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For example: a company spends $1 million to build a factory. The money does not disappear, butrather becomes wages to builders, revenue to suppliers etc. The builders will have higherdisposable income as a result, consumption rises as well, and hence aggregate demand will alsorise. Suppose further those recipients of the new spending by the builder in turn spend their newincome, this will raise consumption and demand further, and so on.

The increase in the gross domestic productis the sum of the increases in net income of everyoneaffected. If the builder receives $1 million and pays out $800,000 to sub contractors, he has a netincome of $200,000 and a corresponding increase in disposable income (the amount remainingafter taxes).

This process proceeds down the line through subcontractors and their employees, eachexperiencing an increase in disposable income to the degree the new work they perform does notdisplace other work they are already performing. Each participant who experiences an increase indisposable income then spends some portion of it on final (consumer) goods, according to his orher marginal propensity to consume, which causes the cycle to repeat an arbitrary number oftimes, limited only by the spare capacity available.

Another example: when tourists visit somewhere they need to buy the plane ticket, catch a taxi

from the airport to the hotel, book in at the hotel, eat at the restaurant and go to the movies ortourist destination. The taxi driver needs petrol (gasoline) for his cab, the hotel needs to hire thestaff, the restaurant needs attendants and chefs, and the movies and tourist destinations need staffand cleaners.

[edit] ApplicationsThe multiplier effect is a tool used by governments to attempt to stimulate aggregate demand.This can be done in a period of recession or economic uncertainty. The money invested by agovernment creates more jobs, which in turn will mean more spending and so on.

The idea is that the net increase in disposable income by all parties throughout the economy willbe greater than the original investment. When that is the case, the government can increase the

gross domestic product by an amount that is greater than an increase in the amount it spendsrelative to the amount it collects in taxes.

The difference is the fiscal stimulus. The net fiscal stimulus may be increased by raisingspending above the level of tax revenues, reducing taxes below the level of governmentspending, or any combination of the two that results in the government taxing less than it spends.

The resulting deficit spending must be financed from government reserves (if any) or netborrowing from private or foreign investors. If the money is borrowed, it must eventually be paidback with interest, such that the long term effect on the economy depends on the trade offbetween the immediate increase to the GDP and the long term cost of servicing the resultinggovernment debt.

It must be noted that the extent of the multiplier effect is dependent upon the marginal propensityto consume andmarginal propensity to import. Also that the multiplier can work in reverse aswell, so an initial fall in spending can trigger further falls in aggregate output.

The concept of the economic multiplier on a macroeconomic scale can be extended to anyeconomic region. For example, building a new factory may lead to new employment for locals,which may have knock-on economic effects for the city or region.[1]

[edit] Various types of fiscal multipliers
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The following values are theoretical values based on simplified models, and the empirical valuescorresponding to the reality have been found to be lower (see below).

Note: In the following examples the multiplier is the right-hand-side equation without the firstcomponent.

y is original output (GDP)

bCis marginal propensity of consumption (MPC)

bTis original income tax rate

bMis marginal propensity to import

y is change in income (equivalent to GDP)

aTis change in lump-sum tax rate

bTis change in income tax rate

G is change in government spending

Tis change in aggregate taxes

Iis change in investment

Xis change in exports

[edit] Standard Lump-sum Tax Equation

Note: only aTis here because if this is a change in lump-sum tax rate then bTis implied to be0.

[edit] Standard Income Tax Equation

Note: only bTis here because if this is a change in income tax rate then aTis implied to be 0.[edit] Standard Government Spending Equation

[edit] Standard Investment Equation

[edit] Standard Exports Equation

[edit] Balanced-Budget Government Spending Equation

y = G * 1

y = T* 1

[edit] Estimated values

[edit] United States of America

American Economist Paul Samuelson credits Alvin Hansen for the inspiration behind his seminal1939 contributions to the theory. The original Samuelson multiplier-accelerator model (or, as hebelatedly baptised it, the "Hansen-Samuelson" model) relies on a multiplier mechanism which isbased on a simple Keynesian consumption function with a Robertsonian lag:

Ct = c0 + cYt-1
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so present consumption is a function of past income (with c as the marginal propensity toconsume). Investment, in turn, is assumed to be composed of three parts:

It = I0 + I(r) + b (Ct - Ct-1)

The first part is autonomous investment, the second is investment induced by interest rates andthe final part is investment induced by changes in consumption demand (the "acceleration"

principle). It is assumed that 0 < b . As we are concentrating on the income-expenditure side, letus assume Ir = 0 (or alternatively, constant interest), so that:

It = I0 + b (Ct - Ct-1)

Now, assuming away government and foreign sector, aggregate demand at time t is:

Ytd = Ct + It = c0 + I0 + cYt-1 + b (Ct - Ct-1)

assuming goods market equilibrium (so Yt = Ytd), then in equilibrium:

Yt = c0 + I0 + cYt-1 + b (Ct - Ct-1)

But we know the values of Ct and Ct-1 are merely Ct = c0 + cYt-1 and Ct-1 = c0 + cYt-2respectively, then substituting these in:

Yt = c0 + I0 + cYt-1 + b (c0 + cYt-1 - c0 - cYt-2)

or, rearranging and rewriting as a second order linear difference equation:

Yt - (1 + b )cYt-1 + b cYt-2 = (c0 + I0)

The solution to this system then becomes elementary. The equilibrium level of Y (call it Yp, theparticular solution) is easily solved by letting Yt = Yt-1 = Yt-2 = Yp, or:

(1 - c - b c + b c)Yp = (c0 + I0)

so:

Yp = (c0 + I0)/(1-c)

The complementary function, Yc is also easy to determine. Namely, we know that it will havethe form Yc = A1r1t + A2r2t where A1 and A2 are arbitrary constants to be defined and wherer1 and r2 are the two eigenvalues (characteristic roots) of the following characteristic equation:

r2 - (1+b )cr + b c = 0

Thus, the entire solution is written as Y = Yc + Yp

In congressional testimony given in July 2008, Mark Zandi, chief economist for Moody'sEconomy.com, provided estimates of the one year multiplier effect for several fiscal policyoptions. The multipliers showed that increased government spending would have more of amultiplier effect than tax cuts. The most effective policy, a temporary increase in food stamps,had an estimated multiplier of 1.73. Making the Bush tax cuts permanent, had the second lowest

multiplier, 0.23. A payroll tax holiday had the largest multiplier for tax cuts, 1.29. Refundablelump-sum tax rebates, the policy used in the Economic Stimulus Act of 2008, had the secondlargest multiplier for a tax cut, 1.26.[2]

Notably, such multipliers ignore the important long run effects on equilibrium output that taxcuts create.

According to Otto Eckstein, estimation has found "textbook" values of multipliers are overstated.The following tables has assumptions about monetary policy along the left hand side. Along the
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4 References

[edit] Common usesTwo multipliers are commonly discussed in introductory macroeconomics.

[edit] Money multiplierMain article: Money multiplier

See also:Fractional-reserve banking

In monetary macroeconomics and banking, the money multipliermeasures how much themoneysupply increases in response to a change in the monetary base.

The multiplier may vary across countries, and will also vary depending on what measures ofmoney are considered. For example, considerM2 as a measure of the U.S. money supply, andM0 as a measure of the U.S. monetary base. If a $1 increase in M0 by the Federal Reserve causesM2 to increase by $10, then the money multiplier is 10.

[edit] Fiscal multipliersMain article:Fiscal multiplier

Multipliers can be calculated to analyze the effects offiscal policy, or other exogenous changesin income and spending, on aggregate output.

For example, if an increase in German government spending by 100, with no change in taxes,causes German GDP to increase by 150, then thespending multiplieris 1.5. Other types offiscal multipliers can also be calculated, like multipliers that describe the effects of changingtaxes (such as lump-sum taxes orproportional taxes).

[edit] Keynesian multiplier

Keynesian economists often calculate multipliers that measure the effect on aggregate demandonly. (To be precise, the usualKeynesian multiplierformulas measure how much the IS curveshifts left or right in response to an exogenous change in income or spending.) Opponents ofKeynesianism have sometimes argued that Keynesian multiplier calculations are misleading; forexample, according to the theory ofrational expectations, it is impossible to calculate the effectof deficit-financed government spending on demand without specifying how people expect thedeficit to be paid off in the future.

American Economist Paul Samuelson credits Alvin Hansen for the inspiration behind his seminal1939 contribution. The original Samuelson multiplier-accelerator model (or, as he belatedlybaptised it, the "Hansen-Samuelson" model) relies on a multiplier mechanism which is based ona simple Keynesian consumption function with a Robertsonian lag:

Ct= c0 + cYt 1so present consumption is a function of past income (with c as the marginal propensity toconsume). Investment, in turn, is assumed to be composed of three parts:

It=I0 +I(r) + b(Ct Ct 1)

The first part is autonomous investment, the second is investment induced by interest rates andthe final part is investment induced by changes in consumption demand (the "acceleration"
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principle). It is assumed that 0 < b . As we are concentrating on the income-expenditure side, letus assume Ir = 0 (or alternatively, constant interest), so that:

It=I0 + b(Ct Ct 1)

Now, assuming away government and foreign sector, aggregate demand at time t is:

Ytd= Ct+It= c0 +I0 + cYt 1 + b(Ct Ct 1)assuming goods market equilibrium (so Yt= Ytd), then in equilibrium:

Yt= c0 +I0 + cYt 1 + b(Ct Ct 1)

But we know the values ofCtand Ct 1 are merely Ct= c0 + cYt 1 and Ct 1 = c0 + cYt 2respectively, then substituting these in:

Yt= c0 +I0 + cYt 1 + b(c0 + cYt 1 c0 cYt 2)

or, rearranging and rewriting as a second order linear difference equation:

Yt (1 + b)cYt 1 + bcYt 2 = (c0 +I0)

The solution to this system then becomes elementary. The equilibrium level of Y (call it Yp, theparticular solution) is easily solved by letting Yt= Yt 1 = Yt 2 = Yp, or:

(1 c bc + bc)Yp = (c0 +I0)

so:

Yp = (c0 +I0) / (1 c)

The complementary function, Yc is also easy to determine. Namely, we know that it will have theform Yc =A1r1t+A2r2twhereA1 andA2 are arbitrary constants to be defined and where r1and r2 are the two eigenvalues (characteristic roots) of the following characteristic equation:

r2 (1 + b)cr+ bc = 0

Thus, the entire solution is written as Y= Yc + Yp

[edit] General methodThe general method for calculating long-run multipliers is calledcomparative statics. That is,comparative statics calculates how much one or more endogenousvariables change in the longrun, given a permanent change in one or more exogenous variables. The comparative staticsmethod is an application of the Implicit Function Theorem.

Dynamic multipliers can also be calculated. That is, one can ask how a change in some

exogenous variable in yeartaffects endogenous variables in yeart, in yeart+1, in yeart+2, andso forth. A graph showing the impact on some endogenous variable, over time (that is, themultipliers for times t, t+1, t+2, etcetera), is called animpulse-response function.[1] The generalmethod for calculating impulse response functions is sometimes called comparative dynamics.

[edit] History
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Illustration of the original visualisation of the tableau conomiqueby Quesnay, 1759.

The tableau conomique (Economic Table) ofFranois Quesnay (1759), which lay thefoundation of the Physiocrats economic theory, is credited as the "first precise formulation" ofinterdependent systems in economics and the origin of multiplier theory.[2] In the tableauconomique, one sees variables in one period (time t) feeding into variables in the next period(time t+1), and a constant rate of flow yields geometric series, which computes a multiplier.

The modern theory of the multiplier was developed in the 1930s, byKahn,Keynes,Giblin, andothers,[3] following earlier work in the 1890s by the Australian economist Alfred De Lissa, theDanish economist Julius Wulff, and the German-American economistN. A. J. L. Johannsen.[4]

Keynesian economicsFrom Wikipedia, the free encyclopedia

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Keynesian economics were first presented in The General Theory of Employment, Interest andMoney, published in 1936; the interpretations of Keynes are contentious, and several schools ofthought claim his legacy.

Keynesian economics advocates amixed economypredominantly private sector, but with alarge role of government and public sectorand served as the economic model during the latter

part of the Great Depression, World War II, and the post-warGolden Age of Capitalism, 19451973, though it lost some influence following the stagflationof the 1970s. As a middle waybetween laissez-fairecapitalism and socialism, it has been and continues to be attacked fromboth the right and the left.[2][3] The advent of the global financial crisis in 2007 has caused aresurgence in Keynesian thought. Keynesian economics has provided the theoreticalunderpinning for the plans of President Barack Obama, Prime MinisterGordon Brown and otherglobal leaders to rescue the world economy.[4]

Contents[hide]

1 Overview

2 Precursors

2.1 Schools

2.2 Concepts

3 Keynes and the Classics

3.1 Wages and spending

3.2 Excessive saving

3.3 Active fiscal policy

3.4 "Multiplier effect" and interest rates

4 Postwar Keynesianism

4.1 Main theories

5 Criticism

5.1 Monetarist criticism

5.2 New classical macroeconomics criticism

5.3 Austrian School criticism

5.4 Methodological Disagreement and Different Results that Emerge

6 Keynesian responses to the critics

7 See also

8 References

9 Further reading

10 External links

[edit] Overview
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In Keynes's theory, there are somemicro-level actions of individuals and firms that can lead toaggregate macroeconomicoutcomes in which the economy operates below itspotential outputand growth. Some classical economistshad believed inSay's Law, that supply creates its owndemand, so that a "general glut" would therefore be impossible. Keynes contended that aggregatedemand forgoods might be insufficient during economic downturns, leading to unnecessarilyhigh unemployment and losses of potential output. Keynes argued that government policiescould be used to increase aggregate demand, thus increasing economic activity and reducingunemployment and deflation.

Keynes argued that the solution to depression was to stimulate the economy ("inducement toinvest") through some combination of two approaches: a reduction in interest rates andgovernment investment in infrastructure. Investment by government injects income, whichresults in more spending in the general economy, which in turn stimulates more production andinvestment involving still more income and spending and so forth. The initial stimulation starts acascade of events, whose total increase in economic activity is a multiple of the originalinvestment.[5]

A central conclusion of Keynesian economics is that, in some situations, no strong automatic

mechanism moves output and employment towards full employment levels. This conclusionconflicts with economic approaches that assume a general tendency towards an equilibrium. Inthe 'neoclassical synthesis', which combines Keynesian macro concepts with a micro foundation,the conditions ofgeneral equilibrium allow for price adjustment to achieve this goal.

The new classical macroeconomics movement, which began in the late 1960s and early 1970s,criticized Keynesian theories, whileNew Keynesian economics have sought to base Keynes'sidea on more rigorous theoretical foundations.

More broadly, Keynes saw his as ageneraltheory, in which utilization of resources could behigh or low, whereas previous economics focused on theparticularcase of full utilization.

Some interpretations of Keynes have emphasized his stress on the international coordination ofKeynesian policies, the need for international economic institutions, and the ways in whicheconomic forces could lead to waror could promote peace.[6]

[edit] PrecursorsKeynes's work was part of a long-running debate within economics over the existence and natureofgeneral gluts. While a number of the policies Keynes advocated (notably government deficitspending) and the theoretical ideas he proposed (effective demand, the multiplier, the paradox ofthrift) were advanced by various authors in the 19th and early 20th century, Keynes's uniquecontribution was to provide ageneral theory of these, which proved acceptable to the politicaland economic establishments.

[edit] Schools

See also: Underconsumption andStockholm school (economics)

An intellectual precursor of Keynesian economics was underconsumptiontheory in classicaleconomics, dating from such 19th century economists as Thomas Malthus to the Americaneconomists William Trufant Fosterand Waddill Catchings, who were influential in the 1920sand 1930s. Underconsumptionists were, like Keynes after them, concerned with failure ofaggregate demand to attainpotential output, calling this "underconsumption" (focusing on thedemand side), rather than "overproduction" (which would focus on the supply side), andadvocating economic interventionism. Keynes specifically discussed underconsumption (which
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he wrote "under-consumption") in the General Theory, inChapter 22, Section IV andChapter23, Section VII.

Numerous concepts were developed earlier and independently of Keynes by the Stockholmschool during the 1930s; these accomplishments were described in a 1937 article, published inresponse to the 1936 General Theory, sharing the Swedish discoveries.[7]

[edit] Concepts

The multiplierdates to work in the 1890s by the Australian economist Alfred De Lissa, theDanish economist Julius Wulff, and the German American economistNicholas Johannsen,[8] thelatter being cited in a footnote of Keynes. [9] Nicholas Johannsen also proposed a theory ofeffective demand in the 1890s.

Theparadox of thriftwas stated in 1892 by John M. Robertson in his The Fallacy of Savings, inearlier forms by mercantilisteconomists since the 16th century, and similar sentiments date toantiquity:[10][11]

There is that scattereth, and yet increaseth; and there is that withholdeth more than is meet, but it tendethto poverty.

The liberal soul shall be made fat: and he that watereth shall be watered also himself.

Proverbs 11:2425

Today these ideas, regardless of provenance, are referred to in academia under the rubric of"Keynesian economics", due to Keynes's role in consolidating, elaborating, and popularizingthem.

[edit] Keynes and the ClassicsPart of the series on

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Keynes sought to distinguish his theories from "classical economics," by which he meant the

economic theories ofDavid Ricardo and his followers, including John Stuart Mill, AlfredMarshall, Francis Ysidro Edgeworth, and Arthur Cecil Pigou. A central tenet of the classicalview, known as Say's law, states that supply creates its own demand. Say's Law can beinterpreted in two ways. First, the claim that the total value of output is equal to the sum ofincome earned in production is a result of a national income accounting identity, and is thereforeindisputable. A second and stronger claim, however, that the "costs of output are always coveredin the aggregate by the sale-proceeds resulting from demand" depends on how consumption andsaving are linked to production and investment. In particular, Keynes argued that the second,strong form of Say's Law only holds if increases in individual savings exactly match an increasein aggregate investment.[12]

Keynes sought to develop a theory that would explain determinants of saving, consumption,

investment and production. In that theory, the interaction of aggregate demand and aggregatesupply determines the level of output and employment in the economy.

Because of what he considered the failure of the Classical Theory in the 1930s, Keynes firmlyobjects to its main theoryadjustments in prices would automatically make demand tend to thefull employment level.

Neo-classical theory supports that the two main costs that shift demand and supply are labor andmoney. Through the distribution of the monetary policy, demand and supply can be adjusted. Ifthere were more labor than demand for it, wages would fall until hiring began again. If there wastoo much saving, and not enough consumption, then interest rates would fall until people eithercut their savings rate or started borrowing.

[edit] Wages and spendingDuring the Great Depression, the classical theory defined economic collapse as simply a lostincentive to produce. Mass unemploymentwas caused only by high and rigid real wages.[citationneeded]

To Keynes, the determination of wages is more complicated. First, he argued that it is not realbut nominal wages that are set in negotiations between employers and workers, as opposed to abarterrelationship. Second, nominal wage cuts would be difficult to put into effect because oflaws and wage contracts. Even classical economists admitted that these exist; unlike Keynes,
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they advocated abolishing minimum wages, unions, and long-term contracts, increasing labor-market flexibility. However, to Keynes, people will resist nominal wage reductions, even withoutunions, until they see other wages falling and a general fall of prices.

He also argued that to boost employment, realwages had to go down: nominal wages wouldhave to fall more than prices. However, doing so would reduceconsumer demand, so that the

aggregate demand for goods would drop. This would in turn reduce business sales revenues andexpected profits. Investment in new plants and equipmentperhaps already discouraged byprevious excesseswould then become more risky, less likely. Instead of raising businessexpectations, wage cuts could make matters much worse.

Further, if wages and prices were falling, people would start to expect them to fall. This couldmake the economy spiral downward as those who had money would simply wait as falling pricesmade it more valuablerather than spending. As Irving Fisherargued in 1933, in hisDebt-Deflation Theory of Great Depressions, deflation (falling prices) can make a depression deeperas falling prices and wages made pre-existing nominal debts more valuable in real terms.

[edit] Excessive saving

To Keynes, excessive saving, i.e. saving beyond planned investment, was a serious problem,encouraging recession or evendepression. Excessive saving results if investment falls, perhapsdue to falling consumer demand, over-investment in earlier years, or pessimistic businessexpectations, and if saving does not immediately fall in step, the economy would decline.

The classical economistsargued that interest rates would fall due to the excess supply of"loanable funds". The first diagram, adapted from the only graph in The General Theory,shows this process. (For simplicity, other sources of the demand for or supply of funds areignored here.) Assume that fixed investment in capital goods falls from "old I" to "new I" (stepa). Second (step b), the resulting excess of saving causes interest-rate cuts, abolishing the excesssupply: so again we have saving (S) equal to investment. The interest-rate (i) fall prevents that ofproduction and employment.

Keynes had a complex argument against thislaissez-faireresponse. The graph belowsummarizes his argument, assuming again that fixed investment falls (step A).First, saving doesnot fall much as interest rates fall, since the income and substitution effects of falling rates go inconflicting directions. Second, since plannedfixed investment in plant and equipment is mostlybased on long-term expectations of future profitability, that spending does not rise much asinterest rates fall. So S and I are drawn as steep (inelastic) in the graph. Given the inelasticity ofboth demand and supply, a large interest-rate fall is needed to close the saving/investment gap.As drawn, this requires a negative interest rate at equilibrium (where the new I line wouldintersect the old S line). However, this negative interest rate is not necessary to Keynes'sargument.

Third, Keynes argued that saving and investment are not the main determinants of interest rates,

especially in the short run. Instead, the supply of and the demand for the stock ofmoneydetermine interest rates in the short run. (This is not drawn in the graph.) Neither changesquickly in response to excessive saving to allow fast interest-rate adjustment.

Finally, because of fear of capital losses on assets besides money, Keynes suggested that theremay be a "liquidity trap" setting a floor under which interest rates cannot fall. While in this trap,interest rates are so low that any increase in money supply will cause bond-holders (fearing risesin interest rates and hence capital losses on their bonds) to sell their bonds to attain money(liquidity). In the diagram, the equilibrium suggested by the new I line and the old S line cannot
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be reached, so that excess saving persists. Some (such as Paul Krugman) see this latter kind ofliquidity trap as prevailing in Japan in the 1990s. Most economists agree that nominal interestrates cannot fall below zero, however, some economists (particularly those from the Chicagoschool) reject the existence of a liquidity trap.

Even if the liquidity trap does not exist, there is afourth (perhaps most important) element to

Keynes's critique. Saving involves not spending all of one's income. It thus means insufficientdemand for business output, unless it is balanced by other sources of demand, such as fixedinvestment. Thus, excessive saving corresponds to an unwanted accumulation of inventories, orwhat classical economists called a general glut.[13] This pile-up of unsold goods and materialsencourages businesses to decrease both production and employment. This in turn lowers people'sincomesand saving, causing a leftward shift in the S line in the diagram (step B). For Keynes,the fall in income did most of the job by ending excessive saving and allowing the loanablefunds market to attain equilibrium. Instead of interest-rate adjustment solving the problem, arecession does so. Thus in the diagram, the interest-rate change is small.

Whereas the classical economists assumed that the level of output and income was constant andgiven at any one time (except for short-lived deviations), Keynes saw this as the key variable that

adjusted to equate saving and investment.Finally, a recession undermines the business incentive to engage infixed investment. Withfalling incomes and demand for products, the desired demand for factories and equipment (not tomention housing) will fall. This accelerator effectwould shift the I line to the left again, achange not shown in the diagram above. This recreates the problem of excessive saving andencourages the recession to continue.

In sum, to Keynes there is interaction between excess supplies in different markets, asunemployment in labor markets encourages excessive savingand vice-versa. Rather thanprices adjusting to attain equilibrium, the main story is one ofquantity adjustment allowingrecessions and possible attainment ofunderemployment equilibrium.

[edit] Active fiscal policy

This section does not cite any references or sources.Please helpimprove this article by adding citations toreliable sources. Unsourced material may bechallenged andremoved.(March 2009)

As noted,[clarification needed] the classicals wanted to balance the government budget. To Keynes, thiswould exacerbate the underlying problem: following either policy [clarification needed] would raisesaving(broadly defined) and thus lower the demand for both products and labor. For example,Keynesians see Herbert Hoover's June 1932 tax increase as making the Depression worse.[citationneeded][clarification needed]

Keynes ideas influenced Franklin D. Roosevelt's view that insufficient buying-power caused theDepression. During his presidency, Roosevelt adopted some aspects of Keynesian economics,

especially after 1937, when, in the depths of the Depression, the United States suffered fromrecession yet again following fiscal contraction. But to many the true success of Keynesianpolicy can be seen at the onset ofWorld War II, which provided a kick to the world economy,removed uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas becamealmost official in social-democraticEurope after the war and in the U.S. in the 1960s.

Keynes theory suggested that active government policy could be effective in managing theeconomy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated whathas been called countercyclical fiscal policies, that is policies which acted against the tide of the
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business cycle: deficit spendingwhen a nation's economy suffers fromrecession or whenrecovery is long-delayed and unemployment is persistently highand the suppression ofinflation in boom times by either increasing taxes or cutting back on government outlays. Heargued that governments should solve problems in the short run rather than waiting for marketforces to do it in the long run, because "in the long run, we are all dead."[14]

This contrasted with the classicaland neoclassical economic analysis of fiscal policy. Fiscalstimulus (deficit spending) could actuate production. But to these schools, there was no reason tobelieve that this stimulation would outrun the side-effects that "crowd out" private investment:first, it would increase the demand for labor and raise wages, hurtingprofitability; Second, agovernment deficit increases the stock of government bonds, reducing their market price andencouraging high interest rates, making it more expensive for business to finance fixedinvestment. Thus, efforts to stimulate the economy would be self-defeating.

The Keynesian response is that such fiscal policy is only appropriate when unemployment ispersistently high, above what is now termed the Non-Accelerating Inflation Rate ofUnemployment, or "NAIRU". In that case, crowding out is minimal. Further, private investmentcan be "crowded in": fiscal stimulus raises the market for business output, raising cash flow and

profitability, spurring business optimism. To Keynes, this accelerator effect meant thatgovernment and business could be complements rather thansubstitutesin this situation. Second,as the stimulus occurs, gross domestic product rises, raising the amount ofsaving, helping tofinance the increase in fixed investment. Finally, government outlays need not always bewasteful: government investment inpublic goods that will not be provided by profit-seekers willencourage the private sector's growth. That is, government spending on such things as basicresearch, public health, education, and infrastructure could help the long-term growth ofpotential output.

A Keynesian economist might point out that classical and neoclassical theory does not explainwhy firms acting as "special interests" to influence government policy are assumed to produce anegative outcome, while those same firms acting with the same motivations outside of the

government are supposed to produce positive outcomes.Libertarians counter that because bothparties consent, free trade increases net happiness, but government imposes its will by force,decreasing happiness. Therefore firms that manipulate the government do net harm, while firmsthat respond to the free market do net good.

In Keynes' theory, there must be significant slack in the labor market before fiscal expansion isjustified. Both conservative and some neoliberal economists question this assumption, unlesslabor unions or the government "meddle" in the free market, creating persistent supply-side orclassical unemployment.[clarification needed] Their solution is to increase labor-market flexibility, e.g.,by cutting wages, busting unions, and deregulating business.

Deficit spending is not Keynesianism.[citation needed] Keynesianism recommends counter-cyclicalpolicies to smooth out fluctuations in thebusiness cycle.[citation needed] An example of a counter-

cyclical policy is raising taxes to cool the economy and to prevent inflation when there isabundant demand-side growth, and engaging in deficit spending on labor-intensive infrastructureprojects to stimulate employment and stabilize wages during economic downturns. [citation needed]

Classical economics, on the other hand, argues that one should cuttaxes when there are budgetsurpluses, and cut spendingor, less likely, increase taxesduring economic downturns.[citationneeded] Keynesian economists believe that adding to profits and incomes during boom cyclesthrough tax cuts, and removing income and profits from the economy through cuts in spendingand/or increased taxes during downturns, tends to exacerbate the negative effects of the business
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cycle.[citation needed] This effect is especially pronounced when the government controls a largefraction of the economy, and is therefore one reason fiscal conservatives advocate a muchsmaller government.[citation needed]

[edit] "Multiplier effect" and interest rates

Main article: Spending multiplier

Two aspects of Keynes' model had implications for policy:

First, there is the "Keynesian multiplier", first developed by Richard F. Kahn in 1931.Exogenous increases in spending, such as an increase in government outlays, increases totalspending by a multiple of that increase. A government could stimulate a great deal of newproduction with a modest outlay if:

1. The people who receive this money then spend most on consumption goods and save therest.

2. This extra spending allows businesses to hire more people and pay them, which in turnallows a further increase consumer spending.

This process continues. At each step, the increase in spending is smaller than in the previousstep, so that the multiplier process tapers off and allows the attainment of an equilibrium. Thisstory is modified and moderated if we move beyond a "closed economy" and bring in the role oftaxation: the rise in imports and tax payments at each step reduces the amount of inducedconsumer spending and the size of the multiplier effect.

Second, Keynes re-analyzed the effect of the interest rate on investment. In the classical model,the supply of funds (saving) determined the amount of fixed business investment. That is, sinceall savings was placed in banks, and all business investors in need of borrowed funds went tobanks, the amount of savings determined the amount that was available to invest. To Keynes, theamount of investment was determined independently by long-term profit expectations and, to alesser extent, the interest rate. The latter opens the possibility of regulating the economy through

money supply changes, via monetary policy. Under conditions such as the Great Depression,Keynes argued that this approach would be relatively ineffective compared to fiscal policy. Butduring more "normal" times, monetary expansion can stimulate the economy.[citation needed]

[edit] Postwar KeynesianismMain articles:Neo-Keynesian economics,New Keynesian economics, andPost-Keynesianeconomics

In the post-WWIIyears, Keynes's policy ideas were widely accepted. Governments preparedgood quality economic statistics on an ongoing basis and tried to base their policies on theKeynesian theory that had become orthodoxy. In the early era ofnew liberalism and socialdemocracy, most western capitalist countries enjoyed low, stable unemployment and modest

inflation.Through the 1950s, moderate degrees of government demand leading industrial development,and use of fiscal and monetary counter-cyclical policies continued, and reached a peak in the "gogo" 1960s, where it seemed to many Keynesians that prosperity was now permanent. In 1971,Republican US President Richard Nixon even proclaimed "we are all Keynesians now".[15]

However, with the oil shock of 1973, and the economic problems of the 1970s, modern liberaleconomics began to fall out of favor. During this time, many economies experienced high andrising unemployment, coupled with high and rising inflation, contradicting the Phillips curve's
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prediction. This stagflation meant that the simultaneous application of expansionary (anti-recession) and contractionary (anti-inflation) policies appeared to be necessary, a clearimpossibility. This dilemma led to the end of the Keynesian near-consensus of the 1960s, and therise throughout the 1970s of ideas based upon more classical analysis, includingmonetarism,supply-side economics[15] andnew classical economics. At the same time Keynesians beganduring the period to reorganize their thinking (some becoming associated withNew Keynesianeconomics); one strategy, utilized also as a critique of the notably high unemployment andpotentially disappointing GNP growth rates associated with the latter two theories by the mid-1980s, was to emphasize low unemployment and maximal economic growth at the cost ofsomewhat higher inflation (its consequences kept in check by indexing and other methods, andits overall rate kept lower and steadier by such potential policies as Martin Weitzman's shareeconomy).[16]

Currently, there exists multiple schools of economic thought that trace their legacy to Keynes,notablyNeo-Keynesian economics,New Keynesian economics, and Post-Keynesian economics.Keynes' biographerRobert Skidelsky writes that the post-Keynesian school has remained closestto the spirit of Keynes' work in following his monetary theory and rejecting the neutrality ofmoney.[17][18]

In the postwar era Keynesian analysis was combined with neoclassical economics to producewhat is generally termed the "neoclassical synthesis", yieldingNeo-Keynesian economics, whichdominated mainstream macroeconomic thought. Though it was widely held that there was nostrong automatic tendency to full employment, many believed that if government policy wereused to ensure it, the economy would behave as neoclassical theory predicted. This post-wardomination by Neo-Keynesian economics was broken during thestagflationof the 1970s. Therewas a lack of consensus among macroeconomists in the 1980s. However, the advent ofNewKeynesian economics in the 1990s, modified and provided microeconomic foundations for theneo-Keynesian theories. These modified models now dominate mainstream economics.

Post-Keynesian economistson the other hand, rejects the neoclassical synthesis, and more

generally, neoclassical economics applied to the macroeconomy. Post-Keynesian economics is aheterodox schoolwhich holds that both Neo-Keynesian economics and New Keynesianeconomics are incorrect, and a misinterpretation of Keynes's ideas. The Post-Keynesian schoolencompasses a variety of perspectives, but has been far less influential than the other moremainstream Keynesian schools.

[edit] Main theories

The two key theories of mainstream Keynesian economics are the IS-LM model of John Hicks,and the Phillips curve; both of these are rejected by Post-Keynesians.

It was with John Hicks that Keynesian economics produced a clearmodelwhich policy-makerscould use to attempt to understand and control economic activity. This model, the IS-LM modelis nearly as influential as Keynes' original analysis in determining actual policy and economicseducation. It relates aggregate demand and employment to threeexogenous quantities, i.e., theamount ofmoney in circulation, the government budget, and the state of business expectations.This model was very popular with economists afterWorld War II because it could be understoodin terms ofgeneral equilibriumtheory. This encouraged a much more static vision ofmacroeconomics than that described above.[citation needed]

The second main part of a Keynesian policy-maker's theoretical apparatus was thePhillips curve.This curve, which was more of an empirical observation than a theory, indicated that increased
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