What is better for the economy, lower taxes or higher taxes? More government spending or less government spending? Ideally, we could answer these questions and have the world's perfect and best-functioning economy! However, it's not as simple as that. There are many economic theories that put forward different ideas for economic growth and stability. Continue reading to learn about the popular economic theory, Keynesian Economics!
Keynesian Economics Definition
Let's begin by defining Keynesian Economics. Keynesian Economics posits that changes in aggregate demand have an impact on output, price level, and employment in the short run. A key idea under Keynesian Economics is that changes in business confidence can also have big effects on the economy. Another key principle of Keynesian Economics revolves around government intervention; the government can and should intervene in the market to mitigate fluctuations in the economy.
Generally, Keynesian Economics believes that government intervention can help an economy that is experiencing a recession or inflation. Keynesian Economics believes that when the economy is in a recession, lower taxes and higher government spending will help increase aggregate demand to close the negative output gap — this is known as expansionary fiscal policy. When the economy is experiencing inflation, higher taxes and lower government spending will help decrease aggregate demand to close the positive output gap — this is known as contractionary fiscal policy.
Keynesian Economics posits that changes in aggregate demand have an impact on output, price level, and employment in the short run.
Expansionary Fiscal Policy is when the government increases government spending and decreases taxes to mitigate a recession.
Contractionary Fiscal Policy is when the government decreases government spending and increases taxes to mitigate inflation.
Fig. 1 - Economic Boom and Recession.
Keynesian Economics Example
Let's look at an example of Keynesian Economics. To do so, we will assume that the economy is experiencing a recession and needs to close the negative output gap.
Fig. 2 - Keynesian Economics Graph, StudySmarter Originals.
Let's review some basic principles of Keynesian Economics to see how this graph represents them. Keynesian Economics believes that aggregate demand influences price level, output, and employment. Based on the graph above, we can see that a rightward shift of the AD curve causes the price level, output, and employment to increase. Keynesian Economics also believes that government intervention is key to resolving a recession and inflation.
Due to the recession, we know that consumer spending and investments will be low. We can see this visually on the graph since the economy has lower output and price levels at Q1 and P1.
To address the recession, the government will lower taxes by 10% and increase government spending by $30 billion.
The decrease in taxes and increase in government spending will encourage higher consumer and investment spending, stimulating aggregate demand growth. The expansionary fiscal policy will cause the aggregate demand curve to shift to the right since consumer spending and investment will now increase. Looking at the graph this can be seen as an increase in aggregate demand (shifting it from AD1 to AD2). This closes the negative output gap (shifting out from Q1 to Q2) in the economy and brings it to full employment.
Keynesian Economics vs. Classical Economics
Let's look at Keynesian Economics vs. Classical Economics. We will do so by looking at graphs of both schools of thought.
Fig. 3 - Keynesian Economics Graph, StudySmarter Originals.
The graph above shows the Keynesian Economics graph. Aggregate demand (AD) is an important factor that can change price level, output, and employment. An increase in aggregate demand will increase prices, output, and employment. We can also see a distinction in the short-run (AS) and long-run aggregate supply (LRAS) in the Keynesian school of thought. Let's look at a brief example of how this distinction will affect consumers and producers.
At E1, the economy is in a recession. We know this since it is below full employment; full employment being where the AD, SRAS, and LRAS all intersect — E2. At E1, the recession causes a decrease in the price level (P1) and the output (Q1). This occurs because, in the Keynes model, wages and prices are sticky in the short run; therefore, the SRAS curve must be upward sloping to adjust to the changes in prices. Once the recession is addressed with expansionary fiscal policy, AD will be stimulated and shift to the right, increasing the price level and output towards full employment.
Now that we have dissected the Keynes model, let's take a look at the differences in the Classical Economics graph.
Fig. 4 - Classical Economics Graph, StudySmarter Originals.
The graph above shows the Classical Economics graph. Here, the short-run aggregate supply (SRAS) is vertical — one of the most significant differences between Classical and Keynesian Economics. Let's look at a brief example of the Classical economics graph.
Let's say that there is a recession in the economy at point E1. Consumer and investment spending is down, but what is occurring on the supply side?
Businesses lower their prices due to the recession but do not alter their output. This is because, to Classical economists, wages and prices will fall together during a recession to a new equilibrium point — E1. Once the recession is over (without government intervention), aggregate demand will increase to the new equilibrium point, E2. Once again, this will increase wages and prices, but will not alter the output. The recession fixes itself, and producers did not have to alter the number of products being made.
As such, Classical Economists believe that aggregate demand only influences the price level in the economy. We can see in the graph that an increase in aggregate demand will increase the price level, but will not change the output and employment. Likewise, a decrease in aggregate demand will decrease the price level with no change in output or employment. Additionally, the Classical school of thought believes that the money supply primarily shifts the demand curve; the Keynesian school of thought believes there are other factors that influence aggregate demand, such as business confidence.
Keynesian Economics vs. Supply Side Economics
Let's go over the differences between Keynesian Economics and Supply-Side Economics.
Supply-side Economics posits that lower taxes will lead to economic growth. This would happen because lower taxes will incentivize more work and investment. Increasing work and investment will inevitably lead to an increase in GDP; thus, growing the economy. In contrast, Supply-Side Economics also believe that high taxes preclude economic growth since there is minimal incentive to work and invest; therefore, it is not advisable to increase taxes in the economy.
Keynesian Economics does not have a "rule" on taxation. Depending on the economic state, the tax rate may need to be higher or lower. For example, if the economy is experiencing a recession, lower taxes will increase aggregate demand and close the negative output gap. In contrast, if the economy is experiencing inflation, higher taxes will decrease aggregate demand and close the positive output gap.
As you can see, taxation is more flexible in Keynesian Economics, whereas Supply-Side Economics prefers taxation to be lower.
Keynesian Economics Criticism
What are some criticisms of Keynesian Economics? We will go over a few of them here.
Keynesian Economics Criticism: Crowding Out
Crowding out is a key criticism of Keynesian Economics. When the government recognizes a recession, expansionary fiscal policy will be utilized to stabilize the economy. To achieve this, the government has to borrow money to fund its spending. The criticism here is that the government is effectively competing with private businesses in the loanable funds market. The government will "beat" private firms to these loans and lower the available number of loans. Interest rates will rise because of the lack of loans in the market. This phenomenon is known as crowding out and is a key criticism of the Keynesian school of thought.
Crowding Out occurs when the government borrows excessively from the loanable funds market, preventing private firms from getting loans. This will cause interest rates to rise due to a lack of loanable funds.
Keynesian Economics Criticism: Time Lags
Time lags are another key criticism of Keynesian Economics. In Keynesian Economics, the government should intervene to stabilize the economy during a recession and inflation. However, what does that actually look like? For one, the government has to recognize a recession or inflation is happening in the first place — this can take some time in and of itself. Then, Congress has to agree on the proper spending bill and get it passed in the House and Senate — a deliberative process that can go on incessantly. Then, the bill's effects need their time for it to be felt in the economy. A tax decrease and funding for infrastructure won't be felt overnight.
As you can see, the entire process can take quite a while. Critics will say that by the time any fiscal policy is passed, it will be too late and the policy will actually harm the economy rather than help it. Therefore, it's better for the market to reorient itself to prevent worsening economic conditions.
Keynesian Economics - Key takeaways
- Keynesian Economics posits that changes in aggregate demand have an impact on output, price level, and employment in the short run.
- Expansionary/contractionary fiscal policies are tools that Keynesian economists believe the government should use during a recession/inflation.
- The difference between Classical and Keynesian economics is the position of the SRAS curve (verticle for Classical; upward sloping for Keynesian) and what affects aggregate demand (money supply for Classical; business confidence for Keynesian).
- The difference between Supply-Side and Keynesian economics is the tax rate; Supply-Side prefers low taxes, whereas Keynesian will alter the tax rate depending on the economic state.
- Time lags and crowding out are the main criticisms of Keynesian Economics.
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