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THE KEYNESIAN REVOLUTION: THE CASE FOR POLICY ACTIVISM

The classical doctrine and its laissez-faire policy prescriptions were almost universally accepted by economists and policymakers until the time of the Great Depression. Then the massive and prolonged unemployment that characterized the industrialized world challenged the predictions of the classical model.

The term "depression" was coined to describe a severe recession. The Great Depression lived up to its name. In 1929, when it began, unemployment stood at 3.2 percent. By 1933, when the economy hit bottom, the unemployment rate had risen to almost 25 percent. During the same period, the economy's output of goods and services (real GDP) fell by more than 25 percent. Moreover, in 1939, ten years after the depression began, unemployment still exceeded 17 percent, and GDP had barely edged back to the levels achieved a decade earlier. Clearly, the classical belief that any unemployment would be moderate and short-lived seemed in direct conflict with reality.

The most forceful critic of the classical model was John Maynard Keynes, a British economist. His major work, entitled The General Theory of Employment, Interest, and Money, was first published in 1936. In a sense, Keynes stood classical economics on its head. Whereas the classical economists believed that supply created its own demand, Keynes argued that causation ran the other way—from demand to supply. In Keynes's view, businesses base their production decisions on the level of expected demand, or expected total spending. The more that consumers, investors, and others plan to spend, the more output businesses will expect to sell and the more they will produce. In other words, supply (or output) responds to demand—not the converse, as the classical economists suggested. Most important, Keynes argued that the level of total spending in the economy could be inadequate to provide full employment, that the classical economists were wrong in believing that interest rate adjustments and wage/price flexibility would prevent unemployment. According to Keynes, full employment is possible only when the level of total spending is adequate. If spending is inadequate, unemployment will result.

In summary, Keynes rejected the classical contention that market economies automatically tend toward full employment; he focused attention on the level of demand or total spending as the critical determinant of an economy's health. We now turn to a more detailed look at his model and the errors he detected in the classical theory.

 
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