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The Rise of Keynesian Economics. When John Maynard Keynes responded to popular demand for an

When John Maynard Keynes responded to popular demand for an

alternative policy to laissez-faire. In his book, The General Theory of

Employment, Interest, and Money, he gave people both an alternative ex-

planation of the depression and a suggestion of what to do about it that

didn’t rely upon cutting wages. While there were many dimensions to

Keynes’s ideas, their essence was that Say’s law (supply creates its own

demand) was wrong. Keynes argued that Thomas Malthus was right—

general gluts could exist (and certainly did exist in the 1930s).

Keynes (a shrewd investor who was extremely active in the financial

sector) argued that the financial sector didn’t work the way Say’s law

assumed it did. It didn’t translate savings into investment fast enough

to prevent a general glut in output. According to Keynes, the level of

savings did not determine the level of investment. Instead the level of

investment would change the level of income and thereby change the

level of savings. Let’s consider an example. Say that a large portion of

the people in an economy suddenly decide to save more and consume

less. Consumption demand would decrease and savings would increase.

If those savings were not immediately transferred into investment (as

the Classicals assumed they would be), investment demand would not

increase by enough to offset the fall in consumption demand and aggre-

gate demand would fall. There would be excess supply. Faced with this

excess supply, firms would cut back production, which would decrease

income. People would be laid off. As people’s incomes fell, their desire

to consume and their desire to save would decrease. (When you’re laid

off you don’t save.) Eventually income would fall far enough so that once

again savings and investment would be in equilibrium, but that equilib-

rium could be at a lower income level at a point below full employment.

In short, what Keynes argued was that the economy could get stuck in

a rut.





Once the economy got stuck in a rut with a glut, it had no way out.

The government had to do something to pull the economy out of the rut.

Keynes and his followers presented a set of models and arguments to ex-

plain their views. Those models, which were aggregate models, became

the central macroeconomic models.

Keynesian ideas spread like wildfire among the younger economists.

By the 1950s Keynesian economics became accepted by most of the

profession. The policies that came to be associated with Keynesian eco-

nomics were monetary policy and fiscal policy. Monetary policy meant

varying the money supply to affect the level of spending in the economy.

Fiscal policy meant varying the government budget deficit or surplus

(by varying government expenditures and taxes) to control the level of

spending. Together they were supposed to provide a steering wheel by

which economists could control the economy, keeping it free of business



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