The SAGE Encyclopedia of Political

Behavior
Keynesian Economics

Contributors: Chi-Wa Yuen

Edited by: Fathali M. Moghaddam
Book Title: The SAGE Encyclopedia of Political Behavior
Chapter Title: "Keynesian Economics"
Pub. Date: 2017
Access Date: June 8, 2017
Publishing Company: SAGE Publications, Inc.
City: Thousand Oaks,
Print ISBN: 9781483391168
Online ISBN: 9781483391144
DOI: http://dx.doi.org/10.4135/9781483391144.n197
Print pages: 429-434
©2017 SAGE Publications, Inc.. All Rights Reserved.
This PDF has been generated from SAGE Knowledge. Please note that the pagination of
the online version will vary from the pagination of the print book.
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In the midst of the Great Depression, John Maynard Keynes (1883–1946) wrote The General
Theory of Employment, Interest, and Money. Due to its real-world relevance and its
revolutionary impact on macroeconomic research, Keynes has since been regarded as the
founder of modern macroeconomics.

Prior to Keynes, mainstream, classical economists believed that supply creates its own
demand (Say’s Law)—whatever is supplied would ultimately be demanded at some (“the”
equilibrium) price. Under perfect price flexibility, there is absolutely no room for excess
production and surplus labor.

However, Keynes warns about the possibility of supply-demand imbalances, exhibiting

especially in the form of unemployment. Goods produced may be left unsold, however
cheaply producers are willing to sell them. Workers may not be able to get a job, however big
a pay cut they are willing to accept. He argues that such imbalances—known as general glut
(or excessive saving)—are due largely to demand deficiencies. Prices are flexible only up to a
certain (say, zero) level. Commodity/labor markets may fail to clear, however, at “positive”
levels of prices/wages when demand for goods/labor is excessively low—for example, when
supply and demand intersect in the negative quadrant. In reality, prices may be rigid even in
the positive quadrant. Imbalances between supply and demand are then not self-correcting
and can result in prolonged periods of stagnation. Viewing such situations as market failure,
Keynes advocates government intervention to revive the economy.

The impact of Keynesian economics on political behavior is most clearly seen through its
theory of economic policy. This has attracted the attention of policy-makers and affected the
democratic politics of budgetary choice—notably the use of budget deficits to pump-prime the
economy—producing political business cycles as a result.

In a nutshell, Keynesian economics consists of three central tenets:

1. Rigid or slow adjustment in prices (especially wages), implying possible existence of

output/employment gaps.
2. Demand shocks as the main source of economic fluctuations.
3. Useful role of active stabilization policies.

Each of these three tenets is elaborated, and their interrelations explained, in the following
sections. In particular, this entry focuses on the contraction phases of the business cycle and
provides a coherent account of the sources of recessions/depressions and their
consequences, as well as their policy implications.

Wage Rigidity and Unemployment

Before Keynes, classical economists held that whatever happens to supply and/or demand,
the labor market would automatically adjust via wage changes to bring about full
employment. During bad times, for instance, when demand for labor is low, workers would
simply accept lower salaries in order to secure their jobs. Under such a presumption,
whatever unemployment we observe would be “natural”—due either to search frictions or to
structural shifts in the economy. There is simply no such thing as cyclical unemployment—
that is, any unemployment over and above the natural level.

Keynes points out that, in practice, wages may not be as flexible as the classical economists

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wish. As an example, consider a contract between employers and employees that fixes the
nominal wage at a certain level—call it W0—within a given period. Suppose full employment
is attained at an initial price level P0, where the implied real wage w0 ( = W0/P0) equates
labor supply to labor demand. If there is an unexpected fall in the price level (say, to P1 w0),
inducing an excess supply of labor, there will be a rise in unemployment. Conversely, an
unanticipated rise in the price level would lead to over-full employment.

Besides labor contracts, rigid or slow adjustment in wages could be a result of minimum-wage
laws or labor-union monopsony. Under nominal-wage rigidity (whatever its reason), any
shocks that drag the general price level below its initial, expected position would jack up the
real wage to create cyclical unemployment. (Under wage indexation,
deflationary/disinflationary shocks would produce similar results.) Such unanticipated price-
level shifts may in turn be caused by either a positive output-supply shock or a negative
output-demand shock. Alternatively, any disturbance that would induce a rise in the supply of
labor and/or a decline in the demand for labor could also give rise to unemployment at the
given wage.

Demand Shocks as Drivers of Business Cycles

Here follows a logically consistent explanation of unemployment that attempts to

accommodate all the above shock possibilities. In so doing, we can better understand why
Keynesians believe that, as engines of business cycles, demand shocks play a more
important role than supply shocks.

Adverse Supply Shock as a Cause of Unemployment?

First, suppose the economy is hit by a negative productivity shock, such as a sudden surge in
oil prices. The shock would dampen the marginal productivities of and reduce the demand for
all variable factor inputs, including labor. On the other hand, the shock, if large and
persistent, may also shrink people’s wealth, inducing them to lengthen their work hours via
the wealth effect. At any initial wage level, such changes would end up generating an excess
supply of labor (i.e., unemployment) while lowering employment (under the short-side rule).
But that is not the end of the story.

Coupled with the adverse productivity change, the fall in labor employment would reduce
aggregate supply (AS) of goods without directly affecting demand (AD). The result is a rise in
the general price level (P) and a fall in real output (y). Given the fixed nominal wage, the real
wage would drop—that is, w↓ = W0/(P↑)—thus narrowing the gap between labor supply and
labor demand and offsetting (at least partially) the initial effects of the shock on
(un)employment. In other words, unemployment may not be too serious in this case and may
even vanish if the price level soars sufficiently to bring the real wage down to its market-
clearing level. Moreover, the countercyclicality of the price level—negative correlation between
P and y—is counterfactual. For these reasons, Keynesians (unlike the classical economists)
do not put much emphasis on supply shocks as drivers of business cycles.

Adverse Demand Shock as a Cause of Unemployment?

Second, consider a negative demand shock arising from, say, a dip in consumer/investor
confidence. The consequent decline in consumption/investment spending would lower AD,
without directly affecting AS. The result is a drop in both P and y. Given the fixed nominal

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wage, the real wage would go up—that is, w↑ = W0/(P↓)—thus creating an excess supply of
labor. This unemployment phenomenon would be even more serious in the case of
imperfectly competitive firms whose (derived) demand for labor would also fall along with AD.
In such a case, the change in labor demand would reduce employment and thus AS as well
and hence reinforce the adverse effect of the demand shock on output (although the price
level may rebound a little in response to the fall in AS to slightly relieve the unemployment
pressure).

Relative to supply disturbances, therefore, demand disturbances can create stronger output
and (un)employment effects and rightly predict the pro-cyclicality of the price level.

Turning Points (and Persistence of Business-Cycle Movements): The Multiplier–Accelerator

Process

Apart from its role as an impulse, the AD channel can also help us understand why, even in
the absence of shock reversals and stabilization policies, the economy could automatically
turn around—from recession to recovery (rising from a trough) or the other way round (falling
off a peak).

First, consider the uphill path. Suppose a positive shock triggers a rise in consumption
spending, which generates higher income for some producers. Given the marginal propensity
to consume is positive but less than unity, they would spend some fraction of their income on
goods supplied by some other producers—who, in turn, would earn extra income and would
use part of it to buy goods from yet others, and so on. This multiplier process is one reason
the initial impact of the shock would spread across firms, markets, sectors, and eventually the
entire economy and why it would spread over time to make cyclical movements persistent.
The other reason lies in the accelerator process, whereby a faster rate of growth of output
would give rise to more optimistic expectations among business firms toward the future and
thus encourage them to increase their investment spending. The rise in investment would
again raise national income via the multiplier effect and then further raise output via the
accelerator effect. Interaction between the two effects would keep pushing the economy
upward.

Is it ever going to reach a peak, and is it ever going to be over the hill? Yes, the peak (boom)
is reached when the economy hits a bottleneck—that is, a capacity constraint that limits
further expansion of the economy—due to gestation lags in the accumulation of capital (e.g.,
machines and equipment) and especially to the 24-hour upper bound on the daily supply of
each worker’s labor hours. As soon as output growth slows down, firms become pessimistic
and would then put off their investment plans. Together with its multiplier counterpart, the
accelerator process would take a 180-degree turn, from an expansion phase to a contraction
phase in economic activities.

This brings us to the downhill path. Those people who first suffer income losses would now
spend less on goods supplied by some producers—who, in turn, would earn lower income
and thus buy less from others, and so forth. As national income continues to fall via this
multiplier process, investment would follow suit via the accelerator process. Interaction
between the two effects would keep dragging the economy downward. Up to this point, the
contraction phase is like a mirror image of the expansion phase.

Is the Economy Ever Going to Hit Bottom, and Is It Ever Going to Recover?

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Yes, the trough (depression) is reached when the economy’s old capital has been fully
depleted after firms have chosen not to invest in new capital, but simply let old capital
depreciate, for a sufficiently long period. At this instant, basic subsistence demand for
consumption is enough to give firms the incentive to resume their new investment. As soon as
investment spending turns positive again, output would start growing and investors would
regain their confidence. Together with its accelerator counterpart, the multiplier process would
take a 180-degree turn, from contraction to expansion. So we are back to ground zero, and
the cycle would start all over again.

Stabilization Policies

Even though, in the absence of further negative demand shocks and with the passage of
time, the economy would bounce back from a recession/depression via the multiplier-
accelerator process, this road to recovery may be unduly long and painful, especially to the
jobless. Keynes thus views business fluctuations as manifestations of market failure and
strongly advocates government intervention via active countercyclical policies. Macro
stabilization policies can be classified into two broad categories—fiscal policy (by the
Treasury, or fiscal authority) and monetary policy (by the central bank, or monetary authority).
In what follows, the focus is on the use of expansionary policies to combat unemployment—
first explaining the logic behind Keynesian policies and then presenting some caveats about
their effectiveness during extreme times.

Fiscal Stimulus

Believing that output decline and unemployment are results of inadequate private demand,
one obvious solution is to let the government jazz up its own expenditure, say, on
infrastructure investment. On the other hand, it can try to stimulate private spending via tax
cuts or transfers/subsidies—such as reduction in income or sales taxes (which would boost
private consumption via a rise in the consumer’s after-tax income or a fall in after-tax
commodity prices) or investment tax credit (which would boost private investment). Either way,
the fiscal authority can replenish demand (AD) and fill the output/employment gap. Via the
multiplier, a one-dollar increase in either public or private spending should be able to
generate a more-than-one-dollar increase in output. So, like magic, the problem is easily and
speedily solved!

All this sounds too good to be true. First, a transitory surge in fiscal expenditure may fail to
bring about a one-for-one increase in AD. This is because public spending may compete with
private spending for society’s limited resources, thus bidding up the interest rate (which
reflects the cost of current resources relative to the future) and making it more costly for the
private sector to finance its investment. This is called the crowding-out effect.

Second, unless the Treasury has piled up a lot of fiscal reserves from previous years, it has to
find some way to finance its budget deficits generated from a rise in its expenditure and/or a
fall in its tax revenue. Concerns abound about deficit financing via an issue of Treasury bills or
longer-term bonds—as this may create a debt burden for the next generation. A tax hike or
spending cut would be needed sometime in the future to retire the debt. Similar problems
would also arise under external (rather than internal) debt-financing. These difficulties would
be all the more profound in the case of protracted recessions and ever-growing twin deficits
(i.e., coexistence of fiscal and trade deficits). If the monetary authority is eventually forced to
print new money to help the fiscal authority pay off its accumulated deficits (i.e., to monetize

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its debt), this may also exhaust the bank’s foreign-exchange reserves and invite speculative
attacks on its currency, leading to massive devaluation and perhaps an ultimate collapse of its
exchange-rate peg against other currencies as well.

Last but not least, lots of uncertainty is involved in the practical formulation of fiscal policy—
including time lags and possible errors at the data-collection stage, at the problem-
identification stage, at the decision stage, at the implementation stage, and between the time
the policy is introduced and the time when it starts taking effect. Poor timing could possibly
turn what is meant to be a stabilization (countercyclical) policy into a destabilizing (procyclical)
one. Due to these policy lags, for instance, a fiscal expansion intended to tackle a recession
may begin to work only after the economy has already reversed its path and may end up
overheating the economy. Time lags may thus transform an intended fiscal change into an
unintended fiscal shock.

Monetary Expansion

Fiscal policy may be too slow to respond to cycles and crises because of its long decision
lags—major fiscal changes have to be approved by the legislature after many rounds of
debates and discussions. In this regard, monetary policy is much speedier. Monetary-policy
committees can call ad hoc meetings (in addition to regular ones) to address urgent economic
conditions.

Believing, once again, that output decline and unemployment are results of deficient demand,
monetary expansion can be used to stimulate private spending via a downward adjustment in
the interest rate. This can be achieved either directly via a cut in the policy rate or indirectly via
an increase in money supply (through open-market purchases of government bonds). So, like
magic, the problem is easily solved!

Again, this sounds too good to be true. One obstacle that confronts many central banks
during times of economic depression is the liquidity trap. This is the situation in which the
interest rate has fallen so low that people find holding money (the most liquid asset on Earth)
more attractive than holding other financial assets, so that their demand for money as a store
of value becomes infinitely interest elastic. In this case, the central bank cannot cut the
(nominal) interest rate below its zero lower bound. Conventional monetary policy fails, and
fiscal policy may not work either (due to the problems listed earlier).

Monetary growth under inflation targeting and forward guidance have been proposed as ways
to raise people’s inflation expectations so as to drive the real interest rate (equal to the
nominal rate minus expected inflation) to a negative level to prompt private spending. But
there is a credibility concern—about the central bank’s ability to commit. Flexible use of open
market operations—allowing the central bank to purchase long-term bonds and even private
assets (rather than Treasury bills) using newly printed money—has also been suggested and
actually implemented during the Great Recession in order to reduce long-term interest rates
(via an operation twist of the yield curve) to stimulate both short- and long-term investment.
The effectiveness of this unconventional policy measure, known as quantitative (and credit)
easing, is subject to debate. After extended periods of economic setback, when people’s
pessimism about the future has grown so deep that their consumption/investment demands
may have become essentially interest inelastic, any policy that attempts to lower the interest
rate without uplifting their confidence is bound to fail.

Conclusion

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Keynesian economics has sometimes been labeled depression economics—gaining its

prominence especially during the Great Depression and the Great Recession. Its emphasis on
the role of sticky prices/wages under imperfectly competitive goods/labor markets in
amplifying and drawing out the dynamic macro effects of aggregate-demand shocks presents
one useful perspective to business fluctuations and provides a good justification for
stabilization policies (despite suspicion about their effectiveness). The contrast between
downward rigidity and upward flexibility of prices may also help explain business-cycle
asymmetry. Alternative perspectives stress the importance of other forms of imperfections or
frictions (e.g., asymmetric information and financial constraints) or other kinds of disturbance
(e.g., financial shocks) in other (e.g., capital) markets, with somewhat different policy
implications. But in terms of their methodology, almost all schools of macroeconomic thought
have converged on one approach—namely, calibration (or moment-matching) exercises and
impulse-response analysis, often known as RBC (real business cycles). In that sense, we do
have a macro synthesis—even though not all economists would want to be crowned
Keynesian.

See alsoCrisis Decision Making and Management; Free Market

Chi-Wa Yuen
http://dx.doi.org/10.4135/9781483391144.n197
10.4135/9781483391144.n197
Further Readings
Blinder, A. S. (2008). Keynesian Economics. In D. R. Henderson (Ed.), Concise encyclopedia
of economics ( 2 n d e d . ) . L i b r a r y o f E c o n o m i c s a n d L i b e r t y . A v a i l a b l e a t
http://www.econlib.org/library/Enc1/KeynesianEconomics.html
Buchanan, J. M., & Wagner, R. E. (1977). Democracy in deficit: The political legacy of Lord
Keynes. L i b r a r y o f E c o n o m i c s a n d L i b e r t y. A v a i l a b l e a t
http://www.econlib.org/library/Buchanan/buchCv8.html
De Vroey, M. (2016). A history of macroeconomics from Keynes to Lucas and beyond.
Cambridge, England: Cambridge University Press.
Dubois, E. (2016). Political business cycles 40 years after Nordhaus. Public Choice, 166(1),
235–259.
Hicks, J. R. (1937). Mr Keynes and the classics: A suggested interpretation. Econometrica,
5(2), 147–159.
Krugman, P. R. (2009). The return of depression economics and the crisis of 2008. New York,
NY: Norton.
Leijonhufvud, A. (1968). On Keynesian economics and the economics of Keynes. Oxford,
England: Oxford University Press.
Mankiw, N. G., et al. (1993). Symposium on Keynesian economics today. Journal of Economic
Perspectives, 7(Winter), 3–82.
Snowdon, B., & Vane, H. R. (2005). Modern macroeconomics: Its origins, development, and
current state. Northampton, MA: Edward Elgar.
Woodford, M. (2009). Convergence in macroeconomics: Elements of the new synthesis.
American Economic Journal: Macroeconomics, 1(January), 267–279.

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