During the Great Depression of the 1930s, unlike classical economists who believed in self-recovery, Keynes argued for the necessity of government intervention. What impact did his theory of effective demand have on the economy?
In the 1930s, the world was plunged into a severe economic depression known as the Great Depression, suffering greatly. In response, classical economists, who formed the mainstream of the economics community at the time, believed that all economic flows would be autonomously regulated according to the laws of supply and demand, and that the economy would naturally recover. They thought that artificial market intervention would only worsen the situation. Keynes, however, held a different view. He believed the root cause of chronic economic stagnation lay in a ‘shortage of demand’ stemming from reduced income. Consequently, Keynes advocated the ‘theory of effective demand’, arguing that governments should implement artificial demand expansion policies by cutting taxes and increasing spending to boost national income and investment.
Keynes’ theory sent shockwaves through the economics community of the time. This was because, while traditional economic theory emphasized the market’s self-adjustment, Keynes stressed the active role of government. He warned that the economy might fail to find equilibrium autonomously and fall into long-term stagnation, arguing that government must actively intervene to prevent this. Keynes’s theory later became the foundation of modern macroeconomics and significantly influenced various policies, particularly those emphasizing the importance of government fiscal policy during economic downturns.
For simplicity, let’s consider a simplified economy consisting only of households, businesses, and financial markets. Businesses require labor to produce goods, and households provide this labor, generating income for the households in the process. Households then consume this income to purchase necessary goods. If households spent all their earned income on goods, income would always equal consumption. However, in the real world, households do not immediately consume all their earned income. The portion of household income not consumed is inevitably saved, and this saved portion is withdrawn from the circular flow of income and consumption. Of course, the money leaked into savings does not just sleep under household mattresses or pillows. Households deposit their savings into the financial market, and businesses receive this investment to purchase production factors.
Keynes believed that if investment consistently falls short of savings, the economy would sink into chronic stagnation. When people increase savings and reduce consumption, corporate production activities contract, which in turn reduces household income. As income declines, people feel anxious about the future, further cutting consumption and increasing savings. This creates a vicious cycle that reduces household income even more. Therefore, from the perspective of the national economy as a whole, savings reduce aggregate demand and have a detrimental effect by deepening the recession. From this viewpoint, Keynes famously stated, ‘Consumption is a virtue, saving is a vice.’
However, classical economists believed that even in such cases, the problem would naturally resolve itself because the ‘interest rate’ would flexibly adjust according to the law of supply and demand. They argued that when savings exceed investment, the law of supply and demand causes interest rates to fall. As interest rates decline, savings decrease and investment increases. Thus, classical economists believed the magnitude of savings and investment would eventually align.
However, Keynes did not think the size of savings and investment would align solely through interest rate adjustments. He pointed out that savings and investment react more sensitively not only to interest rates but also to future economic conditions, political situations, technological developments, and more. He emphasized that artificial demand expansion policies by the government were necessary for economic recovery.
Although Keynes’s arguments sparked much criticism and debate at the time, they gradually gained recognition for their effectiveness as policies adopted to overcome the Great Depression. Particularly after World War II, during the reconstruction process, active government economic intervention played a crucial role, leading to even stronger support for Keynesian economics. His theories became the foundation for important discussions not only in economics but also in politics, society, and various other fields. Even today, they remain a significant part of economic policy considerations in many countries.
