Keynesian Economics
by Alan S. Blinder
Keynesian economics is a theory of total spending in the economy (called
aggregate demand) and of its effects on output and inflation. Although the
term is used (and abused) to describe many things, six principal tenets seem
central to Keynesianism. The first three describe how the economy works.
1. A Keynesian believes that aggregate demand is influenced by a host
of economic decisions—both public and private—and sometimes
behaves erratically. The public decisions include, most prominently,
those on monetary and fiscal (i.e., spending and tax) policy. Some
decades ago, economists heatedly debated the relative strengths of
monetary and fiscal policy, with some Keynesians arguing that
monetary policy is powerless, and some monetarists arguing that fiscal
policy is powerless. Both of these are essentially dead issues today.
Nearly all Keynesians and monetarists now believe that both fiscal and
monetary policy affect aggregate demand. A few economists, however,
believe in what is called debt neutrality—the doctrine that substitutions
of government borrowing for taxes have no effects on total demand
(more on this below).
2. According to Keynesian theory, changes in aggregate demand,
whether anticipated or unanticipated, have their greatest short-run
impact on real output and employment, not on prices. This idea is
portrayed, for example, in Phillips curves that show inflation changing
only slowly when unemployment changes. Keynesians believe the short
run lasts long enough to matter. They often quote Keynes's famous
statement "In the long run, we are all dead" to make the point.
Anticipated monetary policy (that is, policies that people expect in
advance) can produce real effects on output and employment only if
some prices are rigid—if nominal wages (wages in dollars, not in real
purchasing power), for example, do not adjust instantly. Otherwise, an
injection of new money would change all prices by the same
percentage. So Keynesian models generally either assume or try to
explain rigid prices or wages. Rationalizing rigid prices is hard to do
because, according to standard microeconomic theory, real supplies
and demands do not change if all nominal prices rise or fall
proportionally.
But Keynesians believe that, because prices are somewhat rigid,
fluctuations in any component of spending—consumption, investment,
, or government expenditures—cause output to fluctuate. If government
spending increases, for example, and all other components of spending
remain constant, then output will increase. Keynesian models of
economic activity also include a so-called multiplier effect. That is,
output increases by a multiple of the original change in spending that
caused it. Thus, a $10 billion increase in government spending could
cause total output to rise by $15 billion (a multiplier of 1.5) or by $5
billion (a multiplier of 0.5). Contrary to what many people believe,
Keynesian analysis does not require that the multiplier exceed 1.0. For
Keynesian economics to work, however, the multiplier must be greater
than zero.
3. Keynesians believe that prices and, especially, wages respond slowly
to changes in supply and demand, resulting in shortages and surpluses,
especially of labor. Even though monetarists are more confident than
Keynesians in the ability of markets to adjust to changes in supply and
demand, many monetarists accept the Keynesian position on this
matter. Milton Friedman, for example, the most prominent monetarist,
has written: "Under any conceivable institutional arrangements, and
certainly under those that now prevail in the United States, there is
only a limited amount of flexibility in prices and wages." In current
parlance, that would certainly be called a Keynesian position.
No policy prescriptions follow from these three beliefs alone. And many
economists who do not call themselves Keynesian—including most
monetarists—would, nevertheless, accept the entire list. What distinguishes
Keynesians from other economists is their belief in the following three tenets
about economic policy.
4. Keynesians do not think that the typical level of unemployment is
ideal—partly because unemployment is subject to the caprice of
aggregate demand, and partly because they believe that prices adjust
only gradually. In fact, Keynesians typically see unemployment as both
too high on average and too variable, although they know that rigorous
theoretical justification for these positions is hard to come by.
Keynesians also feel certain that periods of recession or depression are
economic maladies, not efficient market responses to unattractive
opportunities. (Monetarists, as already noted, have a deeper belief in
the invisible hand.)
5. Many, but not all, Keynesians advocate activist stabilization policy to
reduce the amplitude of the business cycle, which they rank among the
most important of all economic problems. Here Keynesians and
monetarists (and even some conservative Keynesians) part company
by doubting either the efficacy of stabilization policy or the wisdom of
attempting it.
This does not mean that Keynesians advocate what used to be called
fine-tuning—adjusting government spending, taxes, and the money
supply every few months to keep the economy at full employment.
Almost all economists, including most Keynesians, now believe that the
by Alan S. Blinder
Keynesian economics is a theory of total spending in the economy (called
aggregate demand) and of its effects on output and inflation. Although the
term is used (and abused) to describe many things, six principal tenets seem
central to Keynesianism. The first three describe how the economy works.
1. A Keynesian believes that aggregate demand is influenced by a host
of economic decisions—both public and private—and sometimes
behaves erratically. The public decisions include, most prominently,
those on monetary and fiscal (i.e., spending and tax) policy. Some
decades ago, economists heatedly debated the relative strengths of
monetary and fiscal policy, with some Keynesians arguing that
monetary policy is powerless, and some monetarists arguing that fiscal
policy is powerless. Both of these are essentially dead issues today.
Nearly all Keynesians and monetarists now believe that both fiscal and
monetary policy affect aggregate demand. A few economists, however,
believe in what is called debt neutrality—the doctrine that substitutions
of government borrowing for taxes have no effects on total demand
2. According to Keynesian theory, changes in aggregate demand,
whether anticipated or unanticipated, have their greatest short-run
impact on real output and employment, not on prices. This idea is
portrayed, for example, in Phillips curves that show inflation changing
only slowly when unemployment changes. Keynesians believe the short
run lasts long enough to matter. They often quote Keynes's famous
statement "In the long run, we are all dead" to make the point.
Anticipated monetary policy (that is, policies that people expect in
advance) can produce real effects on output and employment only if
some prices are rigid—if nominal wages (wages in dollars, not in real
purchasing power), for example, do not adjust instantly. Otherwise, an
injection of new money would change all prices by the same
percentage. So Keynesian models generally either assume or try to
explain rigid prices or wages. Rationalizing rigid prices is hard to do
because, according to standard microeconomic theory, real supplies
and demands do not change if all nominal prices rise or fall
proportionally.
But Keynesians believe that, because prices are somewhat rigid,
fluctuations in any component of spending—consumption, investment,
, or government expenditures—cause output to fluctuate. If government
spending increases, for example, and all other components of spending
remain constant, then output will increase. Keynesian models of
economic activity also include a so-called multiplier effect. That is,
output increases by a multiple of the original change in spending that
caused it. Thus, a $10 billion increase in government spending could
cause total output to rise by $15 billion (a multiplier of 1.5) or by $5
billion (a multiplier of 0.5). Contrary to what many people believe,
Keynesian analysis does not require that the multiplier exceed 1.0. For
Keynesian economics to work, however, the multiplier must be greater
than zero.
3. Keynesians believe that prices and, especially, wages respond slowly
to changes in supply and demand, resulting in shortages and surpluses,
especially of labor. Even though monetarists are more confident than
Keynesians in the ability of markets to adjust to changes in supply and
demand, many monetarists accept the Keynesian position on this
matter. Milton Friedman, for example, the most prominent monetarist,
has written: "Under any conceivable institutional arrangements, and
certainly under those that now prevail in the United States, there is
only a limited amount of flexibility in prices and wages." In current
parlance, that would certainly be called a Keynesian position.
No policy prescriptions follow from these three beliefs alone. And many
economists who do not call themselves Keynesian—including most
monetarists—would, nevertheless, accept the entire list. What distinguishes
Keynesians from other economists is their belief in the following three tenets
about economic policy.
4. Keynesians do not think that the typical level of unemployment is
ideal—partly because unemployment is subject to the caprice of
aggregate demand, and partly because they believe that prices adjust
only gradually. In fact, Keynesians typically see unemployment as both
too high on average and too variable, although they know that rigorous
theoretical justification for these positions is hard to come by.
Keynesians also feel certain that periods of recession or depression are
economic maladies, not efficient market responses to unattractive
opportunities. (Monetarists, as already noted, have a deeper belief in
the invisible hand.)
5. Many, but not all, Keynesians advocate activist stabilization policy to
reduce the amplitude of the business cycle, which they rank among the
most important of all economic problems. Here Keynesians and
monetarists (and even some conservative Keynesians) part company
by doubting either the efficacy of stabilization policy or the wisdom of
attempting it.
This does not mean that Keynesians advocate what used to be called
fine-tuning—adjusting government spending, taxes, and the money
supply every few months to keep the economy at full employment.
Almost all economists, including most Keynesians, now believe that the
