Keynesian economics ( /ˈkeɪnziən/ KAYN-zee-ən; also called Keynesianism and Keynesian

theory) is a macroeconomic theory based on the ideas of 20th century English economist John
Maynard Keynes. Keynesian economics argues that private sector decisions sometimes lead to
inefficient macroeconomic outcomes and therefore advocates active policy responses by the
public sector, including monetary policy actions by the central bank and fiscal policy actions by
the government to stabilize output over the business cycle.[1] The theories forming the basis of
Keynesian economics were first presented in The General Theory of Employment, Interest and
Money, published in 1936; the interpretations of Keynes are contentious, and several schools of
thought claim his legacy.

Keynesian economics advocates a mixed economy—predominantly private sector, but with a

large role of government and public sector—and served as the economic model during the later
part of the Great Depression, World War II, and the post-war economic expansion (1945–1973),
though it lost some influence following the stagflation of the 1970s. The advent of the global
financial crisis in 2007 has caused a resurgence in Keynesian thought. The former British Prime
Minister Gordon Brown, former President of the United States George W. Bush, President
Barack Obama, and other world leaders have used Keynesian economics through government
stimulus programs to attempt to assist the economic state of their countries.[2][3]

Contents
[hide]

 1 Overview
 2 Precursors
o 2.1 Schools
o 2.2 Concepts
 3 Keynes and the classics
o 3.1 Wages and spending
o 3.2 Excessive saving
o 3.3 Active fiscal policy
o 3.4 "Multiplier effect" and interest rates
 4 Postwar Keynesianism
o 4.1 Main theories
 5 Criticism
o 5.1 Monetarist criticism
o 5.2 New classical macroeconomics criticism
o 5.3 Austrian School criticism
o 5.4 Methodological disagreement and different results that emerge
 6 Keynesian responses to the critics
 7 See also
 8 References
 9 Further reading
  10 External links

[edit] Overview
According to Keynesian theory, some microeconomic-level actions—if taken collectively by a
large proportion of individuals and firms—can lead to inefficient aggregate macroeconomic
outcomes, where the economy operates below its potential output and growth rate. Such a
situation had previously been referred to by classical economists as a general glut. There was
disagreement among classical economists (some of whom believed in Say's Law—that "supply
creates its own demand"), on whether a general glut was possible. Keynes contended that a
general glut would occur when aggregate demand for goods was insufficient, leading to an
economic downturn resulting in losses of potential output due to unnecessarily high
unemployment, which results from the defensive (or reactive) decisions of the producers. In such
a situation, government policies could be used to increase aggregate demand, thus increasing
economic activity and reducing unemployment and deflation. Most Keynesians advocate an
activist stabilization policy to reduce the amplitude of the business cycle, which they rank among
the most serious of economic problems. This does not necessarily mean fine-tuning, but it does
mean what might be called 'coarse-tuning.' For example, when the unemployment rate is very
high, a government can use a dose of expansionary monetary policy.

Keynes argued that the solution to the Great Depression was to stimulate the economy
("inducement to invest") through some combination of two approaches: a reduction in interest
rates and government investment in infrastructure. Investment by government injects income,
which results in more spending in the general economy, which in turn stimulates more
production and investment involving still more income and spending and so forth. The initial
stimulation starts a cascade of events, whose total increase in economic activity is a multiple of
the original investment.[4]

A central conclusion of Keynesian economics is that, in some situations, no strong automatic

mechanism moves output and employment towards full employment levels. This conclusion
conflicts with economic approaches that assume a strong general tendency towards equilibrium.
In the 'neoclassical synthesis', which combines Keynesian macro concepts with a micro
foundation, the conditions of general equilibrium allow for price adjustment to eventually
achieve this goal. More broadly, Keynes saw his theory as a general theory, in which utilization
of resources could be high or low, whereas previous economics focused on the particular case of
full utilization.

The new classical macroeconomics movement, which began in the late 1960s and early 1970s,
criticized Keynesian theories, while New Keynesian economics has sought to base Keynes' ideas
on more rigorous theoretical foundations.

Some interpretations of Keynes have emphasized his stress on the international coordination of
Keynesian policies, the need for international economic institutions, and the ways in which
economic forces could lead to war or could promote peace.[5]
[edit] Precursors
Keynes' work was part of a long-running debate within economics over the existence and nature
of general gluts. While a number of the policies Keynes advocated (notably government deficit
spending) and the theoretical ideas he proposed (effective demand, the multiplier, the paradox of
thrift) were advanced by various authors in the 19th and early 20th century, Keynes's unique
contribution was to provide a general theory of these, which proved acceptable to the political
and economic establishments.

[edit] Schools

See also: Underconsumption, Birmingham School (economics), and Stockholm school

(economics)

An intellectual precursor of Keynesian economics was underconsumption theory in classical

economics, dating from such 19th century economists as Thomas Malthus, the Birmingham
School of Thomas Attwood,[6] and the American economists William Trufant Foster and Waddill
Catchings, who were influential in the 1920s and 1930s. Underconsumptionists were, like
Keynes after them, concerned with failure of aggregate demand to attain potential output, calling
this "underconsumption" (focusing on the demand side), rather than "overproduction" (which
would focus on the supply side), and advocating economic interventionism. Keynes specifically
discussed underconsumption (which he wrote "under-consumption") in the General Theory, in
Chapter 22, Section IV and Chapter 23, Section VII.

Numerous concepts were developed earlier and independently of Keynes by the Stockholm
school during the 1930s; these accomplishments were described in a 1937 article, published in
response to the 1936 General Theory, sharing the Swedish discoveries.[7]

[edit] Concepts

The multiplier dates to work in the 1890s by the Australian economist Alfred De Lissa, the
Danish economist Julius Wulff, and the German American economist Nicholas Johannsen,[8] the
latter being cited in a footnote of Keynes.[9] Nicholas Johannsen also proposed a theory of
effective demand in the 1890s.

The paradox of thrift was stated in 1892 by John M. Robertson in his The Fallacy of Savings, in
earlier forms by mercantilist economists since the 16th century, and similar sentiments date to
antiquity:[10][11]

Today these ideas, regardless of provenance, are referred to in academia under the rubric of
"Keynesian economics", due to Keynes's role in consolidating, elaborating, and popularizing
them.

[edit] Keynes and the classics

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Keynes sought to distinguish his theories from and oppose them to "classical economics," by
which he meant the economic theories of David Ricardo and his followers, including John Stuart
Mill, Alfred Marshall, Francis Ysidro Edgeworth, and Arthur Cecil Pigou. A central tenet of the
classical view, known as Say's law, states that "supply creates its own demand". Say's Law can
be interpreted in two ways. First, the claim that the total value of output is equal to the sum of
income earned in production is a result of a national income accounting identity, and is therefore
indisputable. A second and stronger claim, however, that the "costs of output are always covered
in the aggregate by the sale-proceeds resulting from demand" depends on how consumption and
saving are linked to production and investment. In particular, Keynes argued that the second,
strong form of Say's Law only holds if increases in individual savings exactly match an increase
in aggregate investment.[12]

Keynes sought to develop a theory that would explain determinants of saving, consumption,
investment and production. In that theory, the interaction of aggregate demand and aggregate
supply determines the level of output and employment in the economy.

Because of what he considered the failure of the “Classical Theory” in the 1930s, Keynes firmly
objects to its main theory—adjustments in prices would automatically make demand tend to the
full employment level.

Neo-classical theory supports that the two main costs that shift demand and supply are labor and
money. Through the distribution of the monetary policy, demand and supply can be adjusted. If
there were more labor than demand for it, wages would fall until hiring began again. If there was
too much saving, and not enough consumption, then interest rates would fall until people either
cut their savings rate or started borrowing.
[edit] Wages and spending

During the Great Depression, the classical theory defined economic collapse as simply a lost
incentive to produce, and the mass unemployment as a result of high and rigid real wages.[citation
needed]

To Keynes, the determination of wages is more complicated. First, he argued that it is not real
but nominal wages that are set in negotiations between employers and workers, as opposed to a
barter relationship. Second, nominal wage cuts would be difficult to put into effect because of
laws and wage contracts. Even classical economists admitted that these exist; unlike Keynes,
they advocated abolishing minimum wages, unions, and long-term contracts, increasing labor-
market flexibility. However, to Keynes, people will resist nominal wage reductions, even without
unions, until they see other wages falling and a general fall of prices.

He also argued that to boost employment, real wages had to go down: nominal wages would
have to fall more than prices. However, doing so would reduce consumer demand, so that the
aggregate demand for goods would drop. This would in turn reduce business sales revenues and
expected profits. Investment in new plants and equipment—perhaps already discouraged by
previous excesses—would then become more risky, less likely. Instead of raising business
expectations, wage cuts could make matters much worse.

Further, if wages and prices were falling, people would start to expect them to fall. This could
make the economy spiral downward as those who had money would simply wait as falling prices
made it more valuable—rather than spending. As Irving Fisher argued in 1933, in his Debt-
Deflation Theory of Great Depressions, deflation (falling prices) can make a depression deeper
as falling prices and wages made pre-existing nominal debts more valuable in real terms.

[edit] Excessive saving

To Keynes, excessive saving, i.e. saving beyond planned investment, was a serious problem,
encouraging recession or even depression. Excessive saving results if investment falls, perhaps
due to falling consumer demand, over-investment in earlier years, or pessimistic business
expectations, and if saving does not immediately fall in step, the economy would decline.

The classical economists argued that interest rates would fall due to the excess supply of
"loanable funds". The first diagram, adapted from the only graph in The General Theory, shows
this process. (For simplicity, other sources of the demand for or supply of funds are ignored
here.) Assume that fixed investment in capital goods falls from "old I" to "new I" (step a).
Second (step b), the resulting excess of saving causes interest-rate cuts, abolishing the excess
supply: so again we have saving (S) equal to investment. The interest-rate (i) fall prevents that of
production and employment.

Keynes had a complex argument against this laissez-faire response. The graph below
summarizes his argument, assuming again that fixed investment falls (step A). First, saving does
not fall much as interest rates fall, since the income and substitution effects of falling rates go in
conflicting directions. Second, since planned fixed investment in plant and equipment is mostly
based on long-term expectations of future profitability, that spending does not rise much as
interest rates fall. So S and I are drawn as steep (inelastic) in the graph. Given the inelasticity of
both demand and supply, a large interest-rate fall is needed to close the saving/investment gap.
As drawn, this requires a negative interest rate at equilibrium (where the new I line would
intersect the old S line). However, this negative interest rate is not necessary to Keynes's
argument.

Third, Keynes argued that saving and investment are not the main determinants of interest rates,
especially in the short run. Instead, the supply of and the demand for the stock of money
determine interest rates in the short run. (This is not drawn in the graph.) Neither changes
quickly in response to excessive saving to allow fast interest-rate adjustment.
Finally, because of fear of capital losses on assets besides money, Keynes suggested that there
may be a "liquidity trap" setting a floor under which interest rates cannot fall. While in this trap,
interest rates are so low that any increase in money supply will cause bond-holders (fearing rises
in interest rates and hence capital losses on their bonds) to sell their bonds to attain money
(liquidity). In the diagram, the equilibrium suggested by the new I line and the old S line cannot
be reached, so that excess saving persists. Some (such as Paul Krugman) see this latter kind of
liquidity trap as prevailing in Japan in the 1990s. Most economists agree that nominal interest
rates cannot fall below zero. However, some economists (particularly those from the Chicago
school) reject the existence of a liquidity trap.

Even if the liquidity trap does not exist, there is a fourth (perhaps most important) element to
Keynes's critique. Saving involves not spending all of one's income. It thus means insufficient
demand for business output, unless it is balanced by other sources of demand, such as fixed
investment. Thus, excessive saving corresponds to an unwanted accumulation of inventories, or
what classical economists called a general glut.[13] This pile-up of unsold goods and materials
encourages businesses to decrease both production and employment. This in turn lowers people's
incomes—and saving, causing a leftward shift in the S line in the diagram (step B). For Keynes,
the fall in income did most of the job by ending excessive saving and allowing the loanable
funds market to attain equilibrium. Instead of interest-rate adjustment solving the problem, a
recession does so. Thus in the diagram, the interest-rate change is small.

Whereas the classical economists assumed that the level of output and income was constant and
given at any one time (except for short-lived deviations), Keynes saw this as the key variable that
adjusted to equate saving and investment.

Finally, a recession undermines the business incentive to engage in fixed investment. With
falling incomes and demand for products, the desired demand for factories and equipment (not to
mention housing) will fall. This accelerator effect would shift the I line to the left again, a
change not shown in the diagram above. This recreates the problem of excessive saving and
encourages the recession to continue.

In sum, to Keynes there is interaction between excess supplies in different markets, as

unemployment in labor markets encourages excessive saving—and vice-versa. Rather than
prices adjusting to attain equilibrium, the main story is one of quantity adjustment allowing
recessions and possible attainment of underemployment equilibrium.

[edit] Active fiscal policy

This section does not cite any references or sources.

Please help improve this article by adding citations to reliable sources. Unsourced material may be
challenged and removed. (March 2009)

As noted,[clarification needed] the classicals wanted to balance the government budget. To Keynes, this
would exacerbate the underlying problem: following either policy[clarification needed] would raise
saving (broadly defined) and thus lower the demand for both products and labor. For example,
Keynesians see Herbert Hoover's June 1932 tax increase as making the Depression worse.[citation
needed][clarification needed]

Keynes′ ideas influenced Franklin D. Roosevelt's view that insufficient buying-power caused the
Depression. During his presidency, Roosevelt adopted some aspects of Keynesian economics,
especially after 1937, when, in the depths of the Depression, the United States suffered from
recession yet again following fiscal contraction. But to many the true success of Keynesian
policy can be seen at the onset of World War II, which provided a kick to the world economy,
removed uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas became
almost official in social-democratic Europe after the war and in the U.S. in the 1960s.

Keynes′ theory suggested that active government policy could be effective in managing the
economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated what
has been called countercyclical fiscal policies, that is policies which acted against the tide of the
business cycle: deficit spending when a nation's economy suffers from recession or when
recovery is long-delayed and unemployment is persistently high—and the suppression of
inflation in boom times by either increasing taxes or cutting back on government outlays. He
argued that governments should solve problems in the short run rather than waiting for market
forces to do it in the long run, because "in the long run, we are all dead."[14]

This contrasted with the classical and neoclassical economic analysis of fiscal policy. Fiscal
stimulus (deficit spending) could actuate production. But to these schools, there was no reason to
believe that this stimulation would outrun the side-effects that "crowd out" private investment:
first, it would increase the demand for labor and raise wages, hurting profitability; Second, a
government deficit increases the stock of government bonds, reducing their market price and
encouraging high interest rates, making it more expensive for business to finance fixed
investment. Thus, efforts to stimulate the economy would be self-defeating.

The Keynesian response is that such fiscal policy is only appropriate when unemployment is
persistently high, above the non-accelerating inflation rate of unemployment (NAIRU). In that
case, crowding out is minimal. Further, private investment can be "crowded in": fiscal stimulus
raises the market for business output, raising cash flow and profitability, spurring business
optimism. To Keynes, this accelerator effect meant that government and business could be
complements rather than substitutes in this situation. Second, as the stimulus occurs, gross
domestic product rises, raising the amount of saving, helping to finance the increase in fixed
investment. Finally, government outlays need not always be wasteful: government investment in
public goods that will not be provided by profit-seekers will encourage the private sector's
growth. That is, government spending on such things as basic research, public health, education,
and infrastructure could help the long-term growth of potential output.

A Keynesian economist might point out that classical and neoclassical theory does not explain
why firms acting as "special interests" to influence government policy are assumed to produce a
negative outcome, while those same firms acting with the same motivations outside of the
government are supposed to produce positive outcomes. Libertarians counter that because both
parties consent, free trade increases net happiness, but government imposes its will by force,
decreasing happiness. Therefore firms that manipulate the government do net harm, while firms
that respond to the free market do net good. Theoretically, in a democracy, the populace consents
to or refutes government policy through elections and could thereby be considered a consenting
party not subjected unilaterally to the government's will.

In Keynes' theory, there must be significant slack in the labor market before fiscal expansion is
justified. Both conservative and some neoliberal economists question this assumption, unless
labor unions or the government "meddle" in the free market, creating persistent supply-side or
classical unemployment.[clarification needed] Their solution is to increase labor-market flexibility, e.g.,
by cutting wages, busting unions, and deregulating business.

Contrary to some critical characterizations of it, Keynesianism does not consist solely of deficit
spending. Keynesianism recommends counter-cyclical policies to smooth out fluctuations in the
business cycle. An example of a counter-cyclical policy is raising taxes to cool the economy and
to prevent inflation when there is abundant demand-side growth, and engaging in deficit
spending on labor-intensive infrastructure projects to stimulate employment and stabilize wages
during economic downturns. Classical economics, on the other hand, argues that one should cut
taxes when there are budget surpluses, and cut spending—or, less likely, increase taxes—during
economic downturns. Keynesian economists believe that adding to profits and incomes during
boom cycles through tax cuts, and removing income and profits from the economy through cuts
in spending and/or increased taxes during downturns, tends to exacerbate the negative effects of
the business cycle. This effect is especially pronounced when the government controls a large
fraction of the economy, and is therefore one reason fiscal conservatives advocate a much
smaller government.

[edit] "Multiplier effect" and interest rates

Main article: Spending multiplier

Two aspects of Keynes' model had implications for policy:

First, there is the "Keynesian multiplier", first developed by Richard F. Kahn in 1931.
Exogenous increases in spending, such as an increase in government outlays, increases total
spending by a multiple of that increase. A government could stimulate a great deal of new
production with a modest outlay if:

1. The people who receive this money then spend most on consumption goods and save the
rest.
2. This extra spending allows businesses to hire more people and pay them, which in turn
allows a further increase consumer spending.

This process continues. At each step, the increase in spending is smaller than in the previous
step, so that the multiplier process tapers off and allows the attainment of an equilibrium. This
story is modified and moderated if we move beyond a "closed economy" and bring in the role of
taxation: the rise in imports and tax payments at each step reduces the amount of induced
consumer spending and the size of the multiplier effect.
Second, Keynes re-analyzed the effect of the interest rate on investment. In the classical model,
the supply of funds (saving) determined the amount of fixed business investment. That is, since
all savings was placed in banks, and all business investors in need of borrowed funds went to
banks, the amount of savings determined the amount that was available to invest. To Keynes, the
amount of investment was determined independently by long-term profit expectations and, to a
lesser extent, the interest rate. The latter opens the possibility of regulating the economy through
money supply changes, via monetary policy. Under conditions such as the Great Depression,
Keynes argued that this approach would be relatively ineffective compared to fiscal policy. But
during more "normal" times, monetary expansion can stimulate the economy.[citation needed]

[edit] Postwar Keynesianism

Main articles: Neo-Keynesian economics, New Keynesian economics, and Post-Keynesian
economics

Keynes's ideas became widely accepted after WWII, and until the early 1970s, Keynesian
economics provided the main inspiration for economic policy makers in Western industrialized
countries.[15] Governments prepared high quality economic statistics on an ongoing basis and
tried to base their policies on the Keynesian theory that had become the norm. In the early era of
new liberalism and social democracy, most western capitalist countries enjoyed low, stable
unemployment and modest inflation, an era called the Golden Age of Capitalism.

In terms of policy, the twin tools of post-war Keynesian economics were fiscal policy and
monetary policy. While these are credited to Keynes, others, such as economic historian David
Colander, argue that they are rather due to the interpretation of Keynes by Abba Lerner in his
theory of Functional Finance, and should instead be called "Lernerian" rather than "Keynesian".
[16]

Through the 1950s, moderate degrees of government demand leading industrial development,
and use of fiscal and monetary counter-cyclical policies continued, and reached a peak in the "go
go" 1960s, where it seemed to many Keynesians that prosperity was now permanent. In 1971,
Republican US President Richard Nixon even proclaimed "we are all Keynesians now".[17]
However, with the oil shock of 1973, and the economic problems of the 1970s, modern liberal
economics began to fall out of favor. During this time, many economies experienced high and
rising unemployment, coupled with high and rising inflation, contradicting the Phillips curve's
prediction. This stagflation meant that the simultaneous application of expansionary (anti-
recession) and contractionary (anti-inflation) policies appeared to be necessary, a clear
impossibility. This dilemma led to the end of the Keynesian near-consensus of the 1960s, and the
rise throughout the 1970s of ideas based upon more classical analysis, including monetarism,
supply-side economics[17] and new classical economics. At the same time Keynesians began
during the period to reorganize their thinking (some becoming associated with New Keynesian
economics); one strategy, utilized also as a critique of the notably high unemployment and
potentially disappointing GNP growth rates associated with the latter two theories by the mid-
1980s, was to emphasize low unemployment and maximal economic growth at the cost of
somewhat higher inflation (its consequences kept in check by indexing and other methods, and
its overall rate kept lower and steadier by such potential policies as Martin Weitzman's share
economy).[18]

Currently, multiple schools of economic thought exist that trace their legacy to Keynes, notably
Neo-Keynesian economics, New Keynesian economics, and Post-Keynesian economics. Keynes'
biographer Robert Skidelsky writes that the post-Keynesian school has remained closest to the
spirit of Keynes' work in following his monetary theory and rejecting the neutrality of money.[19]
[20]

In the postwar era Keynesian analysis was combined with neoclassical economics to produce
what is generally termed the "neoclassical synthesis", yielding Neo-Keynesian economics, which
dominated mainstream macroeconomic thought. Though it was widely held that there was no
strong automatic tendency to full employment, many believed that if government policy were
used to ensure it, the economy would behave as neoclassical theory predicted. This post-war
domination by Neo-Keynesian economics was broken during the stagflation of the 1970s. There
was a lack of consensus among macroeconomists in the 1980s. However, the advent of New
Keynesian economics in the 1990s, modified and provided microeconomic foundations for the
neo-Keynesian theories. These modified models now dominate mainstream economics.

Post-Keynesian economists on the other hand, reject the neoclassical synthesis, and more
generally, neoclassical economics applied to the macroeconomy. Post-Keynesian economics is a
heterodox school which holds that both Neo-Keynesian economics and New Keynesian
economics are incorrect, and a misinterpretation of Keynes's ideas. The Post-Keynesian school
encompasses a variety of perspectives, but has been far less influential than the other more
mainstream Keynesian schools.

[edit] Main theories

The two key theories of mainstream Keynesian economics are the IS-LM model of John Hicks
and the Phillips curve; both of these are rejected by Post-Keynesians.

It was with John Hicks that Keynesian economics produced a clear model which policy-makers
could use to attempt to understand and control economic activity. This model, the IS-LM model
is nearly as influential as Keynes' original analysis in determining actual policy and economics
education. It relates aggregate demand and employment to three exogenous quantities, i.e., the
amount of money in circulation, the government budget, and the state of business expectations.
This model was very popular with economists after World War II because it could be understood
in terms of general equilibrium theory. This encouraged a much more static vision of
macroeconomics than that described above.[citation needed]

The second main part of a Keynesian policy-maker's theoretical apparatus was the Phillips curve.
This curve, which was more of an empirical observation than a theory, indicated that increased
employment, and decreased unemployment, implied increased inflation. Keynes had only
predicted that falling unemployment would cause a higher price, not a higher inflation rate. Thus,
the economist could use the IS-LM model to predict, for example, that an increase in the money
supply would raise output and employment—and then use the Phillips curve to predict an
increase in inflation.[citation needed]

[edit] Criticism
[edit] Monetarist criticism

One school began in the late 1940s with Milton Friedman. Instead of rejecting macro-
measurements and macro-models of the economy, the monetarist school embraced the
techniques of treating the entire economy as having a supply and demand equilibrium. However,
because of Irving Fisher's equation of exchange, they regarded inflation as solely being due to
the variations in the money supply, rather than as being a consequence of aggregate demand.
They argued that the "crowding out" effects discussed above would hobble or deprive fiscal
policy of its positive effect. Instead, the focus should be on monetary policy, which was
considered ineffective by early Keynesians.

Monetarism had an ideological as well as a practical appeal: monetary policy does not, at least
on the surface, imply as much government intervention in the economy as other measures. The
monetarist critique pushed Keynesians toward a more balanced view of monetary policy, and
inspired a wave of revisions to Keynesian theory.

[edit] New classical macroeconomics criticism

See also: Lucas critique

Another influential school of thought was based on the Lucas critique of Keynesian economics.
This called for greater consistency with microeconomic theory and rationality, and particularly
emphasized the idea of rational expectations. Lucas and others argued that Keynesian economics
required remarkably foolish and short-sighted behavior from people, which totally contradicted
the economic understanding of their behavior at a micro level. New classical economics
introduced a set of macroeconomic theories which were based on optimising microeconomic
behavior. These models have been developed into the Real Business Cycle Theory, which argues
that business cycle fluctuations can to a large extent be accounted for by real (in contrast to
nominal) shocks.

[edit] Austrian School criticism

Austrian economist Friedrich Hayek criticized Keynesian economic policies for what he called
their fundamentally collectivist approach, arguing that such theories encourage centralized
planning, which leads to malinvestment of capital, which is the cause of business cycles.[21]
Hayek also argued that Keynes' study of the aggregate relations in an economy is fallacious, as
recessions are caused by micro-economic factors. Hayek claimed that what starts as temporary
governmental fixes usually become permanent and expanding government programs, which
stifle the private sector and civil society.
Other Austrian school economists have also attacked Keynesian economics. Henry Hazlitt
criticized, paragraph by paragraph, Keynes' General Theory.[22] Murray Rothbard accuses
Keynesianism of having "its roots deep in medieval and mercantilist thought."[23]

[edit] Methodological disagreement and different results that emerge

Beginning in the late 1950s neoclassical macroeconomists began to disagree with the
methodology employed by Keynes and his successors. Keynesians emphasized the dependence
of consumption on disposable income and, also, of investment on current profits and current cash
flow. In addition Keynesians posited a Phillips curve that tied nominal wage inflation to
unemployment rate. To buttress these theories Keynesians typically traced the logical
foundations of their model (using introspection) and buttressed their assumptions with statistical
evidence.[24] Neoclassical theorists demanded that macroeconomics be grounded on the same
foundations as microeconomic theory, profit-maximizing firms and utility maximizing
consumers.[24]

The result of this shift in methodology produced several important divergences from Keynesian
Macroeconomics:[24]

1. Independence of Consumption and current Income (life-cycle permanent income

hypothesis)
2. Irrelevance of Current Profits to Investment (Modigliani-Miller theorem)
3. Long run independence of inflation and unemployment (natural rate of unemployment)
4. The inability of monetary policy to stabilize output (rational expectations)
5. Irrelevance of Taxes and Budget Deficits to Consumption (Ricardian Equivalence)

[edit] Keynesian responses to the critics

The heart of the 'new Keynesian' view rests on microeconomic models that indicate that nominal
wages and prices are "sticky," i.e., do not change easily or quickly with changes in supply and
demand, so that quantity adjustment prevails. According to economist Paul Krugman, "while I
regard the evidence for such stickiness as overwhelming, the assumption of at least temporarily
rigid nominal prices is one of those things that works beautifully in practice but very badly in
theory."[25] This integration is further spurred by the work of other economists which questions
rational decision-making in a perfect information environment as a necessity for micro-economic
theory. Imperfect decision making such as that investigated by Joseph Stiglitz underlines the
importance of management of risk in the economy.

Over time, many macroeconomists have returned to the IS-LM model and the Phillips curve as a
first approximation of how an economy works. New versions of the Phillips curve, such as the
"Triangle Model", allow for stagflation, since the curve can shift due to supply shocks or changes
in built-in inflation. In the 1990s, the original ideas of "full employment" had been modified by
the NAIRU doctrine, sometimes called the "natural rate of unemployment." NAIRU advocates
suggest restraint in combating unemployment, in case accelerating inflation should result.
However, it is unclear exactly what the value of the NAIRU should be—or whether it even
exists.
The Crash of 2008 led to a revival of interest in and debate about Keynes. Keynes's biographer,
Robert Skidelsky, wrote a book entitled Keynes: The Return of the Master.[26] Other books about
Keynes published immediately following the Crash were generally favorable.[27]