Summary
John Maynard Keynes would go on to become a household name in economics, ultimately achieving the highest honor of becoming an adjectival eponym for his ‘Keynesian’ style of economic thinking. Keynes published this monumental work in 1936 during the height of the Great Depression, a period that baffled many classical economists. The primary issue at the time was cripplingly high unemployment rates paired with low demand, triggering a deflationary spiral. Theoretically, this situation should not have occurred because higher unemployment would typically lead to lower wages due to increased competition for jobs. Lower wages should, in turn, result in higher profits for investors, leading to increased investment and, subsequently, higher employment. This is what economists call equilibrium, where demand and supply are perfectly balanced. So why wasn’t this happening during the Great Depression? Classical economists believed that some form of market distortion, such as fiscal or monetary policy, must have been at play. Keynes, however, argued that the distortion they sought was not the result of policy but an inherent feature of economies themselves. While it might be simplistically argued that free markets will eventually find the prized equilibrium, Keynes believed that economies could get stuck along the way, like a climber snagged on a ledge. He summarized this idea in his best-known quote: “The long run is a misleading guide to current affairs. In the long run we are all dead.” The central idea of Keynes’ The General Theory is that the level of employment is not determined by the price of labor but by the aggregate demand in the economy. This marked a departure from classical schools of thought, which assumed that supply would naturally generate demand. Keynes observed several circumstances that could disrupt this process. For example, wages tend to be “sticky,” meaning they are more easily adjusted upwards than downwards. As long as demand grows, wages can be sustained, but when demand contracts, employers are more likely to lay off workers than reduce wages. Moreover, Keynes emphasized the role of behavioral economics, noting that while thrift may be a virtue for individuals, widespread saving instead of investing can contract overall demand. One solution Keynes proposed for governments to stimulate a stagnating economy was through active spending. In hindsight, this is precisely what helped pull the U.S. out of the Great Depression. Between FDR’s New Deal and the massive government investment spurred by World War II, these actions acted like defibrillators, restarting the economic engine. Why is government spending sometimes necessary to combat deflation and high unemployment? It starts with a Keynesian concept known as the multiplier. This principle connects to another economic concept—the marginal utility of income. If someone with no money is given $1, that first dollar has a huge impact. Each additional dollar continues to have an effect, but eventually, the impact diminishes. This principle is known as the Marginal Propensity to Consume (MPC). Classical economists assumed that each new dollar would be equally likely to be saved or invested, but Keynes’ MPC demonstrates why this is not always true. In a deflationary spiral, the problem becomes how to encourage consumption when prices continue to fall. The multiplier effect shows that if you target individuals with a high MPC, you can increase overall demand. Government programs that direct funds to those most likely to spend can create a virtuous cycle, where every dollar spent by the government increases the gross domestic product (GDP) by a multiplier. For example, the 2009 American Recovery and Reinvestment Act, which allocated over $780 billion to boost economic demand, had an estimated multiplier effect ranging from 1.5 to 2.5—meaning every dollar spent could add up to $2.50 to the GDP.
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