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What is Keynesian Theory?

By Osmand Vitez
Updated May 17, 2024
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The basis of Keynesian theory is that aggregate demand behaves erratically and suffers effects from public and private forces. The two primary public forces include monetary and fiscal policies set by a nation’s government. Left unchecked, a fall in aggregate demand can result in too much supply of goods, increases in unemployment, and price swings for consumer goods. To correct the lack of consumer demand, Keynesian theory states that targeted government spending can jump-start the national economy.

Most economists agree that free market economies center on the basic idea of supply and demand. When supply increases, prices rise and demand is low. As prices fall, supply is low and demand increases. The difference between Keynesian theory and other economic theories is how a government should act when a general glut occurs. This indicates that supply greatly exceeds demand and consumers are unable purchase enough goods from this excess supply.

Another focus of Keynesian economics is that prices do not respond as fluidly in a free market economy. When prices fail to move quickly, a shortage of supply or lack of demand will occur. Stagnant price levels will then lead to the general glut mentioned earlier. This creates an inflexible environment, where businesses and consumers cannot react positively to economic changes. These events can often occur in individual markets or all at once in an economy.

Keynesian theory believes that a government can improve the national economy by entering the market and spurring economic movement. For example, when a general glut occurs, the government can begin purchasing the excess supply. This will provide income to businesses with unsold inventory and allow for a spark to help restart economic growth. At other times, the government can provide rebates or funds to consumers that increase wages and allow them to purchase more goods.

Strong economies are typically seen as those at full employment. In theory, no economy has 100 percent employment; full employment is usually seen when a nation has 5 percent or less of unemployment. This creates an equilibrium where companies can maximize their production output and individual consumers have sufficient income to purchase goods. In Keynesian theory, no mechanism is available to move an economy to full employment. The activities that spur an economy focus more on creating equilibrium among supply and demand.

Essentially, Keynesian economics attempts to remove the natural downturns of the business cycle. By allowing targeted government actions, businesses and consumers may not experience the full force of a downturn, or the economy may simply not experience them. Few actual results exist, however, to truly determine if the Keynesian approach to economics adds support to a national economy.

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