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The Theory of Spending in the Economy

Keynesian Theory

What is Keynesian Theory?

This is a theory that was developed by the British Economist John Maynard Keynes during the 1930s in order to understand the Great Depression, which was the longest recession of the 20th century. The theory mainly focuses in the total spending in the economy and hoe it would affect inflation.

Keynes believed that the increase of government spending and the lowering of taxes would stimulate demand and pull the global economy out of the depression. It was coined the Keynesian Theory because it was used to refer to the concept that the economy could achieve peak performance and could prevent economic collapses by influencing aggregate demand.

Key Concepts of Keynesian Economics

According to the Keynesian Theory, the changes that occur in demand, may it be expected or not, have the greatest short-run effect on real output and employment and not on the price of goods.

In developing this theory, Keynes argued that saving and investment are not the main factors of interest rates, especially in the short run. The supply and demand for the stock of money determines interest rates in the short run.

Keynes suggested that, because of the fear of losing capital on assets that is beyond money, Keynes thought that this might cause a “Liquidity trap” setting a floor in which interest rates cannot fall.

The erratic effect of the Great Depression put this theory in great tests but it proves to show that structural stubbornness and certain characteristics of the market economies would eliminate economic weakness and cause total demand to plunge deeper.

While in this “trap” the increase of interest rates will be abnormally slow. If there are any increase in the supply of money, bond holders will sell their bonds in order to gain more money.

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