Aggregate Spending (Simple Keynesian Model)

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John Maynard Keynes

Adam Smith believed that a market economy has a self-correcting mechanism. Although recessions do occur, Adam Smith believed that the invisible hand will be able to automatically make the necessary adjustments and move the economy out of a recession. Hence there is no need for government intervention to deal with such problems.

The great depression of 1929 was a deep and prolonged period of decline in GDP, and significant unemployment without any signs of recovery in sight. Adam Smith's (classical) theory did not seem to provide an explanation and answer to the problems at hand. It was in this environment that John Maynard Keynes criticized the classical theory and presented his alternative view. He believed that the market economy is functional for most parts but fails to respond adequately and in a timely fashion to decline in demand, which in turn may lead to occurrence of recessions and depressions in the economy. He believed that under such circumstances the government needs to step in and, with the help of fiscal and monetary policies, stimulate the economy out of the recession. In this part we will discuss the foundation of the Keynesian theory and its implications.