Keynesian Economics

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.

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.

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.

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.

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.