Business Cycles Explained: Keynesian Theory

Business Cycles Explained: Keynesian Theory

Simple way to think about
the Keynesian model. Keynesian, New Keynesian. But let’s boil it down to essentials. Economic downturns are very often caused
by a shortfall in aggregate demand. Aggregate demand you can think
of very crudely as spending. So more formally, aggregate demand is consumption plus
investment plus government spending. Think of that as a flow of funds, a flow of revenue directed to
producers of goods and services. Consumption plus investment
plus government spending. If aggregate demand falls, in essence, that means the flow of revenue to
producers of goods and services is also falling, or it’s lower than it
had been, or lower than we want it to be. And this creates a problem
of economic adjustment. The question, then,
is how well does an economy handle this problem of
economic adjustment. There exists an equilibrium,
to use that famous economic phrase, which has become a kind of joke. But there exists an equilibrium in
which that flow of spending falls, and at more or less the same,
time wages fall also. So even though spending is down, costs and expenses are down, and businesses can keep
on producing what they had been producing, keep output at its previous level, keep
profits at their previous level and so on. But allthough that’s
a possible equilibrium, very often that’s not what happens. This is a problem, and economists
call it price and wage stickiness. Let’s focus on wage stickiness. So if we’re talking about costs falling
for businesses, for a lot of businesses, the main costs,
especially at the margin, is labor cost. It’s hiring more people. It’s paying someone to do something. So if your revenue is falling,
to keep your same profit in real inflation adjusted terms, it’s very hard to
cut the wages of your workers, because workers don’t like
having their wages cut for reasons which may be emotional, or
we economists would call behavioral. But think of it as a problem of morale. If you’ve been working seven
years at a company, and all of a sudden your wage is cut,
you feel like you’re not valued anymore, you feel like maybe you’ll be fired. You feel you’re not treated very well. You complain about the boss,
you don’t work as hard. Maybe you create trouble, in extreme
conditions, you sabotage production. And it’s very costly for
bosses, in many situations, to cut the wages of their employees. So wages are somewhat sticky. And often if that flow of
revenue is slowing down, what will happen is the employers
lay off some of the laborers, very often the least abled ones, and
then you have increased unemployment. Those people don’t have jobs. Their expenditures fall. That, in turn, contracts revenue streams
for other parts of the economy, and you get this progressive downturn where
many different sectors at once are all shrinking or contracting or falling back,
because of this initial shortfall of aggregate demand combined with what
economists call price and wage stickiness. Particular strengths of
the Keynesian model. The first strength of the Keynesian model,
first and most obvious strength, is that it explains a good deal of
real-world business fluctuations. That is, you can go out and
look at economic history, and you find numerous important
cases where a major problem, or the major problem,
has been a shortfall in aggregate demand. The classic example, I think,
is the Great Depression. Go back to 1929 through 1932. You have a very large number of
bank failures in the United States. People essentially lose their checking
accounts, or lose part of that value. Consumer spending is much lower. There’s a big negative shock to
aggregate demand, and as a result, you end up with this
shortfall in economic output. The Keynesian model explains some parts
of the Great Depression very well. The Keynesian model has
a few major weaknesses. The first, simply, is that not all economic downturns are
caused by declines in aggregate demand. The second weakness of
the Keynesian model, is that it is often better as
a diagnosis than as a cure. So Keynesians typically recommend
activist monetary policy, or activist fiscal policy,
to get an economy out of a downturn. There’s a lot of evidence form
history that fiscal policy very often doesn’t work very well. Monetary policy, in my opinion,
is much more effective. But to advocate that
kind of monetary policy, you don’t actually need
the full Keynesian model. You can be what Scott Sumner and
I called neo-monetarists. Be a sophisticated quantity theory, and
you can pick up a lot of the better sides of the Keynesian argument without picking
up a lot of the excess theoretical baggage that is often found among
Keynesian economists. Those are not the only
criticism of Keynes, but I think they’re two of the most direct and

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About the Author: Oren Garnes


  1. you make the mistake of thinking the government HAS TO manage the economy. central planning has failed every time. it does not work. recoveries were swift when there was no govt interference.
    I didn't say only the fed is responsible for monetary manipulation. read what i write dumbass. banks used to print their own bank notes and through fractional reserve banking, they can increase credit.
    capitalism is natural and doesnt have a founder. google again.

  2. if you don't understand concepts such as unproductive vs productive jobs and limited resources, then you just dont understand economics. don't feelbad though. the world is filled with dummies like you. run for govt office. you'll fit right in

  3. how's that GM stock doing? that bailout costs the taxpayers billions and all that resulted was a transference of wealth

  4. The keynesian idea is to make up lower consumer demand or investment, by increasing government spending, but shouldn't we really try to figure out why demand is falling, probably it is falling because it was too high to begin with; do to government actions.

  5. The Keynesian prescription for getting out of a recession is for the government to borrow money and spend it. To put a finer edge on it, the prescription is not to borrow money and give it to the people to spend.

  6. The Austrian theory actually incorporates pretty much everything Prof. Cowen said, except that it also looks at problems in the structure of the economy, not simply the amount of spending. What money gets spent on is very important. Even monetary stimulus adds more distortions, as we saw in the last decade. Trying to re-inflate out of the Tech Bubble recession contributed to the housing bubble.

    "I want real growth, not a series of bubbles"-Hayek in "Keynes vs. Hayek, Round II"

  7. I think the real solution is not to print more money, which causes more economic distortions, but to make wages and prices less sticky. Its harder, especially politically, but it would be massively more effective.

  8. No, I'm a loose Objectivist. I don't worship Rand like some Objectivists do. Rand was wrong about MANY things, mainly war, homosexuality, and anarchism. She was right about fundamental ethics though.

  9. People need to help themselves and take care of themselves most of them can but people have always taken care of seniors because seniors are there parents it isn't until social security that people didn't live in an extended family situation. You do however assume that it isn't greed to have the government take from one person and give to another.

  10. I do not know anyone who literally worships greed. Then again, I probably wouldn't know a greed-shrine if I saw one.

  11. You know what? Japan has shrines to greed. I am not making this up! I went to a large shrine in Kyushu that is dedicated to the deity of fortune. He looks like a fox.

    Anyways, I am surrounded by Democrats, and they tell me that Ronald Reagan literally worshiped greed. Democrats say this so often that it must be correct.

  12. Rand's personal views on homosexuality should not be confused with objectivism. She had mentioned that people are free to do as they feel, but she personally did not approve of it. However, she did interact with many homosexuals during her lifetime. I'm not sure what her view on anarchy is. She supported a government that protects rights and enforces contracts between businesses. War is much more debateable.

  13. But if consumption falls, that just means people are saving their money, meaning they well spend their money in the future rather than the present. That is completely normal and not a market deficiency.

  14. This guy is mucking up the big picture. Business cycles happen when productivity (supply) outpaces demand (wages). This happens when wages are suppressed while you have productivity gains, or when you give businesses tax cuts, that will stimulate supply, without also stimulating demand. At that point 1 of 2 things will happen. Prices will fall, or if prices are sticky, then new debt creation must make up for the loss in demand. And thus a bubble is formed.

  15. The point is that business cycles would not happen if supply did not out pace demand. That is why we've had so many of these massive bubbles as of late. Supply siders keep making economic policies.

  16. that was only true before 1913, post 1929 the govt stepped in and tried to control the economy, not knowing that the corrections were needed, and not a bad thing. After the government stepped in, it threw all markets out of whack and promoted false signals amongst the markets.

    Keynes had the worst explanation, because his model was based on a post 1929 economy, not taking into account the damn gov't and the horribly evil federal reserve bank.

  17. Instead of trashing the Fed, maybe you ought to take a look at just how horribly unstable the market was prior to the Fed. We had endless bank panics, one right after the other. The only way we've ever made capitalism a stable economic system in this country is with Keynesian policies and with a federal reserve. All other times when those two things weren't happening, things were in a constant mess. Do a wiki search of "list of bank panics"

  18. i'm trying to determine if you're insane, a mole for the bilderburg group, or an avid MSNBC fan gone wild.

    1. your fallacy assumes that there was some massive, concerted, bank run, that occurred unanimously.

    Just a casual look at the country in 1903 will show you that there is no centralized hive like mentality of the people. the U.S. was very sparsely populated, over vast areas of land. All runs we started due to contractions, and corrections in the markets, which the FED has never stopped.

  19. Well, I guess we've all figured out that you're one of those nutty Alex Jones conspiracy theorists. Bilderburg Group? really? Next you'll tell me that the Illuminati installed invisible cameras in your toilet to spy on your bowel movements.

    A casual look at the number of bank panics we had before 1913 and the number of bank panics we had after 1913, will tell you just how incredibly effective the Fed has been. Look it up. Google is your friend.

  20. you're the nutjob. or is it when a liberal tries to aggregate that which doesn't go together, it's called "alternative statistics".

    the fed didn't even step in to do anything until 1929, and they still did not stop bank runs. google is not your friend, actually going to a library and looking up real reference material is.

  21. but the government and the fed wants people to spend spend spend 24/7. they cannot conceive that people's monetary habits might expand and contract, although money supply expands and contracts.

  22. I'm pretty sure you're using the word "aggregate" incorrectly.

    The number of bank panics from 1913 to 1929 were significantly fewer in number than the bank panics prior to 1913. Bank panics became virtually non-existent after 1929. I rest my case.

    You're right that Google can't be trusted. I hear Google is controlled by the space aliens out there in Area 51. You can't trust the stuff in the library either. Everyone knows that the free masons run libraries.

    Stay sharp, genius. 😉

  23. "Bank panics became virtually non-existent after 1929. I rest my case."

    SOURCE SOURCE SOURCE…. you can't make that statement without a source. Take your time. I'll wait.

  24. that didn't support your theory at all. you stated bank runs were non existent post 1913, and your wikipedia source said nothing about that at all.

  25. Um, you do realize that people can look at our previous comments here, right? Let's see, can you spot the difference between these two statements. 1)"you stated bank runs were non existent post 1913" and 2) "The number of bank panics from 1913 to 1929 were significantly fewer in number than the bank panics prior to 1913".

  26. no no i quoted you buddy. no need to try and go back and change your statement. and in fact, even the watered down version of what you said is not proven by your silly wikipedia article.

  27. "how horribly unstable the market was prior to the Fed." Is there really consensus opinion on this? From the reading I've done on the financial history of the US, the pre-Fed panics:
    1) were short lived;
    2) had smaller losses than those under the Fed;
    3) were closely linked with gov't action (like suspending payment in specie)

  28. Might I suggest you read more about it. For a while there, we had bank panics every other year or so. Talk about instability in the market place.

    Furthermore, I would suggest you research what came to be known as The Long Depression. It was a period of downturns from 1873-1896. In many ways, the Long Depression was harder than the Great Depression, simply because it lasted so long. The Gold backed dollar led to deflation, which kept people in debt for a generation.

  29. Keynesian theory merely explains what's happening after a form of recession has started, it ignores completely what causes the recession.

  30. I'm not a Keynesian. But your argument doesn't hold water. There were serious recessions when we had a classical system. If this system is so perfect, and doesn't cause a recession/depression from time to time over a wide span, why did Keynes even develop his general theory?

  31. You last statement isn't very well thought out. I could say, if Keynesian economics is so great, why do people have opposing views? Is every new idea a good idea? There are economic down turns in both systems, but the fix to the system in the Keynes Theory has not been proven to work. The fundamental issue with the Keynes model, is that it hampers people by leveraging more debt and increasing taxes which gives individuals less freedom. Once consumer debt is maxed out, consumers work for the bank

  32. I never said that Keynes solved the business cycle troughs. Has it smoothed out the busts? Perhaps, we may never know because we can't implement both classical and Keynesian theories at the same time. Plus, today is by no means Keynesian. Today's debt problems, both household and public, is off the charts and ridiculous. Not even Keynes would agree with this situation, we need austerity. I call for monetarism out of anything, Keynes wasn't wrong on all things.

  33. There will always be opposing viewpoints, of which I do agree with. Again, I'm not a Keynesian. I was simply stating that the market showed failures before, someone came with an idea to fix those cycles, to believe the free-market is the absolute perfect system while ignoring the externalities is foolish. Yet, the market should always be preserved. Monetarism is a great philosophy.

  34. There's one great flaw in the way the theory of effective demand is represented. Effective demand is the total amount of spending in an economy–which is not just the amount spent on goods and services. The total amount of spending(effective demand) is equal to the amount spent on goods and services(NGDP) PLUS the amount spent on assets(NAT–net asset turnover). Each transaction has two sources: income or debt. Ergo, AD=I+dD/dt=NGDP+NAT (not the AD=I=NGDP nonsense).

  35. Thank you LearnLiberty, your videos have been a great help during my final year of reading Economics. If I had one suggestion/wish, it would be to reduce the volume of the music relative to the speech!

  36. The Keynsians still cannot explain why aggregate demand will fall from time to time. I am a fervent believer in the Austrisn

  37. Austrian theory of the business cycle as there is empirical evidence to support it, and the theory covers all aspects, what causes the problem, and how to solve it.

  38. You forgot Net Exports in aggregate demand! Keynesian always shows a decrease in GDP when aggregate supply decreases too! Get your stuff straight.

  39. What causes the drop in AD initially, suddenly? This is something Keynesians can't explain! To say that then letting workers go in an attempt to correct the problem at the business level makes the problem worse denies people the means to make corrections "adjust" to the downturn. Letting people go to seek new opportunities is part of adjustment.

  40. Good point that's been dissected thoroughly by many in the Austrian camp. The brief periods of market correction are favorable to 5-10 year recessions which end up resulting in bigger busts anyways.(Japan is a good modern example). Many Keynesians believe that the problem lies in WHERE government spends, pointing to the fact that government mostly funnels the money to the equity markets and not the "real" economy, but their is historical data that suggests this is not true.

  41. Indeed. It is also important to note that the Keynesian model relies on the assumption that you can borrow and print forever without consequences.

  42. I'm not so sure of the Neo-Monetarist camp these days. Maybe a few decades ago, Milton Friedman was relevant, but Austrians have done a pretty good job convincing me otherwise these days. Thomas J. DiLorenzo wrote a piece over at Mises(dot)org called "The Friedmanite Corruption of Capitalism" which points out an obvious lack of free market practice when it came to the money itself. The FED. Turning the idea of "regulatory capture theory" which Friedmanites warn about on the bank regulators.

  43. Keynesianism is WRONG EVERY TIME for numerous reasons, among them being: They focus on government (THE Most Inefficient source of spending), they focus solely on Demand and don't account for Human Action, they ignore reality and history. This is why Krugman has never been right on anything.

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  45. "Keynesianism is WRONG EVERY TIME"
    Is economy getting better or worse today(let's say compare to 1960s)?
    Then look at the economic policies. Is it getting away from Keynesian or getting closer to Keynesian today?

  46. That, and monetary and fiscal stimulus, in their efforts to stimulate employment, cause production of outputs that end up not actually being valuable, all the while crowding out valuable investment.

  47. not necessarily. You could send the money to people who are already producing. That's called "crony capitalism" in many cases. It still has its problems.

  48. Could the fault in the keynesian model because its not divided by tax rate multiplied by an unknown constant that reduces the input of taxes? In other words (C+I+G)/X*T where taxes = X and X is an indeterminate constant that reduces the tax input to a relatively accurate denominator?

  49. The question is why does Aggregate Demand drop in the first place? Maybe the markets are saturated? Instead of artificially raising demand for existing stuff that people don't need, business must innovate and look for new things to produce. E.g. incentivizing consumers to buy a third car or a second refrigerator is going to increase demand and raise wealth on paper, but owing things that you don't really use in full is not an intrinsic raise of wealth, but a phony appearance.

  50. Keynes dropped the context of agg demand drop, ie, the agg demand rise from central (socialist) bank counterfeiting of money and credit that funds unsustainable investments that necessarily boom and bust. In capitalism there is no agg demand drop because there is no counterfeit-caused agg demand rise. See Mises' online Human Action. Two chapters on credit, etc. Richard Cantillon explained this in 1755.

  51. The fault is the evasion of individual man whose volitional mind is the basic cause of production and trade. You are lost in rationalist floating abstractions which you will then associate w/arbitrarily selected statistics. Keynes is Marx Lite.

  52. Yeah, but thats in the long run and Keynsians are quick-fix, try-any-hairbrained-govt-controlled-scheme Pragmatists. Pragmatists are disappointed idealists. Idealists are not realists. Keynsians know that Marxism is impractical but they want to see how close they can get. Its religion.

  53. Keynes failed to predict the great depression. Keynesian students thought the US economy would collapse after the war spending stopped from WWII. They thought inflation was a good thing under the Carter administration. They spoke highly of Soviet Russia's economy in 1987. Keynesians don't understand the cause of a bad economy. A drop in Aggregate Demand is the economy failing, not the cause. The problem with Demand side economics is that it ignores the other half. (Supply)

  54. I'm actually rather dissapointed in LearnLiberty's videos on business cycles.
    They seem to praise Keynsianism and criticize Austrianism.

  55. Keynsian is NOT a good diagnosis.
    It would putting a new engine in your car after you run out of gas…
    The engine wasn't working, but it wasn't because there was a problem with the engine.
    Agregate demand is down, but it doesn't address WHY agregate demand is down.

  56. Keynesian Theory has been largely discredited at this point has it not? The point is that in order for government to spend into the aggregate demand it must first confiscate that money via taxes — taking from others in the aggregate demand pool. It in effect has (at least) an equal negative affect on demand as it creates demand. 

  57. Reading this comment thread, it clearly seems like Keynesians proponents have this basic argument "you are stupid, therefore I'm right"

  58. Keynesians assume that free lunches exist in our Economy.

    It's like a physicist telling you that the law of conservation of energy is false. Would you trust that guy ?

  59. Wow this was by far the best video on Keynesian's theory I could find. I even prefer this to Kahns Academy's video 😀

    Nice job!

  60. Well, the first criticism is kinda obvious since this theory was simply designed to explain a specific type of occurrences. Just like theory of evolution is designed for explaining the complexity and variations of life forms, not why apples fall. Second objections is kinda vague and it would be better for you to elaborate. As far as I understand it, the Keynesian way is to kick-start a depressed economy but whether it will last is another question which boiler down to my final question. How is debt(and especially private but also debt) related to growth since the time of deregulation(80s)? I mean prior to the subprime mortgage crash, weren't there a lot of private household debt gone bad? And then the debt figures for public debt went significantly up after the crisis started off. Was this a consequence of austerity or temporary depression?

  61. I was told that the government is supposed to weaken the business cycle by spending in a recession and saving in a boom. The latter however never happens because it is so unpopular and that's how the government fails in applying keynesian theory.

  62. If C+I+G = d goes down for some reason. Why would more G revive it? If G grows then C+I contracts, because there is no reason why spending bureaucrats could cause productivity growth.

    Keynes was not an Economist, even though he wrote a book. He never engaged in a scientific debate on economic science, therefore he was not an economist.

  63. The Great Depression was not caused by the "excesses" of the 1920's. The 1920's is a reflection of capitalism working and government sitting at bay. It is when the government got involved by, can't think of his name right now, the president before Roosevelt and FD Roosevelt that caused the Great Depression (GD). The Federal Reserved contracted the money supply by a third, FD Roosevelt outlawed gold, and every time the economy was rebounding and adjusting, FDR and his Congress created another government program. The 1920's represented capitalism and the 1930's represented socialism. Fortunately, for the socialists and democrats, they were able to degrade and nullify the constitution that would have saved those who experienced the GD by allowing the ignorant to vote. In short, they got what they deserved but those who knew better got screwed and knew FDR was a fu*ktard, typical, heartless socialist just like the tyrant in Venezuela, Hitler, and the communists of China's MAO, the current Xi who is killing many, and Stalin to name a few. We, the conservatives, are those opposing such tyrants by the love of patriotism and good natured people that manifests through the USA constitution and the ingeniousness of the USA founders/architects/T. Jefferson.

  64. He's just wrong about the fall in prices and wages. We had price deflation before the Fed and the result was an increase in real wages with lower prices and economic growth. And people have the audacity to say that this was a bad economic time when the reality was economic growth, not depressions.

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