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Keynesian economics

An economic theory based on the ideas of John Maynard Keynes (1883-1946), developed in the 1930s, that assigned an important role to the state as well as to the private sector. Central elements of this theory are the failure of prices, especially wages, to adjust to clear markets; and the effect of changes in aggregate demand on real output and employment. Keynesian economics asserts that aggregate demand is the driving force in the economy; in particular, during a recession the government can boost economic activity by increasing its spending, thereby inducing private consumption and investment, Post-Keynesian economics, which prevailed in the 1960s and 1970s, emphasized the role of uncertainty, path dependence, and the effects of money on the real economy. From the early 1990s the ideas of Keynes have been further developed in New Keynesian economics which endeavours to derive them from microfoundations, in particular, assuming rational expectations for the economic agents. The standard formalization of Keynesian economics is the IS-LM model and its extensions. The IS-LM model combines the national income identity with simple behavioural rules to determine the values of output and interest rate that imply simultaneous equilibrium on the product and money market. This equilibrium is obtained assuming fixed real wages, so the labour market can be out of equilibrium. When there is unemployment the IS-LM model predicts that demand management can shift the IS curve and raise output. This view dominated policy-making through the 1950s and 1960s until the combination of high unemployment and inflation experienced in the 1970s revealed the limitations of demand management. From a theoretical perspective Keynesian economics was always criticized for the lack of microeconomic foundations for its assumptions. Macroeconomic models are now much more developed in this respect. From a policy perspective, demand management has been replaced by a more pragmatic view of the supply side of the economy and the use of the interest rate as the major policy tool.

Reference: Oxford Press Dictonary of Economics, 5th edt.