John Maynard Keynes - Theories

In the General Theory Keynes comprehensively challenged the Classical orthodoxy. He argued that a slump was not a long-run phenomenon that we should all get depressed about and leave the markets to sort out. A slump was simply a short-run problem stemming from a lack of demand. If the private sector was not prepared to spend to boost demand, the government should instead. It could do this by running a budget deficit. When times were good again and the private sector was spending again, the government could trim its spending and pay off the debts they accumulated in the slump. The idea, according to Keynes, should be to balance your budget in the medium term, but not in the short run.

One of his best known quotes summarises this focus on short-run policies:

'In the long-run we are all dead'

So his theory was that the government should actively intervene in the economy to manage the level of demand. These policies are often known as demand management policies, aptly named since the idea of them is to manage the level of aggregate demand. If you want to impress your teachers or lecturers even further and leave them totally stunned with your intimate knowledge of Keynesian economics (!), you could even call these policies counter-cyclical demand management policies. They are termed this because the government should be doing the exact opposite to the trade cycle. When economic activity is depressed (perhaps because it had been reading too much Classical economics!) the government should spend more, and when the economy is booming the government should spend less.

We can see these policies on the diagram below:

If aggregate demand in low (AD1) then the government should pursue reflationary policies such as cutting taxes or boosting government spending to push aggregate demand higher and boost employment and output. However, if aggregate demand is too high (AD4) and causing demand-pull inflation then the government should pursue deflationary policies. These may include increasing taxes or cutting government spending to reduce demand.

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