Keynesian Economics – UPSC Notes – Economy

Keynesian Economics is a demand-side theory emphasizing short-run economic changes. Developed in the 1930s by British economist John Maynard Keynes, it aimed to comprehend the Great Depression. This theory holds significance in the UPSC/IAS Economy syllabus under macroeconomics, explored in detail in this article.

What is Keynesian Economics?

• Keynesian economics: Macroeconomic theory explaining total economic spending and its impact on output, employment, and inflation.
• Keynesians’ belief: Prices being somewhat rigid, changes in government, investment, or consumer spending influence output.
• Example: Government expenditure rise, with other factors constant, leads to increased output.
• Keynes’ contribution: Differentiated individual economic behavior and market study from the analysis of national economic aggregate variables.
• Policy recommendation: Keynes advocated increased government spending and lower taxes to stimulate demand and lift the global economy during depression.
• Labor demand in Keynesian economics: Challenges the idea that lower wages can restore full employment, as labor demand curves slope downward like other demand curves.

Associated Factors & Principles

• Keynesian economic theory: Central tenet is government intervention for economic stabilization.
• Underlying principles:
  • Economic decisions by government and private sectors impact demand.
  • Wages and prices react slowly to changes in supply and demand.
  • Changes in demand have the greatest short-term impact on output and employment.
  • Unemployment is unfavorable due to demand fluctuations.
  • Active stabilisation policy needed to reduce business cycle volatility.
  • Unemployment prioritized over inflation.
• Keynesian Economics and Fiscal Policy:
  • Multiplier effect, by Richard Kahn, crucial in Keynesian countercyclical fiscal policy.
  • According to Keynes’ fiscal stimulus theory, increased government spending leads to heightened business activity and more spending.
  • This theory posits that spending boosts aggregate output and generates more income.
  • If workers spend extra income, resulting GDP growth could exceed the initial stimulus.
  • Fiscal multiplier: One of two broad multipliers in economics, the other being the money multiplier.
• Keynesian Economics and Monetary Policy
  • Keynesian theorists assert that economies require active intervention for quick stabilization and short-term demand boost.
  • Wages and employment respond slowly to market needs, necessitating government intervention.
  • Monetarism: A branch of Keynesian economics arising from gradual price changes due to slow response to monetary policy interventions.
  • Use of money supply and interest rates as tools to influence borrowing and lending.
  • Lowering interest rates: Government intervention to encourage consumption and investment spending.
  • Short-term demand increases: Resulting from interest rate cuts, revitalizing the economy, restoring employment, and increasing service demand.
  • Fiscal policy: Proposed if lowering interest rates proves ineffective.
  • Other interventionist policies:
    • Direct control of the labor supply.
    • Changing tax rates to indirectly influence the money supply.
    • Modifying monetary policy.
    • Restricting the supply of goods and services until employment and demand are restored.

Implementation of Keynesian Economics in India

• In India, the government is striving to break free from a vicious cycle of low economic growth.
• Systematic application of Keynesian philosophy is advocated, akin to its successful use in overcoming the 1929 Great Depression in the U.S.
• Guiding principle: Fiscal expenditure should take precedence over fiscal prudence during economic slowdowns.
• Fiscal spending injects money into the economy, enhancing consumer purchasing power and stimulating demand through the multiplier effect.
• Example in India: Implementation of the MNREGA program aligns with Keynesian principles.
• Government investments in FMCG, infrastructure, and construction sectors recommended:
  • Address structural bottlenecks in the economy.
  • High potential for job creation.
• According to Keynes, the export sector is vital for aggregate demand; ‘Make in India’ initiative addresses this.
• Emphasis on increasing productivity over output.
• Skills training domestically crucial; addressing external barriers internationally is necessary.
• Government should navigate international forums to eliminate obstacles like GSP and import tariff barriers.
• While Keynesian philosophy was designed for developed economies, it holds utility for the developing world, including the Indian economy.

Keynesian Philosophy during Covid-19

• In a post-corona world, the landscape mirrors a shattered, devastated, and fragmented post-World War environment, encompassing political, economic, and social dimensions.
• Keynesian economics emerges as a new form of capitalism in response to this context.
• Positive note: Government’s financial stimulus packages align closely with Keynesian principles, offering relief to the agricultural sector, MSMEs, street vendors, NBFCs, DISCOMs, and real estate sector.
• Focus is on increased government spending, building agro-infrastructure, and injecting more money into the hands of the people.
• India faces challenges with high unemployment, escalating poverty, and widening rural-urban divide.
• Currently, the private sector lacks capacity and desire to address these issues.
• Given dire socio-economic conditions, relying solely on private sector initiatives is insufficient to revive the country.
• Government intervention is imperative at this juncture.

Keynesian Economics vs. Classical Economics

Keynesian Economics	Classical Economics
Advocates government intervention in the business cycle, including borrowing, to boost demand.	Favors laissez-faire (let it be) policies with little to no government intervention.
In this model, demand increases supply and reduces unemployment, as more workers are required to meet increased demand.	Promotes a balanced budget while allowing an uncontrolled free market to self-regulate through the laws of supply and demand.
Prices and wages are relatively inflexible, requiring government assistance to achieve full employment.	Prices and wages are flexible, and any unemployment is considered only temporary.

Conclusion

Post-World War II, Keynesian economics dominated economic theory and policy until the 1970s. However, advanced economies faced a challenging scenario of both inflation and slow growth, termed “stagflation.” This condition eroded the appeal of Keynesian theory as it failed to provide a suitable policy response to stagflation. The global financial crisis of 2007–08 triggered a resurgence of Keynesian thinking. Nevertheless, this crisis exposed a need to revise Keynesian theory to better incorporate the role of the financial system. Addressing this gap, Keynesian economists are currently working on integrating both the real and financial sectors of the economy.

FAQs on Keynesian economics

Question: What is Keynesian economics?

Answer: Keynesian economics is an economic theory that emphasizes the importance of government intervention in the economy, particularly during economic downturns. It suggests that changes in aggregate demand significantly influence economic output and employment.

Question: What is the main idea of Keynesian economics?

Answer: The main idea of Keynesian economics is that during economic recessions, governments should actively intervene by increasing public spending and cutting taxes to boost demand, stimulate economic activity, and address unemployment.

Question: What is the opposite of Keynesian economics?

Answer: The opposite of Keynesian economics is often considered to be classical economics. Classical economists generally advocate for minimal government intervention and believe that markets can self-regulate without the need for active government involvement.

Question: Who Was John Maynard Keynes?

Answer: John Maynard Keynes was a British economist whose ideas laid the foundation for Keynesian economics. He played a crucial role in shaping economic policy during the early to mid-20th century, especially with his influential work, “The General Theory of Employment, Interest, and Money.”

Question: How does Keynesian Economics differ from Classical Economics?

Answer: Keynesian economics differs from classical economics in its approach to government intervention. While Keynesian economics suggests active government involvement to stabilize the economy, classical economics leans towards laissez-faire policies, advocating minimal government interference.

Question: What are the two main ideas of Keynesian economics?

Answer: The two main ideas of Keynesian economics are:

1. Governments should use fiscal policy, such as increased public spending and tax cuts, to manage demand and stabilize the economy.
2. The economy can experience prolonged periods of unemployment, and government intervention is necessary to address such issues.

Question: How is Keynesian economics used today?

Answer: Keynesian economics is applied today through government policies aimed at managing economic downturns. Governments use fiscal measures, like stimulus packages, to boost demand during recessions and address unemployment. However, the extent of its application varies among countries.

Question: What are the 3 major theories of economics?

Answer: The three major theories of economics are:

1. Classical Economics: Emphasizes free markets and minimal government intervention.
2. Keynesian Economics: Advocates for active government involvement, especially during economic downturns.
3. Monetarism: Focuses on the role of money supply in influencing economic activity.

Question: What is the difference between Keynesian and classical economics?

Answer: The key difference lies in their views on government intervention. Keynesian economics supports active government involvement, particularly during economic recessions, while classical economics favors minimal government intervention, relying on market self-regulation.

UPSC PYQ Prelims

Question: Which one of the following statements appropriately describes the “fiscal stimulus”? (UPSC 2011)

• (a) It is a massive investment by the Government in manufacturing sector to ensure the supply of goods to meet the demand surge caused by rapid economic growth.
• (b) It is an intense affirmative action of the Government to boost economic activity in the country.
• (c) It is Government’s intensive action on financial institutions to ensure disbursement of loans to agriculture and allied sectors to promote greater food production and contain food inflation.
• (d) It is an extreme affirmative action by the Government to pursue its policy of financial inclusion.

Answer: (b)

Question: Consider the following statements:

1. Macroeconomics is a study of individual markets of demand and supply and the players or the decision-maker seen as trying to maximise their profits (as producers or sellers) and their personal satisfaction or welfare levels (as consumers).
2. Even a large company is ‘micro’ in the sense that it has to act in the interest of its own shareholders and not necessarily in the interest of the country as a whole.

Which of the statements given above is/are correct?

• (a) 1 only
• (b) 2 only
• (c) Both 1 and 2
• (d) Neither 1 nor 2

Answer: (b)

Question: Macroeconomics as a separate branch of economics, emerged after the British economist John Maynard Keynes published his celebrated book:

• (a) The Wealth of Nations
• (b) On the Principles of Political Economy and Taxation
• (c) The Affluent Society
• (d) The General Theory of Employment, Interest and Money

Answer: (d)

UPSC PYQ Mains

• Question: Discuss the factors that have led to the recent increase in the general price level and the measures taken by the Government to Combat it. (UPSC 1990)
• Question: What are the main components of the non-Plan expenditure of the Government of India? Discuss the recent trends in the growth of this expenditure (UPSC 1989)
• Question: The phenomenon of rising prices has been largely responsible for Indian economy and planning cut of welfare; it also causes hardship to the people. What are the basic reasons for continuous inflation in India and what has been the government strategy to control it? What specific measure have been taken by the Government of India for controlling inflation. (UPSC 1981)

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