Understanding the Keynesian Theory of Employment

The Keynesian Theory of Employment, also known as Keynesian economics or Keynesianism, is an economic theory developed by the British economist John Maynard Keynes in the 1930s. It fundamentally changed how economists and policymakers viewed the functioning of market economies, particularly during economic downturns. Learn the Keynesian Theory of Employment and understand why aggregate demand is key to economic stability and full employment. Explore the policies and concepts that shaped modern economic thought.

During the Great Depression of the 1930s, the existing economic theory could not explain the reasons for the severe worldwide economic downturn or offer an adequate public policy solution to revive employment. British economist John Maynard Keynes spearheaded a revolution in economic thinking. In this blog, we will cover the Keynesian Theory of Employment.

Content

• Who Was John Maynard Keynes?
• What is the Keynesian Theory of Employment?
• Keynes Theory and the Great Depression
• Key Elements to Achieve Full Employment
• Critics of the Keynes Theory

Who Was John Maynard Keynes?

John Maynard Keynes was a British economist (1883 – 1946), born in Cambridge, England, and educated at Eton College and King’s College, Cambridge, UK.

“The General Theory of Employment, Interest, and Money” was among the emote note-worthy works of Keynes. It was published in 1936.

Two significant developments shaped Keynes' professional journey:

• Emergence of Economics as an Independent Discipline: Economics emerged as an independent discipline of study during Keynes' early career, moving from being a branch of Philosophy.
• The Great Depression: The economic collapse of the 1930s profoundly influenced Keynes' thinking and the central focus of his work.

Keynes is famous for his pioneering theory on the short-term behavior of national economies. He described how governments can intervene in an economic downturn with fiscal and monetary policies to achieve a more stable and desirable situation.

Keynes also sat as a member of the House of Lords, representing the Liberal Party, and participated in major international economic conferences, where he shaped policy discussions and influenced global economic thinking. He died in 1946.

Keynes challenged the classical economic theory, which believed in the automated nature of markets and the ability of the economy to reach full employment equilibrium automatically. He reasoned that in a market economy, fluctuations in aggregate demand may lead to persistent unemployment and economic instability.

What is the Keynesian Theory of Employment?

The Keynesian Theory of Employment is a macroeconomic theory of output, employment, and income.

In his book “The General Theory of Employment, Interest, and Money,” John Maynard Keynes put forth his ideas on economic management.  Keynes developed a theory on the short-term behavior of a country’s economy and studied the measures that should be taken to reach a more desirable situation. 

Keynes suggests that the aggregate demand in the economy primarily determines the level of employment. Aggregate demand comprises consumption, investment, government spending, and net exports. Keynes emphasized the role of investment as a driver of economic activity, as changes in investment can have a multiplier effect on income and employment.

Keynes Theory and the Great Depression (1929–1939) 

The Great Depression started in 1929, and the economy declined in 1933. The real GDP plunged nearly 30%. Real per capita disposable income sank by almost 40%. Over 12 million people were terminated from work, and the unemployment rate shot up from 3% in 1929 to 25% in 1933. Some 85,000 businesses failed, and hundreds of thousands of families lost their homes. By 1933, approximately half of all mortgages on all owner-occupied townhouses were delinquent (Wheelock, 2008).

There was no agreement among the leading economists of the time about what was happening.

According to Keynes, the 1929 crisis had reduced demand, and it was necessary to stimulate it somehow, generating additional demand to pull production. The non-interventionist measures of the capitalist states had not achieved this objective. Therefore, he advocated for an active intervention of the State that would restore the balance between supply and demand.

Let us move to the next section to understand his proposal to achieve full employment.

Key Elements to Achieve Full Employment

According to Keynes, the most crucial variable in economic performance is employment. He believed that actions are required from various fronts to achieve full employment. Here are some of the key elements:

Fiscal Policy

Keynes advocated using fiscal policy to stimulate aggregate demand. Increased government spending can boost demand in an economic downturn, leading to higher employment levels. 

Monetary Policy

Keynes emphasizes the value of monetary policy for economic management. He suggests that central banks should manipulate interest rates to influence investment and consumption. Lowering interest rates can decrease borrowing costs and encourage businesses and individuals to invest and spend, thereby boosting employment.

Public Investment

Keynes believes that public investment can help foster economic growth and employment. Government-funded infrastructure projects and other construction projects like roads, bridges, buildings, hospitals and schools can create jobs directly and indirectly, generating additional economic activity.

Wage Policies

Keynes highlighted the importance of wages in determining employment levels. He proposed that policies should be in place to ensure fair wages, which can enhance workers’ purchasing power, leading to increased demand and job creation.

Social Safety Nets

Keynes suggests that social safety nets (non-contributory assistance to improve the lives of the financially vulnerable) can help protect individuals during recessions and high unemployment. Unemployment benefits, welfare programs, and job retraining initiatives can support the affected and thus reduce the negative impact of unemployment.

International Trade and Exchange Rates

Keynes acknowledged the impact of international trade and exchange rates on employment. He advocated for policies that promote balanced trade and cooperation among nations to avoid protectionist measures that could harm employment opportunities.

Critics of the Keynes Theory

The Keynesian theory of employment and its policy recommendations have faced criticism from various economists. Let us discuss some of the most common criticisms of Keynesian theory:

1. Inflation: One criticism is that Keynesian policies can lead to inflationary pressures. Critics argue that excessive government spending or loose monetary policy may overstimulate aggregate demand and increase prices.
2. Government Intervention: Some critics argue that Keynesian economics depends too much on government intervention. Their POV is that excessive government involvement can lead to inefficiencies, distortions, and unintended consequences.
3. Crowding Out Effect: Critics argue that increased government spending, particularly when financed through borrowing, can crowd out private investment, further increasing interest rates and making it more expensive for businesses to borrow and invest.
4. Rational Expectations: Critics contend that Keynesian policies may not have the desired effects if people anticipate the policy measures and adjust their expectations and behaviour accordingly.
5. Long-Term Effects: Some critics argue that Keynesian policies may focus on short-term demand stimulation. They suggest that it is crucial to promote productivity, innovation, and investment in productive capacity to achieve sustained economic growth.
6. Political Feasibility: Critics argue that the timing and effectiveness of fiscal and monetary measures can be difficult to determine political feasibility, and it can be challenging to coordinate policies across different economic sectors.

Please note that these criticisms do not dismiss the entire Keynesian framework but offer alternative perspectives and a heads-up. Such theories must be debated occasionally and adapted as per the dynamic circumstances.

Conclusion

Keynes’ ideas significantly impacted economic thought and policy-making, especially during the Great Depression of the 1930s. His advocacy for active government intervention to manage the economy and promote full employment laid the foundation for what became known as Keynesian economics.

Keynes’ work also influenced the establishment of international economic institutions, such as the International Monetary Fund (IMF) and the World Bank, to promote global economic stability and development.

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