What are Keynesian economics?

What is Keynes?

Keynes was born in 1883 in Cambridge, as a son of John Nevilla and Florence Ada Keynes. His father was a famous economist and linked to the university of Cambridge. One thing Keynes had in common with a lot of big economists before him – like Stuart Mill and Léon Walras – was that the economic principle was taught to him a very young age. Keynes’ mother was even more famous than his father was since she was the major of Cambridge in 1932.
On a very young age Keynes already had some sort of trade, on elementary school Keynes had someone who carried his books for him in exchange for help with homework.

Keynes went to high school in Windsor, where he was taught at Eton college. He stood out because of his talents in Maths and History. One remarkable thing was that his marks for economics have always been pretty low. Years later he explained this by saying: “I evidently knew more than my examiners.”

At the age of 15 he applied to a mathematics course at Kings College in Cambridge, but he replaced this mathematical study pretty fast by an economic one. When Keynes was 21 he was allowed to call himself ‘master’ in economics.
At first Keynes wanted to follow his father and he tried to become a fellow at the university of Cambridge. However, he really stood out and got a job at a government-based employer. The India office.

His courage and gift to solve practical problems with economic theory opened his way to a high position at the British ministry of Finance. In 1911 he became redactor at the economic journal.

Keynes was one of the main advisors for the Versailles treaty where he was one of the British Expert advisors.

Keynes resigned because he didn’t agree with the outcome of the treaty, Keynes mostly disagreed with the penalties for Germany(mostly pushed by the French, led by Clemanceau). According to Keynes the Versailles treaty wouldn’t give recovery to Germany but would rather cause a revenge-action from Germany causing another war. He wrote about this in his book: “The economic consequences of peace.”

He wrote about Clemanceau:“he was a foremost believer in the view of German psychology that the German understands and can understand nothing but intimidation (…) Therefore you must never negotiate with a German or conciliate him; you must dictate to him. On no other terms will he respect you, or will you prevent him from cheating you. (…) The European civil war is to end with France and Italy abusing their monetary victorious power to destroy Germany and Austria-Hungary now prostrate, they invite their own destruction also.”

Keynes foresaw that the recovery-payments or penalties for Germany would have a great impact on the German economy. And he was right:
In 1920 you could buy one bread for 1,20, in 1923 you had to pay 80,000,000,000 for the same bread.



After the Versailles treaty Keynes was mainly occupied doing public debates and he wrote a lot. One of the most famous works was “The end of laissez-faire” in which he writes about the free-market principle.
In 1936 Keynes gives out his highly anticipated book “The General Theory of Employment, Interest and Money”. His book was brought to the market relatively cheap and the timing of the book couldn’t be better. The world was in the middle of “The great depression”.

In this book he describes his economic theory and he knew he came up with something very important which might change the way of economic thinking; he wrote:

““ I believe myself to be writing a book on economic theory which will largely revolutionize—not, I suppose, at once but in the course of the next ten years— the way the world thinks about economic problems.” –

John Maynard Keynes

The main idea of this theory (I will talk about the theory itself in different posts) is that Keynes says that the ‘laissez-faire’ assumption is not valid. The classical economists are wrong, governments should intervene(using the multiplier effect) to make recessions less heavy. (Anti-cyclical government policy)

When the second world war breaks out he writes “How to pay for the war” in 1940. This states that governments should pay for the war by raising taxes and not by accepting debts. The British government agrees with this and does what Keynes advised them to do in 1941.

Also Keynes was involved in the set-up of the Bretton Woods system. During these talks also the IMF was founded. The Bretton Woods system stated that every country had to keep themselves to a certain value of their coin for which this coin would be transferrable to gold. This system has proven to be a success, but in the begin of the ’70s the USA couldn’t guarantee the transfer to gold anymore for their dollar.

Keynes died in 1946.


Before Keynes


Keynes made a difference by going against the most common thoughts of the ‘classical’ economists. The classical assumption – as described by Say’s law – is that the free market will work for itself (laissez-faire) and that there is no need for any government interventions.

Keynes model states that governments should intervene in the markets with an anti-cyclical government policy to make recessions less deep and booms less high. (To reduce booms and bursts. Note: Marco-economic objective is nearly always stated as ‘STABLE economic growth’)
Another difference between Keynes’ model and the classical model is that Keynes is mostly looking at the short run of the economy and the classical model is mostly looking at the long-run. This means that the production cannot change in the Keynesian model making the firms reaching market equilibrium by changing the price only.

The Keynesian economics acknowledges three different stages within the economy:

- Overdemanding; this is where the AD is bigger than the production capacity. During these periods inflation regulation is becoming more important since the AD being higher than the production capacity will lead to more demand for (skilled) workers (raising wages and cost-based inflation) and it will lead to more demand-based inflation. The ‘overdemanding period’ may be cut into two parts. The part where the AD is going up within this period is called a hausse and the part where AD is going down is called recession(officialy it is only called a recession if there is a negative growth for two executive quarters).
- Balance of demand; this is where the AD equals production capacity.
- Underdemanding; this is where the AD is smaller than the production capacity. You may also divide this in two parts. When the AD is going down within the ‘Underdemanding period’ it is called a depression and when the AD is going up within this period it is called recovery.



Normally we look at two kinds of Keynesian models before going to the most difficult version, but that’s not what we are doing now. Keynesian model describes a certain amount of money flows.



Note: The X and M flow might seem to be in the wrong way but this graph describes money flows and not the flow of goods.

The Keynesian model is modeled by a few formula’s; to keep it quite simple:

1) AD=Y
2) AD= C+I+G+X-M
3) C=c*Yd +Co
4) Yd= Y-T
5) T=tY
6) I=Io
7) G=Go
8) X=Xo
9) M=mY

Note: The small letters show ‘quotes’, they represent the amount of the income that is being used to – for example – consume.
Note: Yd = Disposable income

If we substitute the formula’s we will get to a resulting complete formula :

AD=Y= c(Y-tY)+Co+Io+Go+Xo-mY

Let’s take some numbers to show the workings. c = 0,5 ; t= 0,2 ; m=0,2; Co = 50; Io = 10 ; Oo = 25 ; Xo= 15

Y=0,5(Y-0,2Y)+50+10+25+15-0,2Y
Y=0,5(0,8Y)+100-0,2Y
Y=0,4Y+100-0,2Y
Y=0,2Y+100
0,8Y=100
Y=(10/8)*100
Y=125 billion (Point where the green line cuts the blue line in coming picture)

Now there is this very important idea within the Keynesian theory of the multiplier effect, the only thing this actually states is that when I invest 10 million the AD will –ceteris paribus – go up for 10 million in the first place.
But the company receiving the order will also invest some of this money itself because the company is making extra profits. Let’s say it invests 1million extra because of this order. This on itself will raise the AD again with 1 million.
The AD has risen with 11 million already as a result of a basic investment of 10 million, this is describes as the multiplier.

Just imagine that the company that received the 1 million order does not reinvest anything extra, so that the total increase in AD will equal 11 million. Now to calculate the multiplier the only thing we have to do is fill in this formula:

Multiplier= Change in AD/ Change in variable.

Our variable in this story has been I(investments), this has changed 10 million. The AD has changed 11 million making the multiplier 11/10 = 1,1

There is a way in modeling the multiplier effect, and of course with a certain formula.




Lets go back to our previous example(The one with the Y=125 billion outcome) and change the Investments by 15 billion to 25 billion.
This would give us:

AD=Y= c(Y-tY)+Co+Io+Go+Xo-mY
Y=0,5(Y-0,2Y)+50+25+25+15-0,2Y
Y=0,5(0,8Y)+115-0,2Y
Y=0,4Y+115-0,2Y
Y=0,2Y+115
0,8Y=115
Y=(10/8)*115
Y=143,75 billion. (the point where the black line crosses the blue line in the coming picture)

The result is an increase of 18,75 billion as a result of an increase of investments of 15 billion. In our formula for the multiplier this would lead to a multiplier of 1,25

However, there are more sophisticated ways in calculating the multiplier. I won’t go through the mathematical prove of it. But you might also want to use this formula for the multiplier.

1/((1-c)+tc+m) = 1/((1-0,5)+0,2*0,5+0,2 = 1/(0,8) = 1,25

Note: This may not be used for changes in all variables! A change in the Import variable has the formula -1/((1-c)+tc+m and a change in the Taxes uses even another formula.

So what is understood with the Keynesian economics? Keynesian economics use an economic model that is mainly influenced by the idea that ‘laissez-faire’ does not work. The government interventions are more strong than originally thought because of the multiplier effect. This still is very actual, on what basis are countries currently pumping a lot of money into the economy…?