The New Keynesian School

Macroeconomics was developed by John Maynard Keynes (1936) in response to the very high unemployment rates experienced by developed countries during the Great Depression. At the time, the dominant Classical School adhered to Say's Law, which holds that "supply creates its own demand". For labor markets, this means that someone looking for work will soon be able to find a job. Prolonged periods of high unemployment, therefore, should not be possible. Keynes offered an alternative perspective, the theory of effective demand, which holds that demand determines output and production. In this instance, the demand for goods creates a demand by firms for workers and creates jobs. Inadequate demand leads to unemployment. During the post-war decades, a so-called "neoclassical synthesis" arose, which attempted to combine these two views. Following Keynes, it held that any shortfall in demand led to slow economic growth and high unemployment. Following the classical approach, unemployment was explained as a case where the economy was not in equilibrium; labor supply had yet to create enough demand for labor. The policy solutions stemming from the neoclassical synthesis were rather Keynesian in nature – lower interest rates and government deficit spending to stimulate growth. Taking this advice, the US enacted large tax cuts in the 1960s and increased government expenditures (some on infrastructure but more on widening war in Vietnam and a Cold War with the Soviet Union). This helped push the US unemployment rate below 4 percent during the late 1960s, the same time that Keynesian economics reached its apotheosis. In 1971, US President Richard Nixon famously proclaimed that even he, a long-time opponent of government intervention in the economy, was now a Keynesian.