Business Cycles Explained: Keynesian Theory


Simple way to think about
the Keynesian model. Keynesian, New Keynesian. But let’s boil it down to essentials. Economic downturns are very often caused
by a shortfall in aggregate demand. Aggregate demand you can think
of very crudely as spending. So more formally, aggregate demand is consumption plus
investment plus government spending. Think of that as a flow of funds, a flow of revenue directed to
producers of goods and services. Consumption plus investment
plus government spending. If aggregate demand falls, in essence, that means the flow of revenue to
producers of goods and services is also falling, or it’s lower than it
had been, or lower than we want it to be. And this creates a problem
of economic adjustment. The question, then,
is how well does an economy handle this problem of
economic adjustment. There exists an equilibrium,
to use that famous economic phrase, which has become a kind of joke. But there exists an equilibrium in
which that flow of spending falls, and at more or less the same,
time wages fall also. So even though spending is down, costs and expenses are down, and businesses can keep
on producing what they had been producing, keep output at its previous level, keep
profits at their previous level and so on. But allthough that’s
a possible equilibrium, very often that’s not what happens. This is a problem, and economists
call it price and wage stickiness. Let’s focus on wage stickiness. So if we’re talking about costs falling
for businesses, for a lot of businesses, the main costs,
especially at the margin, is labor cost. It’s hiring more people. It’s paying someone to do something. So if your revenue is falling,
to keep your same profit in real inflation adjusted terms, it’s very hard to
cut the wages of your workers, because workers don’t like
having their wages cut for reasons which may be emotional, or
we economists would call behavioral. But think of it as a problem of morale. If you’ve been working seven
years at a company, and all of a sudden your wage is cut,
you feel like you’re not valued anymore, you feel like maybe you’ll be fired. You feel you’re not treated very well. You complain about the boss,
you don’t work as hard. Maybe you create trouble, in extreme
conditions, you sabotage production. And it’s very costly for
bosses, in many situations, to cut the wages of their employees. So wages are somewhat sticky. And often if that flow of
revenue is slowing down, what will happen is the employers
lay off some of the laborers, very often the least abled ones, and
then you have increased unemployment. Those people don’t have jobs. Their expenditures fall. That, in turn, contracts revenue streams
for other parts of the economy, and you get this progressive downturn where
many different sectors at once are all shrinking or contracting or falling back,
because of this initial shortfall of aggregate demand combined with what
economists call price and wage stickiness. Particular strengths of
the Keynesian model. The first strength of the Keynesian model,
first and most obvious strength, is that it explains a good deal of
real-world business fluctuations. That is, you can go out and
look at economic history, and you find numerous important
cases where a major problem, or the major problem,
has been a shortfall in aggregate demand. The classic example, I think,
is the Great Depression. Go back to 1929 through 1932. You have a very large number of
bank failures in the United States. People essentially lose their checking
accounts, or lose part of that value. Consumer spending is much lower. There’s a big negative shock to
aggregate demand, and as a result, you end up with this
shortfall in economic output. The Keynesian model explains some parts
of the Great Depression very well. The Keynesian model has
a few major weaknesses. The first, simply, is that not all economic downturns are
caused by declines in aggregate demand. The second weakness of
the Keynesian model, is that it is often better as
a diagnosis than as a cure. So Keynesians typically recommend
activist monetary policy, or activist fiscal policy,
to get an economy out of a downturn. There’s a lot of evidence form
history that fiscal policy very often doesn’t work very well. Monetary policy, in my opinion,
is much more effective. But to advocate that
kind of monetary policy, you don’t actually need
the full Keynesian model. You can be what Scott Sumner and
I called neo-monetarists. Be a sophisticated quantity theory, and
you can pick up a lot of the better sides of the Keynesian argument without picking
up a lot of the excess theoretical baggage that is often found among
Keynesian economists. Those are not the only
criticism of Keynes, but I think they’re two of the most direct and
straightforward.

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15 thoughts on “Business Cycles Explained: Keynesian Theory

  1. Wow this was by far the best video on Keynesian's theory I could find. I even prefer this to Kahns Academy's video 😀

    Nice job!

  2. Well, the first criticism is kinda obvious since this theory was simply designed to explain a specific type of occurrences. Just like theory of evolution is designed for explaining the complexity and variations of life forms, not why apples fall. Second objections is kinda vague and it would be better for you to elaborate. As far as I understand it, the Keynesian way is to kick-start a depressed economy but whether it will last is another question which boiler down to my final question. How is debt(and especially private but also debt) related to growth since the time of deregulation(80s)? I mean prior to the subprime mortgage crash, weren't there a lot of private household debt gone bad? And then the debt figures for public debt went significantly up after the crisis started off. Was this a consequence of austerity or temporary depression?

  3. I was told that the government is supposed to weaken the business cycle by spending in a recession and saving in a boom. The latter however never happens because it is so unpopular and that's how the government fails in applying keynesian theory.

  4. If C+I+G = d goes down for some reason. Why would more G revive it? If G grows then C+I contracts, because there is no reason why spending bureaucrats could cause productivity growth.

    Keynes was not an Economist, even though he wrote a book. He never engaged in a scientific debate on economic science, therefore he was not an economist.

  5. The Great Depression was not caused by the "excesses" of the 1920's. The 1920's is a reflection of capitalism working and government sitting at bay. It is when the government got involved by, can't think of his name right now, the president before Roosevelt and FD Roosevelt that caused the Great Depression (GD). The Federal Reserved contracted the money supply by a third, FD Roosevelt outlawed gold, and every time the economy was rebounding and adjusting, FDR and his Congress created another government program. The 1920's represented capitalism and the 1930's represented socialism. Fortunately, for the socialists and democrats, they were able to degrade and nullify the constitution that would have saved those who experienced the GD by allowing the ignorant to vote. In short, they got what they deserved but those who knew better got screwed and knew FDR was a fu*ktard, typical, heartless socialist just like the tyrant in Venezuela, Hitler, and the communists of China's MAO, the current Xi who is killing many, and Stalin to name a few. We, the conservatives, are those opposing such tyrants by the love of patriotism and good natured people that manifests through the USA constitution and the ingeniousness of the USA founders/architects/T. Jefferson.

  6. He's just wrong about the fall in prices and wages. We had price deflation before the Fed and the result was an increase in real wages with lower prices and economic growth. And people have the audacity to say that this was a bad economic time when the reality was economic growth, not depressions.

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