Game of Theories: The Keynesians [STARTS AT 1:02] TYLER: Let's start with the Keynesians. Keynesian economics is named after John Maynard Keynes, a British economist who, in 1936, wrote a very famous book called "The General Theory of Employment, Interest and Money." In Keynesian economics there's one key idea, and it's called aggregate demand. So this is very different from the doctrine of real business-cycle theory where the key problem is supply. Now, if you understand this idea of aggregate demand, you'll see, as we get to why Keynesians tend to favor activist monetary and fiscal policy. But first, let's work through aggregate demand just a bit. Let's break it down into its component parts, "C" plus "I" plus "G" plus "Net Exports." That's consumption plus investment plus government spending plus how much we're selling abroad to other countries on net. Those pieces of the puzzle -- that's how much flow of expenditure or aggregate demand there is to sustain labor hires in a given period. That is what, in the Keynesian model, keeps people at work. Now, there's a key assumption here. In the Keynesian model, typically, nominal wages are sticky. Think of a wage as just another price. It's the price of labor. In a typical market, if demand falls then the price falls and the market clears. If that were true in the labor market, a drop in aggregate demand would mean wage cuts, not people losing jobs. But wages aren't like many other prices. They don't always adjust so quickly, hence we say they are "sticky." Why is that? Well, there may be a long-term contract. There may be a law, such as the Minimum Wage Law. Or sometimes it's just worker morale. So how does that work then? Well, if the flow of aggregate demand expenditure into an economy slows down because wages cannot be cut, well, then workers have to be laid off, and that will lower the flow of aggregate demand expenditure all the more because there's lower employment, lower production, less being consumed, less being invested. The key example here -- it really is the Great Depression in the 1930s. Starting in 1929, a lot of American banks failed, depositors lost their money -- this was before governmental guarantees -- the money supply fell by about a third, and the stock market crashed. So there was less consumer spending and less investment. This led to a Great Depression and high levels of unemployment. More recently, the Great Recession of 2008 also had a significant Keynesian element. We're going to cover that in a separate video. Keep in mind in a typical Keynesian scenario, if consumption and investment are falling, usually government spending is going to end up falling as well because there's less revenue being produced in the economy, less tax revenue. And unless governments really borrow a lot, well, that's going to hurt government's ability to spend. That will be an additional negative shock to aggregate demand. So graphically, in a simple aggregate demand-- aggregate supply model, what does this look like? It's pretty straightforward. Take the aggregate demand curve and shift that back and to the left, and you will see pretty simply that output goes down in this model. Also in this setting, there may be some second-order effects. The aggregate supply curve may end up shifting back and to the left as well. For instance, imagine some laid-off workers -- they end up demoralized, or they lose their workplace contacts. In the longer run, those people are probably going to be less productive. What are the potential remedies here? Well, Keynesians tend to favor activist monetary and fiscal policies. Central banks should expand the money supply to help maintain that flow of nominal expenditure. They should lower interest rates and have easy conditions for credit. Keynesians also tend to favor a lot of government deficit spending. That is, governments should spend more, start new Public Works programs, try to put people to work, and fund these programs by borrowing money even if the revenue isn't there from the economy right now. Again, the government is doing everything possible to restore that flow of aggregate demand. [ENDS AT 5:19]