Question

Discuss how the Great Depression contributed to the development of Keynesian economics.

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Answer 1

Keynesian economics is based on the book , " The General Theory of Employment, Interest and Money" written by John M Keynes which was published in 1936 . The book was written in the backdrop of great depression the first global economic crisis of the industrial society . The great depression saw widespread unemployment in the western world which raised some serious questions about the classical macroeconomics . The Classical School could not tackle this Depression with their ideas , this gave rise to Keynesian economics .

Classical macroeconomics relied on the unfettered market mechanism to resolve the problem of unemployment. Any involuntary unemployment according to the classics is a short run phenomenon in nature and any policy to correct the situation would lead to worse economic outcome. The large scale unemployment of 1930s could not be ignored by calling it a short run phenomenon.
Keynes wrote, “In the long run we are all dead". Keynes explained unemployment as a systematic problem and prescribed policies to get away with it. Keynes' fundamental contribution was his systematic focus on demand side of a macroeconomics which was ignored by all the major economists that preceded him .

In classical formulation, aggregate demand has no role in determining unemployment. This idea is formalized by a theorem known as `Say's Law' which states that Supply creates its own demand. This means that goods produced by an agent creates equal amount of income and aggregate demand for goods. According to this law There can be `glut' which will be disposed only in the short run. Because demand played no role in national income determination classical macro-economics, demand management policies such as fiscal and monetary policies was not part of classical prescription to cure recession.

The biggest contribution of Keynes was to analyze the role of aggregate demand in national income determination. Once demand is shown to play a role in aggregate income determination, use of fiscal or monetary policies to cure recession logically follows. Keynes maintained that rate of interest may have a floor below which it may not drop leaving the credit market in excess supply condition . Keynes wrote that investment depends on the “animal spirit of man" and therefore there is no a priori reason that aggregate demand, of which investment constitutes a major part, is always equal to the aggregate supply.