Keynesian Economics

The Great Depression challenged the classical prescription to wait until markets adjust and full employment is automatically restored. As the unemployment rate rose to 24.9 percent in 1933, people asked how long it takes for the market mechanism to adjust. John Maynard Keynes responded with this famous saying, "In the long run we are all dead." Keynes and his book, The General Theory, attacked classical theory and in the process revolutionized macroeconomic thought.

Using fiscal policy to affect aggregate demand is a cornerstone of Keynesian economics. While Keynesians believe monetary policy is often not very powerful, especially during a downturn, they perceive fiscal policy as their "top banana." However, Keynesians recognize that one of the potential problems of fiscal policy is the crowding-out effect. Financing a federal deficit by borrowing competes with private borrowers for funds. Given a fixed money supply, the extra demand from the federal government to finance its deficit causes the interest rate to rise. As a result, businesses cut back on investment spending and offset the expected increase in aggregate demand. The Keynesian view, however, is that the investment demand curve is not very sensitive to changes in the interest rate and therefore only a relatively small amount of investment spending will be crowded out. Thus, the decline in investment only slightly counteracts or offsets an increase in aggregate demand created by a deficit.

Conclusion: Keynesians view the shape of the investment demand curve as rather steep or vertical, so the crowding-out effect is insignificant.