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, setting the stage for World War II.

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 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, helping to correct past excesses—and that nothing should be done.

Some economists, however, argued that slumps were destructive and should be cured. Moreover, they could be cured without compromising the market economy. The most compelling advocate for this view, the British economist John Maynard Keynes, compared the problems of the U.S. and British economies in 1930 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 did he mean, specifically?

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 and Nobel Prize winner 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.” Samuelson was correct on both counts: The General Theory isn’t easy reading, yet 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 indicates, Keynes’s book offers a vast stew of ideas. Keynesian economics is principally based on two innovations. First, Keynes emphasized the importance of short-run effects of changes in aggregate demand on aggregate output, unlike the classicists who focused exclusively on the long-run determination of the aggregate price level. Until The General Theory appeared most economists had treated short-run macroeconomics as a minor issue, a view satirized by Keynes’s famous remark that in the long run we are all dead. Keynes shifted the focus of attention of economists away from the unreachable long run to the world in which people actually live, one 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 33-2 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 that demand falls and the aggregate demand curve shifts leftward from AD₁ to AD₂—say, for example, in response to a fall in stock market prices that leads households to reduce consumer spending.

Panel (a) shows the classical view: in it, the short-run aggregate supply curve is vertical. Therefore the fall in aggregate demand leads to a fall in the aggregate price level, from P₁ to P₂, but leaves aggregate output unchanged. Panel (b) shows the Keynesian view: in it, the short-run aggregate supply curve slopes upward. So a fall 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) portrayed an accurate story in the short run—but they regarded the short run as unimportant. Keynes strongly disagreed, arguing that short-run economic problems caused great social distress and were in fact fixable. [Just to be clear, there isn’t any diagram that looks like panel (b) of Figure 33-2 in Keynes’s General Theory. But Keynes’s discussion of aggregate supply, translated into modern terminology, clearly implies an upward-sloping SRAS curve.]

Keynes’s second innovation concerned the question of what factors shifted the aggregate demand curve and caused business cycles. Classical economists attributed shifts in the demand curve almost exclusively to changes in the money supply. Keynes, by contrast, argued 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 argued that as long as the money supply stayed constant, changes in factors like business confidence would have no effect on either the aggregate price level or aggregate output. Keynes offered a very different picture in which, for example, pessimism about future profits can lead to a fall in investment spending, and this can cause a recession.

Keynesian economics, a view of the business cycle informed by these innovations, 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: “Businesses are holding back on investment spending because they’re worried about low consumer demand, and that’s why recovery has stalled.” Whether the commentator knows it or not, that statement is pure Keynesian economics.

Keynes himself more or less predicted that someday people would make use of his ideas without knowing that they were “Keynesians.” As he famously wrote in The General Theory, “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

The greatest 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.

It’s true that some economists had called for macroeconomic activism before Keynes, in particular advocating monetary expansion to fight economic downturns. And some economists had even argued, as Keynes did, that temporary budget deficits were a good thing in times of recession. But macroeconomic policy activism at the time was considered deeply controversial and those who advocated it were fiercely attacked.

As a result, when some governments during the 1930s followed policies that we would now call Keynesian, they were carried out in a half-hearted way and were insufficient to turn the Great Depression around. In the United States, the administration of Franklin Roosevelt engaged in modest deficit spending in an effort to create jobs, actions which seemed to gain some traction in improving the economy. But, in 1937 Roosevelt gave in to advice from non-Keynesian economists who urged him to balance the federal budget and raise interest rates, even though the economy was still deeply depressed. The result was a renewed slump.

Over time, however, Keynesian ideas spread, and they were widely accepted among economists after World War II. 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.