Keynesian Economic Thought

The Great Depression of the 1930s, which produced mass, prolonged unemployment across the industrialised world, was very difficult to explain using classical economics — Say's Law implied that such a large and lasting glut of unsold goods and unemployed workers simply should not happen. The British economist John Maynard Keynes (1883–1946) directly challenged this in his 1936 book, The General Theory of Employment, Interest and Money, which is generally regarded as the single most influential work in 20th-century economics and the founding text of macroeconomics as a separate branch of the subject.

Keynes rejected Say's Law and argued instead that the total level of output and employment in an economy is determined by aggregate (effective) demand — the total planned spending by households (consumption), firms (investment), and government — rather than automatically settling at the level needed for full employment. If aggregate demand falls short (for example, because firms cut investment spending during a downturn), output and employment can settle at a level well below full employment, and stay there indefinitely — the economy does not automatically correct itself, contrary to what classical economists had assumed.

Keynes introduced several tools that remain central to macroeconomics today: the consumption function, describing how household spending depends on income; the investment multiplier, showing that an initial increase in investment spending raises national income by a larger amount, because the money spent becomes someone else's income, part of which is spent again, and so on (a simple version is the multiplier $k = \dfrac{1}{1 - MPC}$, where MPC is the marginal propensity to consume); liquidity preference, his theory of why people hold money rather than only interest-earning assets, which determines the rate of interest; and the marginal efficiency of capital, the expected rate of return on a new investment, which businesses compare against the interest rate when deciding whether to invest. …