Keynesian economics: the basics


If you are are looking for a simple, jargon-free explanation of Keynesian economics and the debate on what government should do about the recession, you've come to the right place. It will still be hard work if you haven't studied this stuff (it's not the easiest concept in the world), but you certainly don't need an economics degree or advanced training to understand any of it.

The central Keynesian insight is this: when you decide to hoard some extra cash rather than spend it, income in the rest of the economy goes down by the exact same amount, which then has a knock-on effect on your income. A recession ensues: a period when we work and produce less than we would like, and as a result get paid less too.

To illustrate the point while keeping things simple, let's say there are just two people in the world - me and you. This is an unrealistically small economy, but as we will see, the basic lesson applies to economies of any size.

In this make believe world, I make £100 a week by selling bread to you at £1 a loaf, and you make £100 a week by selling chocolate to me at £1 a bar.  The total income in this economy (its Gross Domestic Product or GDP) is £200, which corresponds to 100 loaves of bread and 100 bars of chocolate.

Now, let's say that one fine day you decide to save £20 out of your £100 and keep it in cash. As a result, my income falls to £80, and the total income in the economy is now £180 - with the economy producing 20 chocolate bars fewer than before. In the following week, I only have £80 to spend, which means that your income also falls to £80, and you end up buying fewer of my loaves. 

In the end, both our incomes are lower, and we produce and consume less than our potential. Our economy is in recession.


How does this carry forward to the real, larger, economy? Just think of me and you as blocks of people: essentially, when too many individuals decide to increase their cash holdings simultaneously - perhaps because they turn pessimistic about the future - a recession ensues.  As Paul Krugman puts it beautifully (in mild economese):

The key to Keynes’s contribution was his realization that liquidity preference — the desire of individuals to hold liquid monetary assets — can lead to situations in which effective demand isn’t enough to employ all the economy’s resources.

So, this is how a recession starts; the question is, how can we climb back out of it?

Our first option is to do nothing. If you paid close attention to the story above, you will have noticed that despite the slump in demand (you now only demand 80 loaves of bread rather than 100), I kept my price fixed at £1 per loaf. But I would really like to sell more bread to you because I can then have more income. Eventually I will start lowering my prices so that I can go back to selling all 100 loaves I can produce.

By exactly the same logic, you will do the same and we will be back where we started - producing at our full potential of 100 loaves of bread and 100 bars of chocolate. Recession kaput.

And here's where the difference between neoclassical and Keynesian economics lies.

The former school of thought assumes that the adjustment process is instantaneous: if you decide to hold £20 extra in cash, neoclassical economics assumes that we both immediately lower our prices to £0.80 so that nothing real changes: the economy keeps producing (and consuming) 100 loaves and 100 bars of chocolate, and there's never any recession.

(This is not strictly true. Neoclassical economics doesn't say GDP can never fall - to stick with our example, you might fall sick and not be able to work, or decide to work less because you want to spend time with the kids, leading to less chocolate, bread and incomes all round. What you can't have with neoclassical economics, however, is a demand-driven recession: a fall in economic activity simply because too many people decide to increase their cash holdings and consume less at a point in time)



Recessions, then, are generally self-correcting: prices will eventually adjust, and the economy will go back to producing at potential. And while this offers some consolation, we would still like to lessen the pain by either avoiding or speeding up the process of adjustment.

In our simple example, there is an obvious solution. Let's say that when you first made your decision to hold £20 in cash rather than spend it to buy my loaves, the government printed an extra £20 and used it to buy my unsold produce. My income at the end of that week would be £100 just as it was before, and because my income is your income (remember, I spend my income on your chocolate bars and you spend yours on my loaves) the economy doesn't go through a period of under-producing at all. There is no recession, there is no need for a lengthy period when prices adjust, and we happily keep producing at our potential.

This is as far as our simple story will take us. Recessions can ensue for as silly a reason as people wanting to hold more cash, and the government can in principle take action to correct the situation.




If you found this post worthwhile, let me know and I will build on this basic story to cover the action government can take (fiscal and monetary policy), the complications that arise in practice, and the role of banks and financial markets.



by datacharmer | Tuesday, October 06, 2009
  | | Keynesian economics: the basics @bluematterblogtwitter

22 comments:

  1. Luis Enrique Says:

    lovely post; more please.

    I think it's incredible how the economics profession still hasn't got to the bottom of whether this story is true, or not. I think your point about how 'demand shocks' don't make sense in certain breeds of neoclassical, markets-always-clear models, is crucial. When I find myself in discussions with economists who think fiscal stimulus will be ineffective, I can't shake the suspicion it's because they're thinking about an economy in which recessions like you describe just can't happen. Although I suppose even if you accept the Keynesian story of liquidity preference driven recessions, there's still lots of room for disagreement about what actually happens when the goverment decides to 1. print new money or 2. borrow existing money and spend it. On a related theme to this post, but perhaps harder to follow, I found this post about what happens when you add money to the story, by those worthwhile Canadians, very useful.

    I presume, by the way, that the people who are deciding to keep money under the mattress aren't you & I, or firms, but the banks? You & I, and firms, may decide to increase net saving, but as soon as the money finds its way into the banking system, these guys are holding on to it. Or do you think that higher money holdings outside the banking sector are important?

  2. Stephan Says:

    I disagree with your argument that we should get back to where we started (buying 100 loafs and selling 100 bars), in the belief that this would kaput the recession. The truth of the matter is that we cannot afford 100 loafs of bread. We have not been realizing that because we have lived to long in a fundamentally flawed system where credit has grown faster than our income, corporate profits or the national GDP.

    Furthermore, the recession was not caused by stashing away £20, but rather by realizing that £20 worth of purchased premium loafs turned out to be stones.

    In my view, what we really need to do is buy 80 loafs of bread for a long time and and indeed stashing away £20 to savings, because we have a long way of credit expansion to "undo".

    Also, I disagree that recessions are self-correcting. I would agree that they would be self correcting in a free market, without intervention, where vendors with bad bread or chocolate would be forced out of the market and better salesmen may overtake part of their facilities and would emerge with more market share. Your suggested consolidation may work in the medium term, with debt continuing to grow faster than income and eventually amplifying the next recession.

    Economics and world affairs are never black and white, but often fundamental decision require an either/or approach. In light of markets I would always go the Hayek approach as opposed to Keynes. I respectfully, but utterly disagree with your articles viewpoint.

    My heart will shine when I'll read a depiction of Hayek on Bluematter soon :)

  3. Cullen Mills Says:

    Like the response earlier, I agree that we don't need to continue buying 100 loafs. The problem is, we bought the "loafs" on credit. Furthermore, we are not stashing away $20 per say but instead we are using that money to pay down our debt which we used to buy the loafs yesterday. Individuals have realized that they have lived outside of their means, mostly on borrowed money, and cannot continue down this path. And what the government is essentially saying is, "If you're not going to spend your money, we will do it for you." Keep in mind that the only source of revenue for the government is either taxes or borrowed money. Both hinder economic growth down the line. The biggest issue I have the Keynesian train of thought is that Keynesians say the government should grow in size when the private sector shrinks and vice versa. The problem with that is that government never decreases in size but only grows in both the good times and bad.

  4. Anonymous Says:

    More like this please datacharmer!

  5. datacharmer Says:

    Luis Enrique - Banks don't change the basic story at all. Keeping with the example I used, assume both I and you only had costs of £80, so when we made £100 we had a profit of £20 which we put in the bank (bank deposits across our deposits: £40), with the bank lending it out or whatever. So, we have total consumption=£200, and total savings=£40, so GDP=240.

    Now, when you decide to save an extra £20, the profits that you deposit in the bank grow to £40. At the same time, I am now only earning £80 while still having costs of £80, so my profits fall to £0. So in the aggregate, consumption=£180 and savings=£40, so GDP=220. That's a fall of twenty units compared to the previous period.

    I'm not saying that banking does not complicate this story; I'm just saying that it's in not necessary to tell it.

  6. Luis Enrique Says:

    thanks! I think I was trying to get at something else .... which was that it's not terribly plausible that recessions are caused by households suddenly deciding to incease their cash holdings or that's an important part of what goes on (during this recession, for instance, I may have cut my borrowing and raised my saving, but the quantity of cash I carry in my wallet has not changed - would data show an increase in cash-on-hand outside banks, I wonder?) but it is easy to understand how banks rebuilding their reserves has the effect of stuffing cash under the mattress. I'm suggesting that where the "liquidity preference" takes place is within the banks, not because I think it changes the story, just because I find it easier to believe.

    I'm not sure about your latest amendment to the story - you're not really keeping track of what happens to the money once it's lent out. Have to think on it.

  7. Stef Says:

    Here is Ron Paul on Larry King from 10/29/2009 giving a number of examples why Keynes' principles have not worked in the past and won't in the future.

    http://www.youtube.com/watch?v=1Hn6ad4_FzM
    "Central economic planing in anything fails, and especially in medicine it fails."

    Where is the eagerly expected article on the basics of Hayek?

  8. Anonymous Says:

    yay, the economy is saved! never mind the fact that £20 magically appeared out of nowhere. and that, assuming there to be £200 in the economy, my £100 and your £100, then £20 magically appeared, increasing the total money in the economy to £220, a 10% increase in the total amount of money in the economy. This reduces the value of each unit of currency so that £1 before the government intervention is worth about £.91 afterwards. welcome to inflation!!!

    not to mention the issue that the individual held back £20, and lost 1.82 as a result, which could encourage that individual to withhold more money in the future.

  9. Anonymous Says:

    I think there is a failure when we talk aout the economy and fail to describe the boundaries in terms of being national or international.

    In Australia the former Rudd government gave out a "stimulus" package of $1000 to all households. Where did this money go? mainly on LCD + plasma TVs and other consumer items. These weren't manufactured in Australia, so only a portion of that $1000 remained in Australia. You could argue that the cost of shop staff, edlivery staff, wholesaler staff, etc (all the middlemen) benefitted but the majority of the $1000 went overseas.

    For a stimulus package such as that done in Australia, the perfect/pure benefit would have come if the full $1000 amount had remained in Australia.

  10. Nicole Says:

    THANK YOU for providing this in plain English. My university course thought it'd be a great idea to throw all the non-economics students into the deep end.

  11. Anonymous Says:

    Thank you. This was most helpful for those who are thrown into the deepened on a Metternich they do not understand.
    Just to correct one thing... The stimulus package was only $900 and I think the big picture was to "stimulate the economy" which it did. You say plasma screens when that was not the case at all. In any event it worked and the Australian economy rode the storm that was the recession quite well. Just my view.

  12. Anonymous Says:

    Brilliant!

    I'm pretty new to Economics thanks to me mainly teaching myself, and Keynesian Economics have been interesting me for a while, it's nice to find someone putting it in plain English!

  13. UII OFFICIAL Says:

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  14. Anonymous Says:

    If you print 20 more euros each one becomes less valuable! It's simple supply and demand! The market will still adjust their prices to be lower.

  15. Anonymous Says:

    holy moly, i love your simple writing style, please write more

  16. Anonymous Says:

    love how simple this is, please write more

  17. Anonymous Says:

    For me, the central issue with Keynesian economics is the definition of hoarding. Are we to believe that monetary wealth is really hoarded? It's not kept under mattresses. If personal funds aren't spent in the open market, it's often invested in the market, which stimulates growth. At the very least it's put into a basic bank savings for a minimum amount of interest earnings. But the interest earned comes from the bank's profit from interest earned on lending, which also amounts to economic growth. I'm no economic major, so point out where I'm wrong and please give a more specific definition of hoarding.

  18. Anonymous Says:

    thank you so much! this is an incredible post. it made it so much simpler for a high school student like me to understand a complicated econonomics concept. keep doing wht you are doing man :)

  19. Anonymous Says:

    Great article

  20. Anonymous Says:

    Thank you so very much! While this is a very simplified explanation of Keynesian Economics, it helped me understand the basic premises. Thank you, thank you!

  21. Anonymous Says:

    I thought this was great. Reading the is principle from my textbook didn't make any sense, but I had a question. Sine you said the government could print more money to replace the 20 pounds you lost, wouldn't it cause the value of the currency to depreciate?

  22. datacharmer Says:

    Thanks - glad you found this useful.

    Currency wouldn't depreciate in this simple example because prices have remained the same (not to mention that this was defined as a closed economy to begin with).

    The point you are making would be relevant if you decide to spend the £20 you saved at the same time as the government spending an extra £20 - in that case we would have higher prices and (in an open economy) a depreciating currency.