Keynesian Economics, Part 1

“If you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront.” – Gregory Mankiw.

The economy is in recession, and some question if the Federal Reserve Board can use monetary policy to avoid a steep decline. Therefore, I think we will all need to reacquaint ourselves with Keynesian economics.

Gregory Mankiw is a professor of economics at Harvard University. His op-ed piece What Would Keynes Have Done? in today’s New York Times is a good summary and review of Keynesian economics and how it applies today.

According to Keynes, the root cause of economic downturns is insufficient aggregate demand. When the total demand for goods and services declines, businesses throughout the economy see their sales fall off. Lower sales induce firms to cut back production and to lay off workers. Rising unemployment and declining profits further depress demand, leading to a feedback loop with a very unhappy ending.

The situation reverses, Keynesian theory says, only when some event or policy increases aggregate demand. The problem right now is that it is hard to see where that demand might come from.

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