Key points

  • The Keynesian prescription for stabilizing the economy implies government intervention at the macroeconomic level—increasing aggregate demand when private demand falls and decreasing aggregate demand when private demand rises.
  • This does not, however, imply that the government should be passing laws or regulations that set prices and quantities in microeconomic markets.

The Keynesian perspective on market forces

Ever since the birth of Keynesian economics in the 1930s, controversy has simmered over the extent to which government should play an active role in managing the economy. In the aftermath of the human devastation and misery of the Great Depression, many people—including many economists—became more aware of vulnerabilities within the market-oriented economic system. Some supporters of Keynesian economics advocated a high degree of government planning in all parts of the economy.
However, Keynes himself was careful to separate the issue of aggregate demand from the issue of how well individual markets worked. He argued that individual markets for goods and services were appropriate and useful but that sometimes that level of aggregate demand was just too low.
When 10 million people are willing and able to work but one million of them are unemployed, Keynes argued, individual markets may be doing a perfectly good job of allocating the efforts of the nine million workers—the problem is that insufficient aggregate demand exists to support jobs for all 10 million. Thus, he believed that—while government should ensure that overall level of aggregate demand is sufficient for an economy to reach full employment—this task did not imply that the government should attempt to set prices and wages throughout the economy nor take over and manage large corporations or entire industries directly.
Even if one accepts the Keynesian economic theory, a number of practical questions remain. In the real world, can government economists identify potential GDP accurately? Is a desired increase in aggregate demand better accomplished by a tax cut or by an increase in government spending? Given the inevitable delays and uncertainties as policies are enacted into law, is it reasonable to expect that the government can implement Keynesian economics? Can fixing a recession really be just as simple as pumping up aggregate demand?
The Keynesian approach, with its focus on aggregate demand and sticky prices, has proved useful in understanding how the economy fluctuates in the short run and why recessions and cyclical unemployment occur. But, there are shortcomings in the Keynesian approach that make it not especially well-suited for long-run macroeconomic analysis.
 

Summary

  • The Keynesian prescription for stabilizing the economy implies government intervention at the macroeconomic level—increasing aggregate demand when private demand falls and decreasing aggregate demand when private demand rises.
  • This does not, however, imply that the government should be passing laws or regulations that set prices and quantities in microeconomic markets.