescue!)

Keynes felt that when a modern economy fell into a recessionary gap, it was most likely due to inadequate spending. In other words, recessions happened in modern economies because AD shifted the left, not because of some supply shock shifting LRAS or SRAS. This reduction in AD was most likely the result of households and firms becoming pessimistic about the future – reduced expectations. As real GDP declined, these lowered expectations become a self-fulfilling prophecy resulting in the exact bad times that people feared. The key is to restore confidence so that expectations improved and spending increased. Somehow, the AD curve has to be shifted to the right.

Keynes proposed that government was in the perfect position to accomplish such a shift in AD. Keynes proposed counter-cyclical fiscal policy. When the economy has moved into the down-phase of the business cycle, into a recession, the government should run a deficit budget. In a recession, the government should increase spending without raising taxes (or cut taxes without cutting spending). This will increase aggregate spending and raise real GDP. When firms and households see that their expectations of bad times don’t come true, they will respond by increasing their spending. Later in the business cycle, when the economy has been growing for a long time and is in danger of trying to “overheat” or go into an inflationary gap, the government could reduce AD. By running a budget surplus in an inflationary gap, the government will shift AD to the left and reduce the inflationary pressures in the economy.

Either way, the government has the power to shift AD in the opposite direction from which people’s expectations are moving. When people are becoming pessimistic, cutting their spending and putting th economy into recession, a government deficit will pull reverse expectations shift AD back to full employment. When people are becoming overly enthusiastic and spending too much, a government surplus will dampen the total spending and return to stable prices and full employment.

In other words, a modern, industrial market economy is inherently unstable since people’s expectations keep changing. But intelligent government fiscal policy can stabilize the economy and help achieve our macro goals of growth, stable prices, full employment, and stable cycle.

Types of Fiscal Policy: Expansionary and Contractionary

Fiscal Policy is just the use of the overall government budget to obtain macroeconomic goals. The effects of any particular government budget can be seen as expansionary (also called stimulus), neutral, or contractionary as seen in this table.

Type of Fiscal Policy Government Budget When to Use It Effect on AD Effect on Economy How to:
How to: T How to: Transfers
Expansionary Deficit (or increase the deficit) Recession AD moves right raises GDP, reduces unemployment increase spending cut taxes increase transfers
Neutral Balanced Budget Full employment none none G + Transfers =T
Contractionary Surplus Inflationary Gap AD moves left stable prices- prevents inflation; return to LRAS full employment cut spending increase taxes cut transfers

Which theory is best?

First, define “best”. If by “best” we mean the model that most clearly resembles the structure and predicts the behavior of our current macro-economy, then the answer is would be some form of Keynesian or it’s descendants. In particular, the Great Recession/Financial Crisis in 2007-09, the reactions to it, and the path followed by different nations has provided a rare “laboratory experiment” in macroeconomic policy.  In particular, different nations have followed strong Keynesian recommendations, others strong Classical austerity-based recommendations, and others a mix. The results have largely supported the Keynesian analysis. Yet opinions still vary widely. It depends on whether you think our modern industrialized economy consists primarily of very competitive markets with many firms and consumers and prices that are flexible, or whether you think the economy is dominated by monopolistic large corporations, unions, and governments with prices that don’t adjust easily. If you believe it’s competitive and dynamic, then Classical policy models make the most sense. If you believe the economy is inherently unstable and uncompetitive, then the Keynesian or Post-Keynesian models are  more appropriate.

Prior to the Great Recession/Financial Crisis of 2007-09 there appeared to be a wide  consensus among many mainstream macroeconomists that while the Keynesian theory provided some useful insights, the foundation of understanding the economy was better viewed as Classical.  This view was called the Neo-classical or New Keynesian view (New Keynesian isn’t really very Keynesian).  The Neo-classical view did not hold up well in the crisis. Since then  the debate has expanded to include some less well know theories known as heterodox ideas.  One major reason that the Neoclassical view did no fare well in the crisis is because it has an incomplete explanation of the monetary sector. We will study the monetary sector in Part III. But before we look at the monetary and financial sectors, we look at the government budget, deficits, and debt in the next unit.

Ideas shape the course of history.
The difficulty lies not so much in developing new ideas as in escaping from old ones.
“In the long-run we are all dead.”
— John Maynard Keynes