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Keynesian Economic Theory

Exploring the governments' roles during economic recession

What is Keynesian Economic Theory?

Keynesian Economic Theory is an economic school of thought that broadly states that government intervention is needed to help economies emerge out of recession. The idea comes from the boom-and-bust economic cycles that can be expected from free-market economies and positions the government as a “counterweight” to control the magnitudes of these cycles.

The theory was developed by British economist John Maynard Keynes (1883-1946) in the 1940s. Keynes is also well known for his work on wartime economics and helped spur the creation of the International Monetary Fund (IMF) and the World Bank.

 

John Keynes: Keynesian Economic Theory
John M. Keynes (Source: Biography Online)

 

Government intervention

According to Keynesian Economic Theory, there are three main metrics that governments should closely monitor: interest rates, tax rates, and social programs.

 

Interest rates

Interest rates, or the cost of borrowing money, play a crucial role in enabling economic prosperity.

During times of prosperity (or “boom” cycles), Keynesian Economic Theory argues that central banks should increase interest rates in order to generate more income from borrowers. Controlling the magnitude of an economic boom is important since too much investment in the public and private sectors could lead to a reduction in the money supply and a severe recession as a result. Keynesian Economic Theory also prompts central and commercial banks to accumulate cash reserves off the back of interest rate hikes in order to prepare for future recession.

During times of recession (or “bust” cycles), the theory prompts governments to lower interest rates in a bid to encourage borrowing. Thus, investments in the private sector will help bolster output and drive the economy out of recession. Unlike in boom cycles, banks should aggressively combat the magnitude of the bust cycle in order to ensure that the economy recovers within a reasonable time frame.

 

Tax Rates

Income taxes are the government’s main source of income to finance public sector initiatives such as infrastructure, healthcare, social programs, etc.

During times of prosperity (or “boom” cycles), Keynesian Economic Theory argues that governments should increase income tax rates in order to participate in the growth of economic activity. Such times are also ideal to launch new public initiatives such as a tax system remap or healthcare system overhaul as they face a lower risk of failing. Governments may choose to introduce entirely new taxes that did not exist before in order to generate even more income from rising wages. To help supplement the initiative, governments may also offer proportionately smaller tax breaks in order to spur consumer spending and collect.

During times of economic recession (or “bust” cycles), Keynesian Economic Theory argues that governments should lower income tax rates on individuals and businesses. Thus, the private sector would have the additional financial capital to invest in projects and drive the economy forward. The hope here is that cash reserves generated during economic booms would help cushion the dip in government proceeds.

 

Social programs

During times of prosperity (or “boom” cycles), Keynesian Economic Theory argues that governments should decrease spending on social programs since they would no longer be as needed during boom cycles. Social programs aim to provide skills training to individuals in order to stimulate the labor market with an influx of skilled laborers. During prosperous economic times, the economy is thought to have a thriving labor force, thus additional investments are not necessarily needed.

During times of economic recession (or “bust” cycles), Keynesian Economic Theory argues that governments should increase spending in social programs in order to stimulate the job market with an influx of skilled labor. The thought is that a rise in the supply of skilled labor would cause wages to drop, thus enabling businesses to gain more productive employees without significant costs. Thus, the economy would be able to slowly get out of a recession through a strong labor force.

 

The table below provides a quick summary of Keynesian Economic Theory:

 

keynesian economic theory summary

 

More Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

  • Normative Economics
  • Purchasing Power Parity
  • Quantitative Easing
  • Supply and Demand

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