Background
During the Great Depression unemployment approached or exceeded 20% in some countries, yet classical economics held that flexible wages and prices would restore full employment. John Maynard Keynes's General Theory of Employment, Interest and Money (1936) offered a new explanation and became the starting point of modern macroeconomics.
Core ideas
Effective demand
Contrary to Say's law that supply creates its own demand, Keynes argued that firms produce only what they expect to sell, so aggregate demand determines output and employment. The economy can therefore settle in an equilibrium with involuntary unemployment.
Consumption function and multiplier
Consumption rises with income but by less than income (the marginal propensity to consume, MPC, is between 0 and 1). An increase in government spending or investment raises income by 1/(1−MPC) times the initial amount: the multiplier. With an MPC of 0.8 the multiplier is 5.
Liquidity preference and the liquidity trap
The interest rate is set by the demand for money (transactions, precautionary and speculative motives) and the money supply. At very low rates people may hoard money, making monetary policy ineffective: the liquidity trap.
Animal spirits
Investment depends on uncertain expectations and "animal spirits," which makes business cycles volatile.
Policy implications
- Countercyclical fiscal policy: more spending or tax cuts in recessions, restraint in booms
- Automatic stabilizers such as progressive taxes and unemployment benefits
- Hicks (1937) formalized the ideas in the IS-LM model used in textbooks.
Later debates
| School | Claim |
|---|---|
| Monetarism (Friedman) | Money supply matters most; discretionary fiscal policy can destabilize because of lags. |
| New Classical (Lucas) | With rational expectations, anticipated policy has little effect. |
| New Keynesian | Microfoundations for sticky prices and wages rebuild Keynesian conclusions. |
Large fiscal stimulus after the 2008 financial crisis and the 2020 COVID-19 shock revived empirical research on the size of fiscal multipliers.
References
- Keynes, J. M. (1936). The General Theory of Employment, Interest and Money. Macmillan.
- Hicks, J. R. (1937). Mr. Keynes and the "Classics": A suggested interpretation. Econometrica, 5(2), 147-159.
- Friedman, M. (1968). The role of monetary policy. American Economic Review, 58(1), 1-17.
- Mankiw, N. G., & Romer, D. (Eds.). (1991). New Keynesian Economics (2 vols.). MIT Press.
- Ramey, V. A. (2019). Ten years after the financial crisis: What have we learned from the renaissance in fiscal research? Journal of Economic Perspectives, 33(2), 89-114.