Keynesian theory starts from the simple premise that firms typically produce what they expect to sell. A restaurant, for example, will not cook more meals than people are willing to buy. If customers buy fewer meals, the restaurant will necessarily decrease production. Its level of production is determined by its demand.
Inventories and Production
Why might a firm’s production differ from actual or expected sales? One reason is that the firm may want to raise or lower its inventory stocks. These adjustments can be significant over relatively short periods. Indeed, inventories played an important role in the recent Great Recession. They subtracted more than one percentage point from growth at the bottom of the recession (late 2008 and early 2009) and added more than two percentage points to growth in the early part of the recovery. But over the medium term, firms adjust production to expected sales.
While all economists agree that firms will only produce output that they expect to sell, expected sales may not always be what actually determines the level of production and employment. Alternatively, a firm’s production may be constrained by its capacity and resources to produce output. If there were not enough food, kitchen equipment, or experienced cooks to prepare the food for everyone who was willing to pay for a meal, then the number of meals produced would be limited by the quantity the restaurant is able to supply, regardless of how much customers demand.
This is the underlying logic that, when applied to the entire economy, distinguishes between what economists call “demand-side” and “supply-side” economics. If the production of firms throughout the economy is limited by inadequate sales, then the economy is constrained by the “demand side.” In contrast, if production throughout the economy is constrained by available labor and capacity, then it is constrained by the “supply side.”
An economy constrained by supply fully uses the available resources that firms and workers choose to offer. Labor is fully employed. Businesses fully utilize their capacity to produce. At such a point, economists say that the economy has reached its potential output. When output is at the potential level, the economy is constrained by supply and output can rise only if available resources increase or technology improves. For example, potential output would rise if immigration leads to an increase in the number of people willing to work or innovation in automation raises labor productivity.
Alternatively, if the economy is constrained by aggregate demand, actual output is below the supply-determined, potential level. Resources sit idle in the economy because there is not enough demand to warrant putting them to use.
Idle, wasted resources caused by low spending and insufficient sales are the key problem that Keynesian demand-side theory is designed to explain. Society could benefit from more production, while idle workers are willing and able to satisfy the needs and wants for more production. But in a demand-constrained economy, the economic system cannot bridge the gap between available resources and the material needs and desires of its citizens. This is a problem of first-order importance in modern societies, as has become evident in the stagnation that has followed the Great Recession. A more detailed discussion of this point can be found in the section on unemployment.
What Determines Employment: Supply or Demand?
If both demand and supply can constrain the economy, how do we know which one actually constrains output and employment at any point in time? No economist would reject the claim that firms will only produce what they can sell (now or in the future). In other words, expected demand is indisputably necessary for production. Nevertheless, Classical and Keynesian theorists disagree over whether a lack of demand will actually constrain production.
Employment Redistribution
Suppose that the demand for Italian food decreases, but the demand for Mexican increases. While an Italian restaurant may employ fewer workers, there will be no overall loss to employment in the economy (since Mexican restaurants will employ more workers). Thus, a demand shifts from one activity to another just redistributes where people are employed. When spending decreases across the aggregate economy, however, total employment can fall.
Demand can change in a variety of ways. People can choose to spend less or be forced to cut spending because they lose access to new credit. Or government could cut its spending. Or businesses could reduce the investment goods they choose to buy from other firms. When these things happen, it may seem obvious that production and employment would fall at the firms that lose sales.
Yet, in its purest form, supply-side theory, or as Keynes called it “classical” theory, maintains that insufficient spending does not constrain economic output or employment. Why do some economists believe that low demand never constrains production and employment in the economy as a whole?
Classical “Fresh Water” Macro
The theory that aggregate demand does not constrain output is often called “classical” or, more recently, “new classical” economics. Among economists, new classical theory is also known as “fresh water” economics because it has largely dominated economics departments at places like the Universities of Chicago, Minnesota, and Rochester (close to the Great Lakes). In contrast, Keynesian, demand-side macroeconomics is called “salt water” because many of its most prominent advocates teach at schools like Harvard, M.I.T., and Princeton (close to the ocean). We note, however, that these distinctions have blurred over time as fresh water thinking has spilled over to the salt water school of thought, and vice-versa. This geographic description for economic schools of thought gave rise to our playful “muddy water” title. Please see the About Us page for more explanation.
Let’s consider a simple demand shock, a decline in the desire (or ability) of households to consume. Suppose that firms initially sell all that they produce. When consumption falls, aggregate demand falls by an equivalent amount. This demand shock creates a gap between sales and production. While Keynesian macroeconomics asserts that reduced sales cause firms to cut output and employment, supply-side economists argue that other market adjustments in the economy act quickly and automatically to offset the drop in consumer spending and to fill in this demand gap. These offsetting market responses—or mechanisms—rely on the changes in various prices, including interest rates, wages, and the prices of goods and services. Classical economists believe that adjustment of these prices restores demand to its previous level. Therefore, firms do not need to cut output when sales decline and the economy can continue to operate at potential output and full employment.
The next two pages present a dialog between classical and Keynesian macroeconomics about the effects of interest rate, wage, and price adjustment. We describe the classical argument that adjustment of the interest rate when demand declines automatically eliminates any demand gap. We then demonstrate why, according to the MWM perspective, and Keynesian macroeconomics more generally, this mechanism fails to solve the problem of insufficient aggregate demand. Next we discuss how wage and price adjustment might affect the problem of unemployment. Again, we conclude that demand constraints are likely to be important even in an economy with flexible wages and prices. We encourage our readers to proceed to these pages for a deeper understanding of Keynesian macroeconomics, how these ideas are criticized, and how Keynesian economists respond to their critics.
Key Points
- The starting point for Keynesian macroeconomics is to recognize that firms change output and employment when demand for their goods changes.
- Insufficient demand can prevent the economy from fully utilizing its resources and cause involuntary unemployment.
- Keynesian theory contrasts with supply-side—or classical—macroeconomics. Supply-side theory asserts that the only limits on production are the resources available, such as labor, and the technology that translates inputs into outputs. In supply-side economic models, automatic market adjustment mechanisms assure that there will be enough demand to purchase the economy’s potential output.
To really understand the debate between Keynesian and classical macroeconomics , and to fully appreciate the “MWM perspective” that is the foundation of all the discussion on this site, we encourage you to proceed to these pages (same as those on the menu bar to the right):
Interest Rates, Aggregate Demand, and the Paradox of Thrift
Will Wage and Price Adjustment Cure Unemployment?
If you are short on time, however, and anxious to get to more applied topics, go to the short overview page: The MWM Perspective on Macroeconomics.