The Great Depression demonstrated, once and for all, that economists cannot safely ignore the short run. Not only was the economic pain severe; it threatened to destabilize societies and political systems. In particular, the economic plunge helped Adolf Hitler rise to power in Germany.

The whole world wanted to know how this economic disaster could be happening and what should be done about it. But because there was no widely accepted theory of the business cycle, economists gave conflicting and, we now believe, often harmful advice. Some believed that only a huge change in the economic system—such as having the government take over much of private industry and replace markets with a command economy—could end the slump. Others argued that slumps were natural—even beneficial—and that nothing should be done.

Some economists, however, argued that the slump both could and should be cured—without giving up on the basic idea of a market economy. In 1930 the British economist John Maynard Keynes compared the problems of the U.S. and British economies to those of a car with a defective starter. Getting the economy running, he argued, would require only a modest repair, not a complete overhaul.

Nice metaphor. But what was the nature of the trouble?

In 1936 Keynes presented his analysis of the Great Depression—his explanation of what was wrong with the economy’s starter—in a book titled The General Theory of Employment, Interest, and Money. In 1946 the great American economist Paul Samuelson wrote that “it is a badly written book, poorly organized …. Flashes of insight and intuition intersperse tedious algebra …. We find its analysis to be obvious and at the same time new. In short, it is a work of genius.” The General Theory isn’t easy reading, but it stands with Adam Smith’s The Wealth of Nations as one of the most influential books on economics ever written.

As Samuelson’s description suggests, Keynes’s book is a vast stew of ideas. Keynesian economics is principally based on two innovations. First, Keynes emphasized the short-run effects of changes in aggregate demand on aggregate output, rather than the long-run determination of the aggregate price level. As Keynes’s famous remark about being dead in the long run suggests, until his book appeared most economists had treated short-run macroeconomics as a minor issue. Keynes focused the attention of economists on situations in which the short-run aggregate supply curve slopes upward and shifts in the aggregate demand curve affect aggregate output and employment as well as aggregate prices.

Figure 18-2 illustrates the difference between Keynesian and classical macroeconomics. Both panels of the figure show the short-run aggregate supply curve, SRAS; in both it is assumed that for some reason the aggregate demand curve shifts leftward from AD₁ to AD₂—let’s say in response to a fall in stock market prices that leads households to reduce consumer spending.

Panel (a) shows the classical view: the short-run aggregate supply curve is vertical. The decline in aggregate demand leads to a fall in the aggregate price level, from P₁ to P₂, but no change in aggregate output. Panel (b) shows the Keynesian view: the short-run aggregate supply curve slopes upward, so the decline in aggregate demand leads to both a fall in the aggregate price level, from P₁ to P₂, and a fall in aggregate output, from Y₁ to Y₂.

As we’ve already explained, many classical macroeconomists would have agreed that panel (b) was an accurate story in the short run—but they regarded the short run as unimportant. Keynes disagreed. [Just to be clear, there isn’t any diagram that looks like panel (b) of Figure 18-2 in Keynes’s General Theory. But Keynes’s discussion of aggregate supply, translated into modern terminology, clearly implies an upward-sloping SRAS curve.]

Classical economists emphasized the role of changes in the money supply in shifting the aggregate demand curve, paying little attention to other factors. Keynes’s second innovation was his argument that other factors, especially changes in “animal spirits”—these days usually referred to with the bland term business confidence—are mainly responsible for business cycles. Before Keynes, economists often argued that a decline in business confidence would have no effect on either the aggregate price level or aggregate output, as long as the money supply stayed constant. Keynes offered a very different picture.

Keynesian economics has penetrated deeply into the public consciousness, to the extent that many people who have never heard of Keynes, or have heard of him but think they disagree with his theory, use Keynesian ideas all the time. For example, suppose that a business commentator says something like this: “Because of a decline in business confidence, investment spending slumped, causing a recession.” Whether the commentator knows it or not, that statement is pure Keynesian economics.

Keynes himself more or less predicted that his ideas would become part of what “everyone knows.” In another famous passage, this from the end of The General Theory, he wrote: “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

The main practical consequence of Keynes’s work was that it legitimized macroeconomic policy activism—the use of monetary and fiscal policy to smooth out the business cycle.

Macroeconomic policy activism wasn’t something completely new. Before Keynes, many economists had argued for using monetary expansion to fight economic downturns—though others were fiercely opposed. Some economists had even argued that temporary budget deficits were a good thing in times of recession—though others disagreed strongly. In practice, during the 1930s many governments followed policies that we would now call Keynesian. In Canada, the Bennett government provided some welfare programs to fight the depression, which made the federal government run larger budget deficits.

However, these efforts were half-hearted. Worried about its budget deficit, the Bennett government began to cut spending in 1932. Given that the economy was still depressed, these spending cuts worsened economic conditions.

After World War II, Keynesian ideas were broadly accepted by economists. There were, however, a series of challenges to those ideas, which led to a considerable shift in views even among those economists who continued to believe that Keynes was broadly right about the causes of recessions. In the upcoming section, we’ll learn about those challenges and the schools, new classical economics and new Keynesian economics, that emerged.