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Jul 26, 2012

Business Cycles Explained: Keynesian Theory

In the Keynesian corner, Tyler Cowen examines the Keynesian theory of the business cycle.

According to the Keynesian model, substantial economic slumps come from falling aggregate demand—the sum of overall consumption, investment, and government spending within the economy. When Aggregate Demand falls, producers of goods and services lose revenue and are forced to adjust.

How does the market handle this economic adjustment? In order for businesses to maintain profit levels, they must reduce production costs. But cost cutting is difficult because of what economists call ‘sticky wages and prices.’

Cutting wages can cut morale and, in turn, cut productivity. In the end, employers wind up cutting people altogether in order to escape the sticky situation. So stickiness translates into higher levels of unemployment. Unemployment leads to decreased spending and further depresses aggregate demand. Falling aggregate demand combines with wage stickiness, dragging the economy into systemic crisis.

Cowen awards the Keynesian model points for accurately describing real-world business fluctuations. Falling aggregate demand has paved the way to major downturns, including the Great Depression.

However, Cowen notes that aggregate demand is not the primary culprit in all crises. And when it comes to curing crises, the Keynesian model comes up short.

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