Keynes proposed economic ideas that saved the economy during the great depression of the 1930s. He encouraged government intervention into the economy to rescue it from the excessive recession. His ideas were against previous views held by an economist that the government should allow the economy to adjust back from depression to recovery as per the business cycle. The previous economic ideas were not working during great depression because the economy was showing little signs of recovery. The depression created a huge recession gap. Thus, real GDP was quite below the full potential output (Blinder 1).
Keynes believed that aggregate demand in the economy was a summation of private and public spending. The government decisions are based on monetary and fiscal policies. The change in fiscal policy alters the aggregate demand because it either increases or reduces government spending. Keynes proposes that the government should increase its spending during the depression to replace the decreased private spending. This will create an adequate market for firms to increase investments and offer jobs to the people.
Keynes idea during the recession was for the government to expand its fiscal policy i.e. adopt the expansionary fiscal policy. The expansionary fiscal policy is expected to enable the government to start federal programs that stimulate employment and demand. Some of the popular programs are infrastructure spending and public works. The employed people spend their income on goods and services in the society. This creates a new market for commodities, and it encourages private investors to expand their production. Therefore, the economy can operate at its full potential if the government can increase aggregate demand. The economy grows upon adoption of expansionary fiscal policy because of increase in all the components of the gross domestic product. These components are consumption, investment, and government spending.
The Principal Tenets of Keynesian Theory
Private and public spending influences aggregate demand. During a recession, the private sector spending falls. The fall increases the length of recession, and government should increase its spending to replace the decreased aggregate demand (Sarwat, Mahmud, &Chris 1)
The second principle is that prices and wages respond slowly to increase in demand and supply in the market. This causes periodic surpluses and shortages for labor. The last principle is that a change in aggregate demand has the greater influence on employment and real output than on prices. This rigidity allows output to increase as a result of increased government spending. This results in the multiplier effect in the economy where the final increase in output is more than the initial increase in government spending (Blinder 1).
How the Keynesian Ideas Worked To End Depression
The United States of America did not carry out expansionary fiscal policy until the onset of world war. The war forced the federal government to increase the budget deficit. The increased spending during the war increased government purchases. This stimulated investment and production in the country.
The graph shows that aggregate demand shifted to the right in 1940, 1941 and 1942. This shift increased the demand in the economy. For example, many people who were employed to serve in the war were previously unemployed. Their salaries were spent in the economy increasing demand for goods and services. Firms responded by expanding their production. The expansion of firms created new employment opportunities. Thus, the overall number of the employed kept on increasing and the economy recovered from recession (Hubbard 55).
Blinder, Alan S. "Keynesian Economics." : The Concise Encyclopedia of Economics. Web. 15
Apr. 2016. <http://www.econlib.org/library/Enc/KeynesianEconomics.html>.
Hubbard, R. Glenn. Macro Economics. Frenchs Forest, N.S.W.: Pearson Prentice Hall, 2009.
Sarwat, Jahan, Mahmud Ahmed Saber, and Chris Papageorgiou. "What Is Keynesian
Economics? - Back to Basics - Finance & Development, September 2014." What Is Keynesian Economics? - Back to Basics - Finance & Development, September 2014. 2014. Web. 15 Apr. 2016.