Keynesian economics

The General Theory, 1936

Economics — demand management and the postwar consensus

The body of theory descending from John Maynard Keynes's General Theory of Employment, Interest and Money of 1936, which argued that an economy can settle at a level of output well below full employment, because total spending — effective demand — is too low, and that in such a slump the government can and should make up the difference. The claim was a direct challenge to the view that markets clear themselves given time; Keynes's answer to that was that in the long run we are all dead. The approach dominated policy from 1945 until the stagflation of the 1970s, was heavily revised in response, and returned to the centre of debate after 2008.

How to spot them

▸Animal spirits, the paradox of thrift, effective demand and the multiplier
▸Burying banknotes in disused coal mines and paying people to dig them up again
▸Two crossing curves labelled IS and LM
▸A Cambridge man who led the British delegation to a New Hampshire hotel in 1944

Key facts

The 1936 book that argued an economy can settle in equilibrium with mass unemployment (1936)

The General Theory of Employment, Interest and Money

'In the long run we are all dead' — an answer to those who said markets would right themselves eventually (1923)

From A Tract on Monetary Reform, thirteen years before the famous book

The proposal to bury bottles of banknotes in disused coal mines and let private enterprise dig them up (1936)

A deliberately absurd illustration that any spending, however useless, beats none at all

The 1919 polemic against the Versailles settlement that made its author famous (1919)

The Economic Consequences of the Peace, written after he resigned from the British delegation

John Hicks's 1937 diagram of two crossing curves that made the theory teachable (1937)

The IS–LM model, from the article 'Mr Keynes and the Classics'

Richard Kahn's 1931 article on the effect of one pound of public spending on total employment (1931)

The multiplier, which Keynes took over and made central

The rejected 1944 proposal for a world clearing union with its own unit of account, the bancor (1944)

Keynes's plan at Bretton Woods, defeated by the American scheme of Harry Dexter White

Key ideas

Effective demand: output and employment are determined by how much people actually spend, not by how much the economy could in principle produce.
The paradox of thrift: what is prudent for one household is destructive for all of them at once, because one person's spending is another's income.
Animal spirits: investment depends on 'a spontaneous urge to action rather than inaction', not on a reliable calculation of returns, because the future is genuinely uncertain rather than merely risky.
The liquidity trap: when interest rates are already near zero, cutting them further cannot stimulate demand, and fiscal policy has to do the work.
New Keynesian economics, from the 1980s, rebuilt the conclusions on foundations of individual optimisation with sticky prices and wages — a response to the Lucas critique that older models ignored how behaviour changes when policy does.

Quick-fire facts

•John Maynard Keynes lived from 1883 to 1946; he was a Fellow of King's College, Cambridge, and a member of the Bloomsbury Group
•The General Theory was published in February 1936
•'In the long run we are all dead' comes from A Tract on Monetary Reform (1923), not from the General Theory
•The multiplier was formalised by Keynes's student Richard Kahn in 1931
•The IS–LM interpretation was set out by John Hicks in 1937 and became the standard teaching version; Hicks later expressed misgivings about it
•Paul Samuelson's 'neoclassical synthesis' fused the theory with conventional microeconomics and dominated postwar textbooks
•Keynes led the British delegation to the Bretton Woods conference in 1944; his bancor plan was rejected
•He was created Baron Keynes of Tilton in 1942 and married the Russian ballerina Lydia Lopokova
•'We are all Keynesians now' was said by Milton Friedman in Time magazine in 1965 — and complained about by him afterwards as quoted out of context; Richard Nixon used the phrase in 1971
•The Lucas critique of 1976 and the stagflation of the 1970s were the two great blows to the original programme; the response was New Keynesian economics

Drill it — 8 cards

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Sources

John Maynard Keynes — The General Theory of Employment, Interest and Money 1936
Robert Skidelsky — John Maynard Keynes The three-volume biography, 1983–2000