Keynesian (Demand Side) Economic theory
Supply Side Economic theory (“Reaganomics”)
Each Congress and Presidential administration has its own perception of the proper relationship
between the government and the economy.
Named after John Maynard Keynes, a British
By the 1980s, the policy of deficit spending
economist whose most important and influential
seemed to be out of control—deficits were
work, The General Theory of Employment, Interest, mounting.
and Money (1936) presented reasons behind and
prescription for the terribly high unemployment
Uncontrolled spending by the government on
rates that accompanied the Great Depression.
entitlement programs like Social Security
payments at all levels without accompanying
At the center of his theory was the message that
increases in government revenues (i.e. higher
government had to become involved in economic taxes) resulted in a massive, growing, and
affairs and could no longer trust any invisible
burdensome national debt.
force to right the economy.
In short, the U.S. government did not let prudence
Keynes said there was no natural method of
dictate by reigning in uncontrolled spending.
correction that would easily and quickly force the
economy back into full employment (rather, an
As the national debt continues to rise, the U.S.
artificial stimulus was needed).
federal government will eventually run out of
credit—since the value of the dollar rests on
Keynes claimed the level of employment
peoples’ confidence in the government, there is a
depended on the total demand for goods and
great deal at stake in bringing the debt under
services in the market place.
control.
Since aggregate demand (consumer spending)
diminishes during a depression, producers are
forced to cut back on production and lay off
employees. This causes a decline in demand and
downward spiral begins.
In order to increase the aggregate demand for
goods and services in the marketplace, Keynes
proposed that the government must provide the
means to stimulate consumer spending.
Increased government spending would ignite a
need for increased production, and people would
have to be re-hired.
Through the use of fiscal policy, the government
can use its taxing and spending powers to get
more money in the pockets of consumers (e.g.
reduce taxes and/or increase government
spending on public works projects and welfare
programs or by buying up market surpluses so as
to keep the productions lines open and jobs
available).
In 1980, with the election of Ronald Reagan to
the presidency, the approach to fiscal policy
changed (resulting in yet another episode/battle in
the raging debate over the liberal (loose) v.
conservative (strict) construction of the
Constitutional powers and responsibilities of
government.
Reagan’s conservative supporters denounced most
liberal demand-side policy as inefficient, shortterm manipulation of demand.
Conservative programs sought to generate a
balanced budget and end deficit spending.
Whereas they cut taxes, they never managed to
reduce spending (largely because of defense
spending and the Cold War).
To replace Keynesian (demand side) economics,
President Reagan’s advisors saw a solution in the
writings of Jean-Baptiste Say.
Say was a French economist (1767-1832). In his
This action/policy would then trigger a chain
reaction of buying and producing, thus providing
jobs and reducing unemployment .
Treatise on Political Economy (1803), Say
reorganized and popularized Smith’s market
theories in Europe.
This is known as discretionary (intentional) fiscal
policies; When the economy suffers from
recession or depression (high rates of
unemployment and economic stagnation),
Congress can reduce taxes and/or increase
spending by providing jobs and increasing
government contracts for public works. The
objective is to “prime the pump” (i.e. pump more $
into society to stimulate consumer spending
(aggregate demand).
Say believed that most government intervention
with the economy is harmful—he claimed that
economic stability can be assured not by
stimulating aggregate demand, but by increasing
aggregate supply.
When people are earning an income or get a tax
break (i.e. they keep more of their income),
hopefully, they take that money and spend it in
the marketplace.
This increases spending (aggregate demand) which
further triggers increases in supply because as
people spend more, more goods and services are
needed and factories and private businesses
(prodded by an increase in aggregate demand)
begin to increase production (would necessitate
rehiring people who were hitherto unemployed to
produce the increased amount of goods that
consumers are demanding). Once factory workers
are back in the factories earning wages (i.e. the
unemployment rate drops), they would further
add to aggregate demand. In turn, factories would
have to hire more people, and so on.
During the New Deal, leaders avoided fiscal
policies related to taxes (taxes were already low
and raising them for revenue would have been
disastrous because it would have taken purchasing
power away from consumers and any further
drops in aggregate demand would result in more
factory closings/cutbacks and an even higher rate
of unemployment/underemployment).
FDR stated in his 04-14-1938 Fireside chat on
economic conditions that the cause(s) of the
recessions in the 1930s was under-consumption
and overproduction.
Say’s interpretation of Smith’s ideas, he argued
that supply creates its own demand.
Producers not encumbered by government rules
(laissez-faire) act in their own self-interest to
realize profits, and in doing so, they stimulate
growth (Say’s law).
According to Say’s law, producers create demand
by paying for all of the factors of production
necessary to put a good or service on the
market—meaning every payment made by a
producer is income for someone else. Once that
income is obtained, it is spent, essentially
becoming new demand.
In this way, Say maintains the production of one
good stimulates the creation and consumption of
others.
To supply-side economists, this means that growth
is defined by an economy’s ability to produce.
The more the economy produces, the wealthier it
is.
Say’s economic theory also embraced and
endorsed Smith’s doctrine of laissez faire.
According to Say, any economic depression that
existed was caused by trade barriers (tariffs) that
government put up to prevent the free exchange
of goods and services with other nations.
Output must have markets in which to be sold.
When government prevents producers from
accessing these markets, it causes the
Instead, New Deal programs centered on spending
actions.
In order for the government to “prime the pump”
(stimulate the economy by triggering an increase
in aggregate demand), it must have the financial
resources to use. To spend more while keeping
taxes low, the government goes into financial
markets to borrow money on a very large scale.
In truth, the government spends what it does not
have (called deficit spending).
Continued deficit spending will invariably
increase the national debt ((the total amount the
federal government owes to creditors—it
represents the accumulated unpaid balance of
many past years’ deficits).
FDR in his 04-14-1939 fireside chat:
“Such an addition to the net debt of the United
States need not give concern to any citizen, for it
will return to the people of the United States many
times over in increased buying power and
eventually in much greater Government tax
receipts because of the increase in the citizen
income.”
In short, higher employment rates (i.e. increases
in private income) would result in increased tax
revenues that, once collected, could be used to
pay back the government for the borrowed
money it had to spend (i.e. pay down the deficit).
This role of economic stabilization raises
questions of Constitutionality and it often results
in heated debates surrounding the perpetual loose
v. strict battle over the use of implied powers and
what is actually considered “necessary and
proper” functions of government in carrying out its
expressed powers.
New Dealers claimed the role was implied as an
evolution of the function of taxation. In other
words, the elastic clause (Article I Section 8)
allowed it, just as it did a B.U.S. to stabilize
finances.
depressions. Say claimed overproduction cannot
harm the economy if trade is free. Only
government interference with trade keeps goods
and services from reaching world markets.
Say’s supply side ideas became the basis for
Reagan’s conservative economic programs,
popularly known as “Reaganomics”.
Conservatives want a reduction of the economic
roles of government—their program includes
income tax cuts for citizens and corporations,
government spending cuts on programs
(exception: defense spending), and cuts in
government regulation of the economy
(deregulation).
Conservative supply-siders claimed these changes
would provide producers with incentives to
increase investment and production—they
reasoned that more production would mean more
jobs, and more jobs would mean more income,
and more income would mean more spending,
and more spending would mean growth and
prosperity.
Thus, supply-siders believed that stimulating
supply would trigger a growth of aggregate
demand.
During the twenty years between the end of WWII
and the mid-1960s, the government’s taxation and
spending grew, and the economy flourished
(employment/growth in certain industries like
defense and construction soared as a result of the
Cold War, construction of the Interstate Highway
System, and urban renewal initiatives). This
sustained period of economic growth and
prosperity convinced many authorities of Keynes’
wisdom—it was clear, at least to them, that this
form of fiscal policy could be used to keep the
economy growing and meeting the goals of
economic stabilization policy: (1) zero
unemployment; (2) no inflation (i.e. continued
and sustainable economic growth and
prosperity).
Since the New Deal, most Presidents and
Congresses have followed the liberal Keynesian
style of fiscal policy.
The Keynesian approach was institutionalized with
the passage of The Employment Act of 1946 that:
1. required the President to make an annual
report on the condition of the economy, 2.
authorized a three person Council of Economic
Advisors for the President to assist with this, 3.
established a Joint Congressional Economic
Committee.
This act acknowledged a permanent role for
government to use tax policies and spending
programs to stabilize the economy. With this
legislation, the government now had a legal
obligation to use discretionary fiscal policy to
influence aggregate demand and make other
adjustments to the economy.
From FDR’s New Deal through the Carter
administration, John Maynard Keynes’ ideas were
part of our government’s economic activities.
To demand side economists, growth is defined by
an economy’s ability to consume.
Increasingly, Americans have become dependent
on the government for economic help. The
public’s desire to create smaller, less costly
government has always been hindered by its
dependence on government services.
Amid their cries for lower taxes and budget deficit
reduction in the 1990s, many Americans still
wanted a national government health care
program in spite of the cost.
Since the Great Crash of 1929, local, state, and
federal bureaucracies have been growing
continually.
In the 1930s Depression, the situation was
desperate enough to alter the sacred doctrine of
laissez-faire. In the New Deal, Congress frequently
stretched the Elastic Clause to give the federal
government more and more economic power, and
the public accepted all the help it could get.
From the Great Depression’s desperate
experience, people came to expect help anytime
they needed it (floods, earthquakes, hurricanes,
unemployment, bad weather and freezing crops,
etc.).
People now expect government grants, subsidies,
low interest loans, and emergency finances to
rebuild, restore, replace, replenish, resurrect,
repair, and recover.
Today, people demand more from government
and its economic roles have grown—more people
and more problems means more spending and
bigger government.
Some people feel entitled to all the services and
protections as if they were a birthright.
Yet, when government turns to taxpayers for
revenue (income), they balk. Although taxes are
the obligatory fees citizens pay for government,
nothing causes more reaction to government than
the mere mention of taxes since they decrease
personal income and thus purchasing power.
Government is expected to provide goods, and
services, protect consumers and workers from
harm in the marketplace, furnish the needy with
assistance through transfer payments, and keep
jobs safe while keeping prices stable (fiscal and
monetary policies).
While they often denounce the cost, leaders feel
people want a “great safety net” to protect them
from life’s problems.
When the government is unable to meet people’s
expectations, they blame its activity (or lack of
action) for everything that is wrong.
Both supply side and demand side economic theories have the same objective—they simply offer
different routes for getting to the same place. Supply side economic policies diminish the government’s
role.
There are limitations to these approaches, however: Whilst the supply side approach assumes business
tax cuts will wisely go into investments in product research and development or plant expansion (as
opposed to increasing corporate executive salaries, raising dividends for their stockholders, in overseas
investments, or in buying out competitors through mergers and acquisitions), the demand side approach
claims that putting more money in consumers’ hands will lead to more spending.