Understand the Keynesian View on Changes in Government Spending and Taxation

Keynesians believe, based on the experience of the Great Depression, that the economy can be in equilibrium at a level of GDP that does not correspond to full employment, and that the economy can stay at that level for an extended period of time. This equilibrium can correspond to either a recession or an inflationary boom.

Because of this belief that either the economy is not self-correcting, or that the correction may take a long period of time, Keynesians also believe that government has a responsibility to manage the economy. They encourage stimulating the economy during recessionary times and slowing the economy down during booms, using a combination of fiscal and monetary policy. Let’s consider how this might work in the real world.

One criticism of early Keynesians was that they didn’t believe monetary policy was very useful. The reality is more nuanced. Keynes was the preeminent monetary economist of his generation. Indeed, before he wrote The General Theory, his magnum opus on macroeconomics/the book which founded macroeconomics, he wrote a two volume Treatise on Money. To say that he didn’t understand or believe monetary policy could be effective was simply not true. That said, he did identify a situation when expansionary monetary policy wouldn’t work. It is to that “Liquidity Trap” that we now turn.