The Basics of Keynesian Economics

The basics of Keynesian economics are built on the premise that the state should intervene in the markets to smooth over the cracks.

Keynesian economics is a theory attributed to John Keynes (1883 - 1946), an economist from the United Kingdom. It was his uncomplicated explanation for the origin of the Great Depression for which he is famous for. His economic theory was built on the premise that money flowed in a circular pattern. His ideas caused a good deal of interventionist policies in the Great Depression.

The Basics of Keynesian Economics:

Keynes theory is that active government involvement in the open market and monetary policy is the finest technique of guaranteeing economic expansion and stability. A follower of Keynesian economics believes it is the states position to level out the humps and bumps in business cycles. Intervention would be in the shape of government spending as well as tax breaks to kick start the economy and government expenditure cuts and tax hikes in good economic times, to control inflation.

This essentially means that when you decide to save some spare cash rather than fritter it away by spending it, earnings in the remainder of the economy reduces by the precise same amount, which subsequently has a direct effect on your income. A recession then develops.

To demonstrate the point in a simplistic form, let's imagine there are only two people in the world, you and your friend. This is not a realistic economy however the basic example can be applied to any size of economy.

You make €100 a week by selling milk to your friend at €1 a bottle, and he makes €100 a week because you buy chocolate from him at €1 a bar. The entire income in this economy (its Gross Domestic Product or GDP) is €200, which corresponds to 100 bottles of milk and 100 bars of chocolate.

One day you make a decision to save €20 out of your €100 and hold it in cash. Consequently, my income falls to €80, and the sum income in the economy is now €180, and the economy produces 20 chocolate bars less than before. In the subsequent week, I only have €80 to spend, hence your takings also fall to €80, and you buy a smaller amount of my milk. 

In the end, you and your friend’s incomes are smaller and you are producing and consuming less than is potentially possible. Your economy has fallen into recession.
So now we have a recession but how do we get out of it? Well the neoclassical free market thinking is that you simply do nothing and the forex market will correct itself. In our example you will reduce the price of milk until you are selling 100 bottles again. Your friend does the same and he is now selling 100 bars of chocolate again. The recession is over.

However, this doesn’t happen overnight and could take a while, months even years. So Keynes advocates intervention by the state. Say the state printed €20 and bought your unsold produce, then you would be back to a monthly income of €100 and so would your friend because your income is his income. Full production is immediate therefore no recession and no reduction in GDP.

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