Economics, Keynesian

International Encyclopedia of the Social Sciences, edited by William A. Darity, Jr., 2nd ed., vol. 2, Macmillan Reference USA, 2008.

Keynesian economics is the approach to macroeconomics that grew out of John Maynard Keynes’s work, especially his The General Theory of Employment, Interest and Money (1936) written during the Great Depression. Since Keynes’s work has been interpreted in different ways and inspired various formulations of macroeconomics, it is defined in a number of different ways, including the approach to macroeconomics in which: aggregate demand plays a major role in determining output and employment; involuntary unemployment can persist; and fiscal and monetary policy can affect the level of output and employment. Keynes himself recognized that he had a number of predecessors, and it has been suggested that major elements of his approach were anticipated by others (most notably, Michal Kalecki).

In The General Theory Keynes argued that employment is determined by the aggregate demand for goods, which is in turn determined (in a closed economy) by consumption demand and investment demand. Consumption depends mainly on the level of real income while investment demand depends on the interest rate, which is determined by money supply and the demand for money, and by business expectations. Given expectations and monetary conditions, employment is determined so that output produced is equal to aggregate demand. The level of employment thus determined may be less than the full employment level at which the supply and demand for labor (which depend on the real wage) become equal. He also examined the aggregate supply side of the economy with a given money wage, and a production function relating output to employment, which determined the average price level. Keynes argued that the wages are likely to be rigid downward when unemployment exists because of the concern of workers with their wage relative to that of others: however, even if wages (and hence the price level) fall, it is unlikely to increase the level of aggregate demand in the face of uncertainty and the negative effect of falling prices on the demand for goods by debtors. Keynes therefore recommended expansionary monetary and especially fiscal policy to increase the level of aggregate demand, employment, and output to reduce unemployment.

Keynes’s analysis is most simply depicted with the income-expenditure model of Figure 1, in which the axes measure income and output, Y, and expenditures or demand, E. The line marked C is the consumption function that shows the relation between consumption and real income, and the line marked C + I + G is aggregate demand that adds (planned) investment, I, and government expenditure, G, both assumed to be exogenously given, to it. Equilibrium output, YE, is determined where the aggregate expenditure line intersects the 45° line so that output equals expenditure. The level of output determines employment, which may imply unemployment. Fiscal and monetary expansion, by increasing G or I, can increase output and reduce employment.

Figure 1

Economists such as John Hicks and Franco Modigliani, who were persuaded by Keynes’s theory, tried to relate it to pre-Keynesian neoclassical macroeconomic theory in which the economy was generally thought to be at full employment. A series of models, including the IS-LM and later the aggregate demand–aggregate supply (AD-AS) models, were developed to produce what has come to be called the neoclassical synthesis approach to Keynesian economics. This approach, which uses different types of demand and supply curves and equilibrium condition as in neoclassical theory, implies that unemployment can exist, due to wage rigidity, in the short run, but in the medium and long runs, in which the wage is flexible, the economy is at full employment. When unemployment exists, over the medium and longer runs the money wage falls, which reduces the costs of firms and hence the price level, which reduces the nominal demand for money. The resulting excess supply of money is used to increase spending on goods (by what is called the real balance effect), or is lent out, implying a fall in the interest rate and a rise in investment (and possibly consumption) demand. This increase in aggregate demand increases output and employment and takes the economy to full employment. With rigid wages in the short run, however, this mechanism does not work itself out, and unemployment can exist. Expansionary fiscal and monetary policy can increase output in the short run, but only increases the price level in the medium and long runs when the economy is at full employment.

In the 1960s, after most advanced countries experienced low unemployment for long periods (arguably due to the success of Keynesian macroeconomic policies), and inflationary pressures began to mount, alternative approaches to macroeconomics began to emerge. Three of them adopted positions opposed to Keynesian economics and can be briefly discussed to show what it is not. The first, monetarist, approach developed by Milton Friedman in 1968 and others returned to the pre-Keynesian idea of flexible wages in the short run, so that full employment always prevails, but allows changes in aggregate demand to affect the level of output and employment, because of misperceptions about the effects of aggregate demand changes, to make it consistent with the facts regarding business cycles. For instance, when money supply increases, workers find their money wage to be higher, but by not taking into account that the price of goods is higher too, they supply more labor, which leads to an increase in output. In the longer run, as workers revise their price expectation, this expansionary effect disappears. According to this approach, although full employment always prevails due to the flexibility of wages, macro policy has a temporary effect on real variables due to the misperceptions of the workers. The second also maintains the assumption of flexible, labor-market clearing wages, but assumes that economic agents do not make systematic expectational errors as they do in the earlier monetarist approach, and assumes rational expectations. This new classical approach developed by Robert Lucas in 1983 and others points out that with agents having rational expectations in the sense that they use all relevant information about the economy to calculate price expectations, fiscal and monetary policy (apart from tax policy changes that affect the supply of labor) are not effective even in the short run, unless the policies’ changes are random and hence unanticipated. The third approach, called the real business cycle approach, continues in this tradition, but explains business cycle fluctuations in terms of technology shocks that affect investment demand and the interest rate and bring about the intertemporal substitution of labor to explain changes in employment.

In addition to real-world phenomena mentioned earlier, Keynesian economics lost ground to these new classical approaches because of its alleged problem in providing proper microfoundations to macroeconomics. The neoclassical synthesis Keynesian approach explained unemployment in terms of wage rigidity, but did not relate the analysis to optimizing microfoundations. The new Keynesian approach tries to develop Keynesian economics to address this problem. An early branch of this approach merely introduced fixed prices and wages into the standard micro-founded general equilibrium model, examining disequilibrium situations in which actual transactions occurred at the “short” side of the market and the effects of such deviations from market clearing in one market spilled over into other markets. Another branch of the approach responded directly to the monetarist and rational expectations approaches, introducing wage price stickiness (such as staggered or sticky wage adjustment) into models with rational expectations to show that it is complete wage flexibility, rather than the assumption about expectations, that produced the policy ineffectiveness result. A final, and most popular new Keynesian branch, provided optimizing microfoundations to wage, price, and interest rate rigidity. Efficiency wages (which prevent the wage from falling when unemployment exists because of its adverse effect on labor efficiency) and wage bargaining, imperfect competition and the “menu” costs of price changes, and asymmetric information in credit markets have been used to explain these rigidities. Some models, such as those that distinguish the role of insiders and outsiders in the wage determination process, imply that aggregate demand changes can have long-term effects on output due to what are called hysteresis effects. While some new Keynesian models imply involuntary unemployment in equilibrium, others do not, but imply only that aggregate demand policies can have effects on output.

The central feature of both the neoclassical synthesis and new Keynesian approach is the rigidity of wages and prices. While wage rigidity is an important element of Keynes’s theory, we have seen that according to Keynes the wage flexibility is no guarantee for full employment. The fact that flexible wages may exacerbate rather than solve unemployment problems has been stressed by another approach to Keynesian economics, called the post-Keynesian approach, which emphasizes the implications of decision-making under uncertainty, monetary institutions, and the effect of income distribution on aggregate demand. According to this approach when the wage and price falls due to the existence of unemployment, the interest rate and real balance effects need not work to increase aggregate demand because an excess supply of money may just lead to a fall in money supply as loans are repaid in a credit money economy with no further effects on the interest rate, because even if the interest rate falls asset holders may wish to hold more money and firms unwilling to increase investment in an uncertain environment, and because falling real wages redistribute income from workers to profit recipients who save a larger proportion of their income. Greater wage flexibility also tends to increase uncertainty in the economy given the importance of wages for both firm costs and profits and household income. These ideas add to Keynes’s own discussion on the implications of wage flexibility, and are also corroborated by some optimizing models with a new Keynesian flavor.

Keynesian economics has generally been thought to be valid for short-run macroeconomics, but ignored in the analysis of long-run growth analysis. However, if wage flexibility does not automatically take the economy to full employment or at least the natural level of output consistent with price stability, and governments are unwilling or unable to do the same over the medium run, and if technology responds to aggregate demand and output, Keynesian economics may be relevant for the longer run as well. Post-Keynesians and other heterodox economists have, in fact, followed Joan Robinson and others in applying Keynesian economics to the study of long-run growth.