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What is Keynesian Economics and How Does it Work?


This article presents the economic philosophies of economist John Maynard Keynes, and the academics and different schools of thought influenced by his teachings.

John Maynard Keynes


Keynesian economic theory had been named after John Keynes, a crucially important economist during the Great Depression that had contributed a significant amount towards the study of macroeconomics.

As a result of Keynes papers following WW2, macroeconomics had undergone close scrutiny by national governments as they paid more attention to the interest rates and employment in the economy.

Keynes was particularly well-known for his economic theory on the circular flow of money, which provided an explanation for the cause of the Great Depression.

This “circular flow” is the idea, that one person’s spending would end up contributing towards another person’s earnings, and when that person should spend his or her earnings, he or she would in effect, support another person’s earnings.

In this way, the circular flow of money would work well.

However, Keynes argued that during the great depression, people’s behavior had been to hoard money thus stopping the circular flow of money, which then led to the stagnation of the economy.

The graph below accurately illustrates Keynes’s theory on the circular flow of money.



Keynes had stressed that this circular flow of money was essential in building and supporting a stable economy. Because of this, Keynes advocated for government intervention during crisis times, in order to stimulate the economy out of a depression.

The picture below depicts the level of government expenditure among various economic theories.


Thus one can see from the graph, Keynes advocated government spending, due to the belief that government spending could stimulate the economy out of depression and allow the economy to achieve full employment.

In order to achieve full employment in the economy, Keynes argued that in addition to private “initiative”, the government should print money to achieve optimum rates of investment in the economy.


Monetary Reform

Keynes had also discussed monetary reform, if only for a brief moment.

He advocated for interest-free loans in his book titled The General Theory of Employment, Interest, and Money, where he wrote,

Furthermore, it seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manners of compromises and of devices by which public authority will co-operate with private initiative.

Keynes was advocating that to achieve full employment in the economy, the government should be able print money in addition to private banks, in order to achieve the optimum rates of investment in the economy.

In contrast to Keynes, contemporary monetary reformers such as Richard Werner and Ellen Brown have called for a return of government monopoly to print money similar to the Lincoln greenback era.

During Abraham Lincoln’s time, Lincoln had requested loans from the private banks in order to fund the Civil War.

However with the interest charges being very high, he and his leadership devised a method of supporting the wars costs through interest-free notes backed by the government, called Greenbacks. This is covered quite extensively in Part 4 of this series.

This is essentially what certain monetary reformers today would like – a government monopoly on the creation of money, in order to avoid the compounded interest charges.

These reformers have argued that government created fiat money would help reduce the national debt and solve the problem of compounded interest.

However, various schools of Keynesian thought have also addressed methods in order to solve the debt woes. These schools are:

  • Neoclassical Synthesis Keynesian Economics
  • New Keynesian Economics
  • Post Keynesian Economics

Each of these is discussed briefly below.


Neoclassical Synthesis Keynesian Economics

In the aftermath of the Second World War, American economics was reformed by various individuals who were influenced by Keynes, such as economist Paul Samuelson.

Paul Samuelson had coined the expression “neoclassical synthesis” to refer to the new theory that blended Keynesianism with neoclassical microeconomics.

In this new theory, Neo Keynesians assumed that involuntary unemployment was only due to inflexible wages and prices.

Neo Keynesian economics encountered heavy criticism during the 1970s due the inability to explain and deal with stagflation which led to it being discredited by other economists.

In response to the criticisms, many advocates for Neo Keynesians morphed into New Keynesians in the 1980s.


New Keynesian Economics

New Keynesian economics differs from classical Keynesianism in terms of how quickly prices and wages adjust.

New Keynesian advocates maintained that prices and wages are “sticky”, meaning that they adjust more slowly to short-term economic fluctuations.

The new Keynesian theory attempts to address, among other things, the sluggish behavior of prices and its cause.

The theory explains how market failures could be caused by inefficiencies and might justify government intervention.

Despite the general popularity of New Keynesian economics, numerous scholars and academics criticized it on the grounds that it misrepresented Keynes’s original ideas.

Many of these scholars rejected New Keynesians in favour of a new philosophy, known as Post Keynesian economics, which would be based on Keynes’ original idea.


Post Keynesians

A majority of Post Keynesian students rejected the neoclassical theory inherent in the previous two economic theories, arguing it was contrary to Keynes original ideals.

Post Keynesians emphasize Keynes’ principle of effective demand and the fundamental role that liquidity preference plays in market economies.

Post Keynesians also emphasize liquidity preference theory and its role in causing involuntary unemployment.

Unlike New Keynesianism, Post Keynesianism is not mainstream economics theory and remains a heterodox school.

Despite this, much attention has been given to the contrasting elements between New Keynesians and Post Keynesians.


Differences between New Keynesians and Post Keynesians

There are several conflicts between Post Keynesians and New Keynesians particular because of the neoclassical axioms (points of reasoning) postulated by New Keynesians.

The two large camps differ on the following points;

  1. Role of money in society
  2. The extent to deficit spending aka stimulus measures
  3. Interchangeability of goods
  4. Assumption on the future based on past model
  5. Differences in the make-up of economic models


Each of these is explained below.


1.) Role of Money

Neo Keynesians believe that money is neutral in the long run, and that the changes in the money supply have no effect on the economy.

Whereas Post Keynesians believe that money is not neutral, in the sense that changes in the money supply can affect the economy.

2.) The extent to deficit spending aka stimulus measures

New Keynesians, such as Paul Krugman, advocate deficit spending on the grounds that the failure to stimulate the economy either by public or private sectors will unnecessarily lengthen economic depression.

Post Keynesians such as Hyman Minsky are against the accumulation of debt and therefore support limited government intervention in the economy.

3.) Interchangeability of goods

New Keynesians also believed in gross substitution axiom of neoclassical thought which maintains that goods are interchangeable. Under this axiom, the relative changes in the price of goods will cause people to shift their consumption in proportion to the change.

For instance, if the price of tea were to rise, then people would buy the substitute good for tea, such as coffee.

Post Keynesians reject this axiom arguing that financial assets are not gross substitutes for commodities. If the price of a certain good were to rise, there is no indication that people would immediately substitute that good for another, especially considering if it is a necessity good.

4.) Assumption on the future based on past model

New Keynesians also believed in the ergodic axiom of neoclassical thought which states that the future is certain and can be predicted based on past economic events.

In other words, economists can extrapolate past events and predict what is going to happen in the future with a good degree of accuracy.

Post Keynesians follow Keynes’s original principles outlined in his book the General Theory of Money, where they advocate that the future is always uncertain because of there is no way of calculating human behavior.

5.) Differences in the make-up of economic models

New Keynesian economic models do not include private debt as a factor on mainstream economics and central bank policy.

In contrast, Post Keynesians under Minsky have called for the inclusion of private debt as a factor in mainstream economic models and as such Steve Keen has developed several models of explaining the economic crises based on Minsky’s theories.


Minsky’s Moment


American economist Hyman Minsky had contributed greatly to the principles inherent in Post Keynesianism and had been particularly critical of the neoclassical synthesis inherent in New Keynesian economics.

He also contributed to the field of macroeconomic theory through the financial instability hypothesis.

In his book titled John Maynard Keynes, Minsky writes,

Thus the integrated Keynesian classical economic theory – what is labeled the neoclassical synthesis – does violence to both the spirit and the substance of Keynes’s work. The substance of what was neglected in the development of the synthesis can be grouped under three headings: decision-making under uncertainty, the cyclical character of the capitalist process, and financial relations of an advanced capitalism economy.

Here Minsky is stating that the neoclassical synthesis Keynesians had neglected several key points central to Keynes’s work including the business cycle.

The cyclical character of the capitalist process and the financial relations of an advanced economy refer to the booms and busts of the business cycles which is accurately predicted by Minsky’s financial instability hypothesis.

In his instability hypothesis, Minsky predicted that the mechanism of accumulating debt by the non-governmental sector would lead to economic collapse or the bust in the business cycle.

He identified three types of borrowers that contributed to the accumulation of the debt: hedge borrowers, speculative borrowers, and Ponzi borrowers.

Minsky’s financial instability hypothesis later went on to influence economist Paul McCulley, who coined the term the Minsky moment when referring to the 2008 financial crisis.  In his view, the Minsky moment refers to the moment when the cost of servicing the debt can no longer be met by the economy’s productive capacity.

The Minsky moment was acknowledged by the current Bank of Canada Governor, Mark Carney, in a speech titled Growth in the Age of Deleveraging,when he said,

The global Minsky moment has arrived… While debt can fuel asset bubbles, it endures long after they have popped. It has to be rolled over, although markets are not always there. It can be spun into webs within the financial sector, to be unraveled during panics by their thinnest threads. In short, the central relationship between debt and financial stability means that too much of the former can result abruptly in too little of the latter.

The President and CEO of the Federal Reserve Bank of San Francisco, Janet Yellen, also outlined the importance of Minsky’s theory on financial instability on describing the 2008 financial crisis at a Conference where he said,

My talk today is titled “A Minsky Meltdown: Lessons for Central Bankers.” I won’t dwell on the irony of that. Suffice it to say that, with the financial world in turmoil, Minsky’s work has become required reading. It is getting the recognition it richly deserves. The dramatic events of the past year and a half are a classic case of the kind of systemic breakdown that he—and relatively few others—envisioned.

Thus as one can see, Minsky’s theories have increasingly becoming recognized by financial leaders and central bankers around the world.

Economist Steve Keen builds upon much of Minsky’s work, developing economic models which explain the cause of the 2008 financial crisis.

Keen’s states that banks had been a major factor in the accumulation of debt and the housing bubble in the financial crisis, relating it to Minsky’s theory of financial instability.

Keen blamed the banks on the grounds that the banks created new money which Ponzi and Speculative borrowers used to inflate the housing market. When these debts had become unsustainable, the bubble burst and resulted in the financial crisis.

New Keynesian Paul Krugman refutes Keen’s statements, arguing that Bank’s were not the cause of the crisis because they were merely linking lenders to borrowers.

Krugman arguments are  articulated in his blog titled Banking Mysticism on the New York Times where he writes

The super-high leverage of banks, and the role of bank deposits as a key form of liquid assets, means that banks broadly defined are usually central players in financial crises. But that’s a quantitative thing, not a qualitative thing. For in the end, banks don’t change the basic notion of interest rates as determined by liquidity preference and loanable funds… Banks don’t create demand out of thin air any more than anyone does by choosing to spend more; and banks

Keen responds by arguing that Krugman’s fundamental economic theory is inaccurate and adds that it has failed to prevent the financial crisis.

Keen’s expresses his arguments against the Krugman’s (New Keynesian) economic theory, in an interview on RT, where he say

They have a vision of the economy that has it in equilibrium or nearby disturbed a bit from equilibrium by shocks and all the ups and downs of these exogenous shocks. And we’ve been saying for a long long time you can’t model the economy as if it’s in equilibrium because – hey it’s not! It’s out of equilibrium and especially at times right now. So there are other approaches to do it, [the] dynamic modeling that I do, that gives you models that include banks and that actually give you the result that, yes you can have crisis like the one we’re in now, and I first read a model of that nature back in 1995. Now Krugman has always ignored us. And what they’ve simply said is ‘Oh you don’t understand our models therefore we can ignore you’…Paul if your models were right we wouldn’t be in a financial crisis.

Clearly, a model is necessary to explain the current crises the world faces today, however Keynesians are still struggling to figure out the correct one.

Despite the criticisms the differing schools of Keynesians have had on the current debt crisis, Austrians have also decided to offer their own attempts at solutions.

Certain Austrian school followers have clung to the belief that gold would be a solution to the fiat money system that they believe has caused the global turmoil. Yet all Keynesian schools have disregarded gold based on its own inherent limitations as money.

Keynesians argue against the gold standard on the grounds that during the 1920s, the scarcity of gold was the contributing factor that limited the power of the Federal Reserve and the Government to recover from the depression.

Other schools of thought such as the Monetarists reject Keynesian economics arguing that there is too much emphasis on government fiscal intervention in the economy.

The next article presents the case of monetarists and how their economic philosophies counter those of Keynesians.



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