What is Keynesian Economics?

A business cycle In a normal business cycle, periods of expansion (prosperity) are followed by periods of contraction (recession). Large expansions are called “booms” and large contractions are “depressions”.

A prosperity cycle When things are going well, all parts of the economy improve. People spend money, companies hire more workers and build new factories, wages are on the rise, and unemployment is low. Governments collect so much in taxes, they lower the rate of the tax, making the spiral go up more.

A recession cycle When the economic boom slows or stops, it affects the entire economy. People stop spending as much as usual and start saving their money, increasing the amount of unsold goods, forcing companies to lower prices and/or lay off workers. With less tax money coming in to government, they usually raise the tax rate to keep up, driving the spiral lower.

The “old” Adam Smith model Business cycles are a normal part of capitalism. They work themselves out on their own. They can be healthy for businesses as weak companies and bad products fail. Some business cycles are shallow (expansion then recession) and some are large (boom then depression). Government should not help out people who are suffering in down times, after all, “The business of America is business”, according to President Coolidge.

The Keynesian model Normally, the economy functions fine by itself; people earn and save in a fairly regular pattern. If the economy is growing too fast and people are spending too much money, the government should do something to discourage people from spending so much. But, if something bad happens to enough people, then people stop spending and start to save more. The government should step in and help the economy recover by encouraging people to spend money again. How does the government do this?

1) Manipulating the supply and cost of money. Our government is constantly monitoring many economic factors and changing the supply of available money. The government uses two tools: spending and interest rates. By changing these two things, the government can drastically change the business cycles.

1) Manipulating the supply and cost of money. This chart shows four different types of money. “M1” is the most important--it is the total amount of ready cash held in banks plus all money held in checking and savings accounts.

1) Manipulating the supply and cost of money. When the economy is growing too quickly, the Federal Reserve Banks restrict how much money they lend out. The US Treasury also makes Savings Bonds available at higher interest rates.

1) Manipulating the supply and cost of money. When the economy is growing slowly, the Federal Reserve Banks make more money available to lenders. The US Treasury also lowers the interest rate paid on Savings Bonds, making people choose to invest money elsewhere.

1) Manipulating the supply and cost of money. The Federal Reserve Banks can also make money more expensive or less expensive by changing the “prime rate”, the rate they charge large banks to borrow money. If the economy needs a boost, the “Fed” lowers rates which usually means loans & mortgage rates go down so people spend more.

2) Government spending The second method involves government spending. When the economy is sluggish, the government can spend more money, creating demand for products and giving people jobs. This is called “deficit spending.”

2) Government spending When spending increases, the government initially loses money, but the positive effect on jobs and consumer confidence brings higher employment and more income through taxes. This is called “pump-priming” or “jump-starting” the economy.

What this means The government is no longer just an observer of the economy, it is now a major player. Government spending and federal money policy can shorten periods of economic recession as well as slow down periods of unhealthy growth. So, if there is a recession or depression, the government can spend lots of money, lower interest rates, and get the economy moving in an upward spiral. This is the Keynesian economic theory.

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