The Keynesian model promotes state intervention to manage economic cycles and challenges the assumption that decision makers always act rationally. It calls for fiscal policy, including government spending to create jobs, but critics argue that monetary policy is more effective.
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. Therefore, it promotes a degree of state intervention to influence the economy, especially to manage the effects of the economic 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 assumption that decision makers would always act rationally and that the market as a whole would in turn function efficiently. Keynes argued that there were various barriers to this happening. One is that human nature means that people are more concerned with the actual amount of their wages than the actual value of their income, taking price changes into account. This meant that the relationship between wages, employment levels and price levels would not always run automatically. For example, people would refuse to accept fewer dollars in wages even if prices had fallen by a larger proportion, and would therefore be better off.
Keynes also questioned the idea that interest rate movements would prevent people from saving too much at the expense of spending, causing drops in demand for goods and services. This was for a variety of reasons, notably that interest rates are decided more by the supply and demand for money to borrow than by the public’s desire to save. This meant that excessive saving could lead to a recession.
The Keynesian model calls for fiscal policy in which governments increase spending at times when the economy slows. This implies a theory described as the multiplier. This states that if the government spends to create jobs, 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 revenue and spending in the economy will be a high “multiple” of original government spending.
Critics of the Keynesian model believe that the money supply in the economy has a larger effect. They also argue that government spending to “boost” economic growth may simply rob the private sector of staff and resources. Instead, critics back monetary policy, which supports measures like interest rate controls to influence the amount of money available to consumers and businesses to borrow. Most governments today use a combination of fiscal policy and monetary policy.
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