What Is the Law of Supply and Demand?

The law of supply and demand is the theory that prices are determined by the
relationship between supply and demand. If the supply of a good or service
outstrips the demand for it, prices will fall. If demand exceeds supply, prices
will rise.

The law of supply and demand is based on two other economic laws: the law of
supply and the law of demand. The law of supply says that when prices rise,
companies see more profit potential and increase the supply of goods and
services. The law of demand states that as prices rise, customers buy less.

Theoretically, a free market will move toward an equilibrium quantity and price
where supply and demand intersect. At that point, supply exactly matches the
demand — suppliers produce just enough of a good or service, at the right
price, to satisfy everyone's demands.

Key Takeaways

 The law of supply and demand predicts that if the supply of goods or services
outstrips demand, prices will fall. If demand exceeds supply, prices will rise.
 In a free market, the equilibrium price is the price at which the supply exactly
matches the demand.
 Understanding the law of supply and demand helps businesses determine how
to set prices and fulfill customer demand while minimizing excess inventory.
Law of Supply and Demand Explained

The law of supply and demand describes how the relationship between supply
and demand affects prices. If a supplier wants more money than the customer
is willing to pay, items will most likely stay on the shelf. If the price is set too
low, customers will be eager to buy the items, but each item will be less
profitable. The law of supply and demand is based on the interaction between
two separate economic laws: the law of supply and the law of demand. Here's
how they work.

The Law of Supply.

The law of supply predicts a positive relationship between pricing and supply.
As prices of goods or services rise, suppliers increase the amount they produce
— as long as the revenue generated by each additional unit they produce is
greater than the cost of producing it. Seeing a greater potential for profits, new
suppliers may also enter the market. For example, prices of lithium and other
metals used in batteries have soared as sales of electric vehicles have
increased. That has encouraged mining companies to explore new sources of
lithium and expand production at existing mines in order to increase the
supply and generate higher profits.

The law of supply can also operate on a local scale. Let's say a well-known
musician is coming to town. Anticipating a huge demand for tickets, promoters
aim to maximize the supply by booking the biggest venue possible and offering
as many tickets as they can, at high prices. As the supply of tickets runs out,
the price of secondhand tickets rises — and so does the supply — as casual
fans who bought tickets at the list price see the opportunity to resell them at a
higher price. As a result, they enter the market as new suppliers.

The Law of Demand.

The law of demand says that rising prices reduce demand. So as prices rise,
customers buy less. That's particularly true if they can substitute cheaper
goods. When the famous musician comes to town, not everyone may be able to
afford a ticket even if they'd like to go. So, if the theater sets prices too high,
fewer people will decide it's a worthwhile purchase, and the show organizers
will be left with empty seats. Fans who want to resell their tickets may need to
lower their asking price. Some people may decide to see another artist instead,
if those tickets are cheaper.

The Law of Supply and Demand.

The price where supply and demand meet is known as the equilibrium price. At
that price point, suppliers produce just enough of a good or service to satisfy
demand, and everyone who wants to purchase the product can do so. In
practice, of course, balancing supply and demand is more complex. As supply
and demand fluctuate, the equilibrium price can vary over time. Furthermore,
the law of supply and demand assumes that all other factors that can affect
pricing remain constant. In reality, that's often not the case. For example,
fluctuating production costs or supply chain problems can have a big impact
on pricing.
Why Is the Law of Supply and Demand Important?

Business success in any competitive market depends on accurately assessing

supply and demand. Every company that launches a new product needs to
determine how much of the product to make and how much to charge. A
business that manufactures too much of a product or sets prices higher than
customers will pay can easily find itself left with products that don't sell and
become dead stock. On the other hand, understocking or setting prices too low
reduces profits and can drive away customers who can't wait for backorders to
be fulfilled. Demand forecasting can help businesses determine the optimal
supply level and find the equilibrium price — the price at which the supply just
meets customer demand.

4 Basic Laws of Supply and Demand

The law of supply and demand predicts four ways that changes in either
demand or supply will drive changes in pricing:

1. Prices fall when supply increases and demand remains constant.

If supply increases without a change in demand, a surplus usually
occurs. This can happen for many reasons, including surges in
productivity. To move excess stock, especially if there's a pending
expiration date, suppliers tend to lower prices to try to boost demand.

2. Prices fall when demand decreases and supply remains constant.

A surplus can also occur when customers want less of a good or service,
even without a change in supply. The effect is the same: lower prices.

3. Prices rise when supply decreases and demand remains constant.

If supply drops, shortages occur. In that situation, customers are often
willing to pay higher prices to get the goods and services they want.
Supply constraints can occur for many reasons, including supply chain
problems. If the problem is temporary, prices tend to return to their
baseline once supply is restored.

4. Prices rise when demand increases and supply remains constant. A

shortage can occur if the demand for a product increases but the
supply doesn't — or if demand increases faster than production can
ramp up. When supply eventually catches up with demand, prices
tend to stabilize.

Supply Demand Inventory Level Price Change

Increases Remains constant Surplus Lower

Remains constant Decreases Surplus Lower

Decreases Remains constant Shortage Higher

Remains constant Increases Shortage Higher

How changes in supply and demand affect prices and supplier inventory.

Demand Curve

A demand curve is a graph that tracks the relationship between price (vertical
axis) and demand (horizontal axis). The downward slope indicates that when
prices rise, demand tends to fall.

The extent to which price changes affect demand varies from product to
product. For any product, the steepness of the curve is a measure of its
demand elasticity — the extent to which demand is affected by changes in the
price. A less steep curve indicates that a small change in price causes a large
change in demand.

Note that the demand curve only considers the effect on demand of a single
factor — price. Other factors that influence demand, such as advertising, can
shift the entire demand curve to the left or right.

Supply Curve

A supply curve shows the relationship between price (vertical axis) and supply
(horizontal axis). It indicates how much output suppliers are willing to produce
at different prices. When a supplier sees more profit potential from higher
prices, it often will allocate more of its resources toward those more profitable
items — usually at the expense of lower-priced items. At the same time,
newcomers may enter the market, further increasing the available supply —
because with the promise of higher revenue, more companies may be prepared
to invest the startup costs required to enter that market.

Like demand curves, supply curves consider the effect of pricing but assume
that everything else remains constant. However, other factors, such as
production costs, can affect the supply. For example, if rising hamburger prices
are dictated by more expensive beef, a restaurant owner may not see enough
profit from the higher prices and may not have much incentive to expand
capacity by adding another grill to the kitchen. Other constraints, such as
limits on manufacturing capacity or the availability of raw materials, may also
negatively impact the ability to increase supply.
 Balance Between Supply and Demand

Understanding the balance between supply and demand is critical in many

industries. Price is a key factor in determining this balance — although it's not
the only factor. The extent to which price affects demand depends on the type
of product being sold. It also depends on the competitiveness of the market.
For some nonessential goods or items with many available substitutes, there
will be high demand elasticity — and demand for one of those products will be
highly affected by price changes. In contrast, demand for essential goods, like
gasoline or health care, is relatively inelastic: If someone needs gas to get to
work, they will probably pay for it no matter the price, especially if they don't
have other options, like public transit.

Many other factors can affect the balance between supply and demand, thus
impacting pricing. For example, supply can be affected by the cost of raw
materials, technology that increases productivity, transportation or other
supply chain issues, and government regulations.

Law of Supply and Demand Examples

The interlocking relationship between supply and demand can be seen at all
levels of the economy. Here are some current and historical examples:

 Sports nutrition company MusclePharm sought to grow its business rapidly to

meet expanding demand, but challenges included poor inventory visibility and
accounting software that lacked the scalability and scope required to meet the
company's objectives. Implementing a highly flexible, scalable and integrated
enterprise resource planning (ERP) solution helped MusclePharm achieve 35x
revenue growth within just a few years.
 Responding to rising demand, Earth-Kind created the first all-natural indoor
rodent repellent approved by the FDA. Streamlining business operations with
an integrated ERP system helped the company maintain a 40% growth rate
and increase the supply of its products to 20,000 retail locations.
 As sales of high-end digital camera models rose during the 1990s, camera
manufacturers invested in technology to increase production and expand the
available supply. However, the resulting oversupply resulted in excess
 inventory and plummeting prices. The demand for digital cameras continued to
decline as consumers switched to alternative products — smartphones that
included cameras that were adequate for many uses.
 Demand for hand sanitizer rose during the early days of the COVID-19
pandemic. As prices rose, some companies that saw a drop in demand for their
primary products, such as breweries, saw an opportunity. Because they had
the capability to make alcohol-based hand sanitizer, they started doing so. This
increased the market supply, helping to meet the growing demand.

Better Supply and Demand Planning With NetSuite

NetSuite Supply and Demand Planning helps businesses balance supply and
demand to ensure that they can fulfill customer orders while minimizing excess
inventory. Part of an integrated suite of business applications, NetSuite Supply
and Demand Planning helps increase forecast accuracy, improve product
availability, minimize inventory carrying costs and reduce production delays.
NetSuite Demand Planning predicts inventory needs, based on factors such as
historical demand, seasonality, growth and profit opportunities and sales
forecasts. NetSuite Supply Planning helps companies determine how best to
meet that demand, generating production and purchasing schedules and
creating the relevant work orders and purchase orders.

Conclusion
The law of supply and demand can provide a useful model for understanding
and determining pricing. It can help determine an equilibrium price, where
suppliers can meet demand without overstocking, and customers get
everything they need at a price they can accept. However, supply, demand and
pricing can also be influenced by factors that the law of supply and demand
doesn't consider, such as production costs, supply chain problems and
regulations.

Classical Economics Definition

Classical economics refers to one of the prominent economic schools of thought

that originated in Britain in the late 18th century. It advocates the development
of a free economy with minimal government intervention to trigger economic
growth.
The concept is more inclined towards capitalism. Freedom to trade and
compete motivates private entities to act on self-interest, resulting in efficient
resource allocation, increased investments, profit generation, and benefit to
society. This scenario prioritizes the production of goods and services,
boosting economic growth.

 Classical economics theory originated in the late 18th century in Britain. Adam
Smith propagated it through his book Wealth of Nations, and the concept
favored the laissez-faire concept, free trade, and competition to stimulate
economic growth.
 The main classical economists are Adam Smith, Jean-Baptiste Say, David
Ricardo, Thomas Robert Malthus, and John Stuart Mill.
 The neoclassical model highlights supply and demand as the major
determining factor behind producing and consuming goods and services.
 Keynesian economics theory encourages government intervention in the
economy.

Classical economics concept was first propagated by Adam Smith, the father of
modern economics, through his famous work “An Inquiry into the Nature and
Causes of the Wealth of Nations“—commonly known as “The Wealth of Nations”
published in 1776. Adam Smith proposed that the wealth of any country is not
derived from its gold reserve but the national income backed by the effective
division of labor and the optimum use of capital. Furthermore, the field was
enriched by the contributions of classical economists like David
Ricardo and John Stuart Mill.

Adam Smith stressed the importance of an economic system based on

individuals’ self-interest. He coined the phrase “invisible hand” to explain the
invisible market forces aligning individuals’ actions out of self-interest to
benefit society. These market forces help the supply and demand of goods and
services in a free market attain economic equilibrium.

The theory emphasized laissez-faire ideas promoting the free market, free
trade, and free competition for economic growth. A free market manifests a
scenario without government intervention; hence the prices of goods and
services are self-adjusted when buyers and sellers negotiate in an open market.
As a result, the supply and demand market forces stabilize the economic
system. Altogether the concept was against the idea and practice of
mercantilist theory, which was prevalent in Britain during the 16th and 17th-
century manifesting high government intervention.
Ricardo strengthened the notion by interpreting and contributing to “labor
theory of value” and “theory of distribution” in the Principle of Political
Economy and Taxation. The labor theory of value highlighted the
proportionality between the cost of goods and the labor costs incurred in
making them. Through the theory of distribution, he explained the importance
of social classes: wages for laborers, profits for owners of capital, and rents for
landlords.
What is the classical theory of economic growth?
Classical economics refers to one of the major economic schools of thought that
emerged in the late 18th century in Britain. The concept supported various
ideas of capitalism and advocated for free commerce and the laissez-faire
approach. Classical economists argue for as little government interference as
possible to promote a free market and maximize economic growth.

What are the main ideas of classical economists?

The idea of a free market, an invisible hand, and Individuals acting out of self-
interest are central to the classical model. Liberal policies, free entrance, and
profit incentives encourage private entities to behave in their self-interest,
resulting in effective resource allocation, higher investments, profit creation,
and societal gain. In a free market, these market forces assist the supply and
demand in reaching equilibrium.

Describe classical economics vs.Keynesian?

The critical distinguishing point between both theories is the participation of
the government. The classical theory admonishes the slightest intervention of
government exhibiting free market trade and economic growth, and market
competition. In comparison to it, Keynesian economics supports the active
participation of the government to control the economy and prevent the
occurrences of events like recessions.
 A Neoclassical Economics Theory says that a product or service governed is
valued above or below the production cost. At the same time, it is a theory that
considers the flow of various goods, services, outputs, and income distribution
through the demand-supply approach, which assumes the unity of customers in
the economy and their main objective is to get satisfaction from the products or
services.

 Neoclassical economics is a theory that examines how goods and services are
valued relative to production costs.
 It also considers the flows of goods, services, outputs, and income distribution
through a demand-supply approach, with a focus on achieving customer
satisfaction from goods and services.
 The theory relies on seven key assumptions: rational agents, marginal utility,
relevant information, perceived value, savings-derived investment, market
equilibrium, and free markets.
 Neoclassical economics emphasizes profit maximization, similar to how
companies aim to optimize their profits within the economic framework.

Below are the top 7 assumptions of neoclassical economic theory:

#1 – Rational Agents

An individual rationally selects products and services considering their

usefulness. Furthermore, people make choices that provide optimum
satisfaction, advantage, and outcome.

#2 – Marginal Utility

Individuals make choices at the margin, meaning marginal utility. Marginal

utility refers to the utility of any good or service that increases with its specific
use and decreases gradually as the usage ceases.
Let us consider an example. John chooses to have a chocolate ice cream at the
nearby outlet; his marginal utility is maximum with the first ice cream and
decreases with more until he pays and balances out his satisfaction or
consumption. Likewise, a producer’s production estimation involves
calculating marginal cost vs. the marginal benefit (in this case, the added
profit it may earn) of producing one additional unit.
#3 – Relevant information

Individuals act independently based on complete, relevant, and readily

available information without bias.
#4 – Perceived Value

Neoclassical economists believe that consumers have a perceived value of

goods and services more than input costs. For example, classical
economics believes that a product’s value is derived from the cost of materials
plus labor. In contrast, neoclassical experts say that an individual perceives a
product’s value, influencing its price and demand.

#5 – Savings derives Investment

Savings determine investment, but it is not the other way round. For example,
if you have enough saved for a car throughout a time frame, you might think of
such an investment.

#6 – Market Equilibrium

Market equilibrium is achieved when individuals and companies have reached

their respective goals. The competition within an economy leads to the efficient
allocation of resources, which helps attain market equilibrium between supply
and demand.
#7 – Free markets

The markets should be free, meaning the state should refrain from imposing
too many rules and regulations. If government intervention is minimal, people
may have a better standard of living. For example, they may have better wages
and a longer average life expectancy.

Example of Neoclassical Economics

One of the important facets of neoclassical economics is “consumer

perception,” as goods or services derive economic value, free trade, and
marginal utility. The theory has been significant in instances where consumer
perception has proven to play a role. For example, you desire to purchase
designer apparel because of the attached brand label. Besides, the clothing
production cost may be insignificant. Here, the perceived value of the brand
label exceeded its input cost, creating an ‘economic surplus.’ At the same time,
this theory also looks flawed when recalling the 2008 financial crisis, where
the synthetic financial instruments with no ceiling were assumed to be
insured against risk. Although, it proved to be responsible for an unforgettable
crisis.
If we think of globalization, free trade and marginal utility seem to have a good
presence. The integration between the world economy and the trade-off
between nations due to many goods and services available for exchange has led
to emerging economies like India and China. In other words, prices have been
determined with efficient resource allocation and limited
government regulation. However, the flip side of this is anti-globalization,
where free trade and marginal utility could not build an optimal set of
parameters for a wider group of people. In turn, the world economy is confined
in the hands of a few major economies and multinationals, where poverty has a
status quo.

The theory of neoclassical economics is based on the premise that market

forces of demand and supply are driven by customers intending to maximize
their satisfaction by choosing amongst the best available alternatives. It is
similar to the way a company aims to maximize its profits. It may be called
‘classical’ based on the belief that competition efficiently allocates resources
and establishes a balance between demand and supply market forces. It is ‘neo’
in that it advances from the classical viewpoint.
So, whether to foster the theory or pull it down draws serious measures on how
an individual perceives the operational world around it. It focuses on how free
trade builds growth, and marginal utility is subjected to satisfaction. However,
neoclassical economic theory is mostly applied in various forms in our daily
lives that we may fail to notice. For example, while choosing a dream home,
one may encounter a scarcity of resources like money and therefore choose an
alternative that meets their requirements. It calls for consumer perception, as a
bungalow might be pricey in the eyes of the middle class. Still, the same may
stand affordable for another segment of society.

1. What is neoclassical economics vs. Keynesian economics?

Neoclassical economics emphasizes rational decision-making by individuals

and firms in a market-driven economy. It assumes perfect competition and
emphasizes equilibrium. In contrast, Keynesian economics, developed by John
Maynard Keynes, focuses on the role of government intervention in stabilizing
the economy during economic downturns. It advocates for fiscal policies like
government spending and monetary policies to manage aggregate demand and
achieve full employment.

2. What are the features of neoclassical economics?

Neoclassical economics assumes that individuals are rational and utility-

maximizing, firms aim to maximize profits, and markets reach equilibrium
through supply and demand forces. It relies on mathematical modeling and
emphasizes free markets, efficiency, and scarcity as the basis for resource
allocation. Neoclassical economists believe in the efficacy of self-regulating
markets and minimal government intervention.

3. What is neoclassical economics criticism?

Neoclassical economics has faced criticism for several reasons. Critics argue
that it’s rationality and perfect competition assumptions do not accurately
reflect real-world behavior and market conditions. Additionally, it is criticized
for neglecting factors like income distribution, power imbalances, and
institutional dynamics that influence economic outcomes. Critics also question
its focus on GDP growth as the sole measure of economic success and its
limited consideration of environmental and social concerns.

Keynesian economics

John Maynard Keynes (1883–1946) was an early 20th-century British

economist, best known as the founder of Keynesian economics and the father
of modern macroeconomics, the study of how economies—markets and other
systems that operate on a large scale—behave. One of the hallmarks of
Keynesian economics is that governments should actively try to influence the
course of economies, especially by increasing spending to stimulate demand in
the face of recession.

Advocacy of Government Intervention in the Economy

Keynes' father was an advocate of laissez-faire economics, an economic

philosophy of free-market capitalism that opposes government intervention.
Keynes himself was a conventional believer in the principles of the free market
(and an active investor in the stock market) during his time at Cambridge.

However, after the 1929 stock market crash triggered the Great Depression,
Keynes came to believe that unrestricted free-market capitalism was
essentially flawed and needed to be reformulated, not only to function better in
its own right but also to outperform competitive systems like communism.2

As a result, he began advocating for government intervention to curb

unemployment and correct economic recession. In addition to government jobs
programs, he argued that increased government spending was necessary to
decrease unemployment—even if it meant a budget deficit.

What Is Keynesian Economics?

The theories of John Maynard Keynes, known as Keynesian economics, center

around the idea that governments should play an active role in their countries'
economies, instead of just letting the free market reign. Specifically, Keynes
advocated federal spending to mitigate downturns in business cycles.

The most basic principle of Keynesian economics is that demand—not supply

—is the driving force of an economy. At the time, conventional economic
wisdom held the opposite view: that supply creates demand.
Because aggregate demand—the total spending for and consumption of goods
and services by the private sector and the government—drives supply, total
spending determines all economic outcomes, from the production of goods to
the employment rate.

Another basic principle of Keynesian economics is that the best way to pull an
economy out of a recession is for the government to increase demand by
infusing the economy with capital. In short, consumption (spending) is the key
to economic recovery.

These two principles are the basis of Keynes' belief that demand is so
important that, even if a government has to go into debt to spend, it should do
so. According to Keynes, the government boosting the economy in this way will
stimulate consumer demand, which in turn spurs production and ensures full
employment.

Keynesian economics is a macroeconomic theory of total spending in the

economy and its effects on output, employment, and inflation. It was
developed by British economist John Maynard Keynes during the 1930s in an
attempt to understand the Great Depression.

The central belief of Keynesian economics is that government intervention can

stabilize the economy. Keynes’ theory was the first to sharply separate the
study of economic behavior and individual incentives from the study of broad
aggregate variables and constructs.

Based on his theory, Keynes advocated for increased government expenditures

and lower taxes to stimulate demand and pull the global economy out of the
Depression. Subsequently, Keynesian economics was used to refer to the
concept that optimal economic performance could be achieved—and
economic slumps could be prevented—by influencing aggregate
demand through economic intervention by the government.
Keynesian economists believe that such intervention can achieve full
employment and price stability

 Keynesian economics focus on using active government policy to manage

aggregate demand to address or prevent economic recessions.
 Keynes developed his theories in response to the Great Depression and
was highly critical of previous economic theories, which he referred to as
classical economics.
  Activist fiscal and monetary policy are the primary tools recommended
by Keynesian economists to manage the economy and fight
unemployment.

Keynesian economics represented a new way of looking at spending, output,

and inflation. Previously, what Keynes dubbed classical economic
thinking held that cyclical swings in employment and economic output create
profit opportunities that individuals and entrepreneurs would have an
incentive to pursue, and in so doing, they correct the imbalances in the
economy.

According to Keynes’ construction of this so-called classical theory, if

aggregate demand in the economy fell, the resulting weakness in production
and jobs would precipitate a decline in prices and wages. A lower level of
inflation and wages would induce employers to make capital investments and
employ more people, stimulating employment and restoring economic growth.
Keynes believed, however, that the depth and persistence of the Great
Depression severely tested this hypothesis.2

In his book The General Theory of Employment, Interest and Money and other
works, Keynes argued against his construction of classical theory, asserting
that, during recessions, business pessimism and certain characteristics of
market economies would exacerbate economic weakness and cause aggregate
demand to plunge further.2

For example, Keynesian economics disputes the notion held by some

economists that lower wages can restore full employment because labor
demand curves slope downward like any other normal demand curve.2

Similarly, poor business conditions may cause companies to reduce capital

investment rather than take advantage of lower prices to invest in new plants
and equipment. This also would have the effect of reducing overall
expenditures and employment

Keynesian economics is sometimes referred to as “depression economics,” as

Keynes’ General Theory was written during a time of deep depression—not
only in his native United Kingdom, but worldwide. The famous 1936 book was
informed by Keynes’ understanding of events arising during the Great
Depression, which Keynes believed could not be explained by classical
economic theory as he portrayed it in his book.

Other economists had argued that, in the wake of any widespread downturn in
the economy, businesses and investors taking advantage of lower input prices
in pursuit of their own self-interest would return output and prices to a state
of equilibrium, unless otherwise prevented from doing so. Keynes believed that
the Great Depression seemed to counter this theory.

Output was low, and unemployment remained high during this time. The
Great Depression inspired Keynes to think differently about the nature of the
economy. From these theories, he established real-world applications that
could have implications for a society in economic crisis.

Keynes rejected the idea that the economy would return to a natural state of
equilibrium. Instead, he argued that, once an economic downturn sets in, for
whatever reason, the fear and gloom that it engenders among businesses and
investors will tend to become self-fulfilling and can lead to a sustained period
of depressed economic activity and unemployment.
In response to this, Keynes advocated a countercyclical fiscal policy in which,
during periods of economic woe, the government should undertake deficit
spending to make up for the decline in investment and boost consumer
spending to stabilize aggregate demand .1

Keynes was highly critical of the British government at the time.3 The
government greatly increased welfare spending and raised taxes to balance the
national books. Keynes said that this would not encourage people to spend
their money, thereby leaving the economy unstimulated and unable to recover
and return to a successful state.

Keynes proposed that the government spend more money and cut taxes to
turn a budget deficit, which would increase consumer demand in the
economy. This would, in turn, lead to an increase in overall economic activity
and a reduction in unemployment.1

Keynes also criticized the idea of excessive saving, unless it was for a specific
purpose such as retirement or education. He saw it as dangerous for the
economy because the more money sitting stagnant, the less money is in the
economy stimulating growth.4 This was another of Keynes’ theories geared
toward preventing deep economic depressions.

Many economists have criticized Keynes’ approach. They argue that

businesses responding to economic incentives will tend to return the economy
to a state of equilibrium unless the government prevents them from doing so
by interfering with prices and wages, making it appear as though the market
is self-regulating.

On the other hand, Keynes, who was writing while the world was mired in a
period of deep economic depression, was not as optimistic about the natural
equilibrium of the market. He believed that the government was in a better
position than market forces when it came to creating a robust economy.

Keynesian Economics and Fiscal Policy

The multiplier effect, developed by Keynes’ student Richard Kahn, is one of the
chief components of Keynesian countercyclical fiscal policy. According to
Keynes’ theory of fiscal stimulus, an injection of government spending
eventually leads to added business activity and even more spending. This
theory proposes that spending boosts aggregate output and generates more
income. If workers are willing to spend their extra income, the resulting growth
in gross domestic product (GDP) could be even greater than the initial
stimulus amount.5

The magnitude of the Keynesian multiplier is directly related to the marginal

propensity to consume. Its concept is simple. Spending from one consumer
becomes income for a business that then spends on equipment, worker wages,
energy, materials, purchased services, taxes, and investor returns. That
worker’s income can then be spent, and the cycle continues. Keynes and his
followers believed that individuals should save less and spend more, raising
their marginal propensity to consume to effect full employment and economic
growth.

In this theory, one dollar spent in fiscal stimulus eventually creates more than
one dollar in growth. This appeared to be a coup for government economists,
who could provide justification for politically popular spending projects on a
national scale.

This theory was the dominant paradigm in academic economics for decades.
Eventually, other economists, such as Milton Friedman and Murray Rothbard,
showed that the Keynesian model misrepresented the relationship between
savings, investment, and economic growth.6 Many economists still rely on
multiplier-generated models, although most acknowledge that fiscal stimulus
is far less effective than the original multiplier model suggests.

The fiscal multiplier commonly associated with the Keynesian theory is one of
two broad multipliers in economics. The other multiplier is known as the
money multiplier. This multiplier refers to the money creation process that
results from a system of fractional reserve banking.7 The money multiplier is
less controversial than its Keynesian fiscal counterpart.

Keynesian Economics and Monetary Policy

Keynesian economics focus on demand-side solutions to recessionary periods.

The intervention of government in economic processes is an important part of
the Keynesian arsenal for battling unemployment, underemployment, and low
economic demand. The emphasis on direct government intervention in the
economy often places Keynesian theorists at odds with those who argue for
limited government involvement in the markets.

Wages and employment, Keynesians argue, are slower to respond to the needs
of the market and require government intervention to stay on track.
Furthermore, they argue, prices do not react quickly and change only
gradually when monetary policy interventions are made, giving rise to a
branch of Keynesian economics known as monetarism.8

If prices are slow to change, this makes it possible to use money supply as a
tool and change interest rates to encourage borrowing and lending. Lowering
interest rates is one way that governments can meaningfully intervene in
economic systems, thereby encouraging consumption and investment
spending.8 Short-term demand increases initiated by interest rate cuts
reinvigorate the economic system and restore employment and demand for
services. The new economic activity then feeds continued growth and
employment.1

Keynesian theorists argue that economies do not stabilize themselves very

quickly and require active intervention that boosts short-term demand in the
economy.8
Without intervention, Keynesian theorists believe, this cycle is disrupted, and
market growth becomes more unstable and prone to excessive fluctuation.
Keeping interest rates low is an attempt to stimulate the economic cycle by
encouraging businesses and individuals to borrow more money. They then
spend the money that they borrow. This new spending stimulates the
economy. Lowering interest rates, however, does not always lead directly to
economic improvement.

Monetarist economists focus on managing the money supply and lower

interest rates as a solution to economic woes, but they generally try to avoid
the zero-bound problem. As interest rates approach zero, stimulating the
economy by lowering interest rates becomes less effective because it reduces
the incentive to invest, rather than simply hold money in cash or close
substitutes like short-term Treasurys.9 Interest rate manipulation may no
longer be enough to generate new economic activity if it can’t spur investment,
and the attempt at generating economic recovery may stall completely. This is
a type of liquidity trap.

When lowering interest rates fails to deliver results, Keynesian economists

argue that other strategies must be employed, primarily fiscal policy. Other
interventionist policies include direct control of the labor supply, changing tax
rates to increase or decrease the money supply indirectly, changing monetary
policy, or placing controls on the supply of goods and services until
employment and demand are restored.1

Keynesian Economics and the 2007-08 Financial Crisis

In response to the Great Recession and financial crisis of 2007–2008, the

Congress and Executive branch undertook several measures that drew from
Keynesian economic theory. The federal government bailed out debt-ridden
companies in several industries including banks, insurers, and automakers. It
also took into conservatorship Fannie Mae and Freddie Mac , the two major
market makers and guarantors of mortgages and home loans.

In 2009, President Obama signed the American Recovery and Reinvestment

Act, an $831-billion government stimulus package designed to save existing
jobs and create new ones. It included tax cuts/credits and unemployment
benefits for families; it also earmarked expenditures for healthcare,
infrastructure, and education.

These stimulus measures and federal interventions helped America's economy

recover, preventing the Great Recession from becoming another full-blown
depression.

COVID-19 Stimulus
In the wake of the COVID-19 pandemic starting in early 2020, the U.S.
government under President Donald Trump and then President Joseph Biden
offered a variety of relief, loan-forgiveness, and loan-extension programs .

The U.S. government also supplemented weekly state unemployment benefits

and sent American taxpayers direct aid in the form of three separate, tax-free
stimulus checks.

Who Was John Maynard Keynes?

John Maynard Keynes (1883–1946) was a British economist, best known as

the founder of Keynesian economics and the father of
modern macroeconomics. Keynes studied at one of the most elite schools in
England, the King's College at Cambridge University, earning an
undergraduate degree in mathematics from the latter in 1905.3 He excelled at
math but received almost no formal training in economics.

How Does Keynesian Economics Differ From Classical Economics?

According to Keynes, classical economics held that swings in employment and

economic output create profit opportunities that individuals and
entrepreneurs have an incentive to pursue, eventually correcting imbalances
in the economy.4 In contrast, Keynes argued that, during recessions, business
pessimism and certain characteristics of market economies would exacerbate
economic weakness and cause aggregate demand to plunge further. Keynesian
economics holds that, during periods of economic woe, governments should
undertake deficit spending to make up for the decline in investment and boost
consumer spending to stabilize aggregate demand.1

What Is Monetarism?

Monetarism is a macroeconomic theory stating that governments can foster

economic stability by targeting the growth rate of the money supply. Closely
associated with economist Milton Friedman, monetarism is a branch of
Keynesian economics that emphasizes the use of monetary policy over fiscal
policy to manage aggregate demand, which contrasts with the theories of most
Keynesian economists.8
The Bottom Line

John Maynard Keynes and Keynesian economics were revolutionary in the

1930s and did much to shape post-World War II economies in the mid-20th
century. His theories came under attack in the 1970s, saw a resurgence in the
2000s, and are still debated today. Keynesian economics, recognizes the role of
government finance in sparking aggregate demand. Federal spending and tax
cuts leave more money in peoples' pockets, which can stimulate demand and
investment. Unlike free market economists, Keynesian economics welcomes
limited government intervention and stimulus during times of recession.