• Keynesian economic theory is a macroeconomic theory that advocates for increased government spending and lower taxes to stimulate demand.
• Keynesian economics was a response to the Great Depression and a critique of classical theory, which suggests supply-side opportunities will correct the economy without government intervention.
• Keynesian economics assumes that changes in demand are the prime influencers of output and employment.

Keynesian economics is a macroeconomic theory developed by the British economist John Maynard Keynes amid the Great Depression in the 1930s. It posits that increased government spending and lower taxes stimulate demand and will pull an economy out of depression.

Known as "demand-side" theory, Keynesian theory suggests the primary factor that drives economic activity is the demand for goods and services. To spur demand, government policy is focused on direct intervention as a way to influence demand and prevent recession.

"The theory holds that during a recession, when consumers stop spending, the government should step in and spend to fill the void," says Dan North, chief economist at Euler Hermes. He points to government spending programs including the $2.2 trillion CARES Act that the government implemented in response to the COVID-19 pandemic as examples.

"Perhaps the most important part of those acts was to send money directly to individuals," Hermes says. "Those people then started to spend that money and the economy recovered - just as Keynes had predicted."

What are the main principles of Keynesian economic theory?

The central tenet of Keynesian economic theory is that government intervention can stabilize the economy.

The principles underlying this supposition include the following:

• Demand is influenced by public and private economic decisions.
• Prices and wages respond slowly to changes in supply and demand.
• Changes in demand have the strongest short-term impact on output and employment.
• Unemployment is subject to the whims of demand and therefore undesirable.
• Active stabilization policy is required to reduce the volatility of the business cycle.
• Inflation is less important than unemployment.

  Note: Macroeconomic refers to dealing with performance, structure, behavior, and decision-making of an economy as a whole.

The history of Keynesian economics

The Great Depression was a time of tremendous financial uncertainty. US unemployment stood at 24%. Prevailing classical economic theory, which focused on economic growth and freedom based on supply-side marketplace competition and a hands-off approach, wasn't working.

In 1936, Keynes published, "The General Theory of Employment, Interest, and Money." In it, he argues that the notion markets tend toward full employment is false and that government intervention is needed to overcome issues of unemployment and recession. Keynes saw demand as key to full employment and the force that creates supply.

Note. Although Keynes' General Theory is his most famous work, its 1930 two-volume precursor, "A Treatise on Money," is often regarded as more important when it comes to economic thought.

From 1933 to 1939, US President Franklin Delano Roosevelt adopted Keynes' economic theories in the creation of New Deal legislation. His intent was to reinvigorate the economy by stimulating consumer demand. This was accomplished by Keynesian-style deficit spending to promote economic growth. While the Keynesian approach was somewhat successful, massive government spending on World War II is what primarily rescued the economy.

During the period from 1946 to 1976, Keynesian economics became dominant. During the 1970s, Keynesian economics failed to explain how high inflation and unemployment, otherwise known as stagflation, could happen at the same time. This resulted in a retreat to classical economics from the mid to late 70s to 2008. Economists once again returned to Keynes during the global financial crisis in 2008. Since then, economic policy has been a mix of the two.

Keynesian economics vs. classical economic theories

Keynesian economics promotes government intervention in the business cycle, including borrowing, as a way to stimulate demand. In this model demand increases supply and reduces unemployment since more workers are needed to keep up with increased demand.

Classical economics advocates laissez-faire (let it be) policy, with little to no government intervention. Instead, it promotes a balanced budget while allowing an uncontrolled free market to use the laws of supply and demand to self-regulate.

Note: Keynes opposed the economic theories of 18th century economist Adam Smith, who was a major proponent of laissez-faire economic policies and the "invisible hand" or tendency of free markets to regulate themselves.

Keynesians believe prices and wages are relatively inflexible and that the government must help achieve full employment. Classicists believe prices and wages are flexible and any unemployment is only temporary.

A comparison of major points shows how the two economic theories differ:

The financial takeaway

Keynesians believe government intervention by way of borrowing and spending is essential to the economy, especially during recessionary times. Classical economists are just as strident in their belief that free markets are self-regulating and efficient. Classicists therefore believe that government intervention is, by its nature, a barrier to free-market efficiency.

Sorting it all out is no easy task. "The theory is nice, but in practice it has been virtually impossible to prove that government stimulus projects work in general," says North. "Sure direct payments helped [as referenced above] but so did opening up the economy. Which helped more?"

Nonetheless, understanding basic economic theory and how it is practiced is essential to understanding macroeconomic conditions. This, in turn, leads to an understanding of the impact of those conditions on companies, stocks, and financial markets in general.