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Theorist Who Brought Economics into the Twentieth Century


Photo: The Bettmann Archive.

John Maynard Keynes (rhymes with "brains") stands with Adam Smith and Karl Marx as one of the world's most influential economists. The son of a noted British economist, Keynes amassed a fortune through specu­lation in stocks and commodities. He served the British government as a financial adviser and treas­ury official through most of his adult life and was a key par­ticipant in the negotiations fol­lowing both World Wars I and II.

Although Adam Smith had written The Wealth of Nations about the time of the American Revolution, by the 1930's little had changed in the thinking of mainstream economists. Most would have agreed with Smith, that the best thing government could do to help the economy would be to keep its

hands off. They reasoned that as long as the economy was free to operate without interference, the forces of sup­ply and demand would come into balance. Then, with total supply and demand in equilibrium, everyone looking for work could find a job at the prevailing wage, and every firm could sell its products at the market price.

But the 1930's was the period of the Great Depression. Despite the assurances of the classical economists, the fact was that unemployment and business failure had reached record proportions in the United States and the rest of the industrialized world. It was at this time (1936) that Keynes' General Theory of Employment, Interest, and Money was published. The General Theory transformed economic thinking in the 20th century, much the way that The Wealth of Nations had in the 18th.

Keynes demonstrated that it was possible for total supply and demand to be at equilibrium at a point well under full employment. What is more, Keynes demonstrated that unemployment could persist indefinitely, unless someone stepped in to increase total demand.

The "someone" Keynes had in mind was government. He reasoned that if, for example, government spent money on public works, the income received by formerly idle wor­kers would lead to increased demand, a resurgence of bus­iness activity and the restoration of full employment.

The suggestion that government abandon laissez faire in favor of an active role in economic stabilization was regarded as revolutionary in the 1930's. Since then, however, the ideas advanced by the "Keynesian Revolution" have become part of conventional wisdom. Now, whenever a nation appears to be entering into a period of recession or inflation. economists and others immediately think of steps the govern­ment might take to reverse the trend.




Reading for Enrichment

The Automatic Stabilizers


The fiscal policies we have described so far are all discre­tionary. By that we mean they are applied when some individual or group decides to use them. One of the prin­cipal drawbacks of discretionary fiscal policies is that unless they are properly timed, the measures applied to correct a contraction or inflationary expansion may arrive too late to do any good. This is not true, however, of the fiscal tools known as theautomatic stabilizers.

Automatic stabilizers are "automatic" because they go into effect when needed, without action by any representative of the President or Congress. They are "stabilizers" because they help increase spending during recessions and decrease spending during times of inflation. They do this by increas­ing government spending, or by reducing taxes, or by some combination of the two, during recessions. In times of expan­sion, when personal income and prices are rising, the auto­matic stabilizers follow an opposite course by reducing government spending and increasing taxes.

One such automatic stabilizer is the personal income tax. Dur­ing times of contraction and recession, people earn less and are, therefore, taxed at a lower rate. In this way the personal income tax provides the public with exactly what is called for during recession — a tax cut. In boom times inflation pushes wages and salaries to higher and higher levels. As this happens people are pushed into higher tax brackets. Once again, tax policy automatically works in keeping with fiscal goals by increasing taxes during inflationary times.

Another set of automatic stabilizers increases and reduces government spending, when needed, to combat recession or inflation. These are the nation's unemployment and welfare benefits. In times of recession government spending automat­ically increases as the number of those eligible to receive unemployment insurance and welfare benefits increases.

Conversely, when the economy improves, unemployment declines, and government spending for these programs is auto­matically reduced.

During periods of prosperity and high employment, taxes automatically rise, putting money into the unemployment insurance fund. This helps to reduce spending at a time when inflation is a threat and makes funds available when a reces­sion appears.



The business cycle is the pattern of periodic ups and downs of business activity. Economists often describe the cycle in terms of its four phases: boom, contraction, recession, and expansion.

Economic activity is measured by a variety of statistical measurements or economic indicators. One of these is the gross national product. When the GNP is adjusted for changes in the price level it is called the "real GNP." The unemployment rate is another frequently cited economic indicator.

In its efforts to stabilize the economy and achieve the goals set forth in the Employment Act of 1946, the federal government relies on the tools of fiscal and monetary policy.

Fiscal policies seek to adjust total demand through the appropriate use of the government's powers to tax and to spend. Fiscal policy is in the hands of the President and Congress.

Monetary policies seek to achieve similar goals by regulating the money supply. Monetary policies are determined by the Board of Governors of the Federal Reserve System.

In times of recession, fiscal policies would call for some combination of tax reductions and/or increases in government spend­ing. Monetary policies in those times would seek to increase the money supply through strategies such as the increased purchas­ing of government securities by the Open Market Committee, a lowering of the discount rate, and a reduction in the reserve ratio.

In times of inflation both fiscal and monetary policies would follow an opposite course.


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