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What is the Keynesian Model?

John Lister
John Lister

The Keynesian model is a set of economic theories pioneered by John Maynard Keynes. The model works on the belief that the private sector does not always produce the most efficient results for the economy as a whole. It therefore promotes a degree of state intervention to influence the economy, most notably to manage the effects of the business cycle of growth and recession. The practical application of the Keynesian model lies somewhere between a purely market-based economy and a purely state-controlled economy, and thus covers the position of most major countries in the 21st century.

Early economic theories worked on the basis that individuals making decisions would always act rationally and that the market as a whole would in turn work efficiently. Keynes argued that there were several barriers to this happening. One of these is that human nature means people are more concerned with the actual amount of their wages than the real terms value of their income, taking into account price changes. This meant that the relationship between wages, employment levels, and price levels would not always run automatically. For example, people would refuse to take a lower dollar amount in wages, even if prices had fallen by a greater proportion and they would thus still be better off.

John Maynard Keynes.
John Maynard Keynes.

Keynes also challenged the idea that interest rate movements would prevent people from saving too much at the expense of spending, causing drops in demand for products and services. This was for a variety of reasons, notably that interest rates are decided more by the supply and demand of money for loans, than the desire of the public to save. This meant that excessive saving could lead to a recession.

The Keynesian model calls for fiscal policy where governments increase spending at times when the economy is in a slowdown. This involves a theory described as the multiplier. This states that if government spends to create jobs, the employed people will have more money to spend. They will then demand goods and services from private companies, which in turn will hire more people, who in turn will have more money to spend, and so on. The idea is that the total increase in income and spending in the economy will be a high "multiple" of the original government spending.

Critics of the Keynesian model believe the supply of money in the economy has a bigger effect. They also argue that the government spending to "kick-start" economic growth may simply take staff and resources away from the private sector. Instead, critics back monetary policy, which backs measures such as controlling interest rates to influence how much money is made available to both consumers and businesses in loans. Most governments today use a combination of the fiscal policy and monetary policy.

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    • John Maynard Keynes.
      John Maynard Keynes.