Whereas classical economics assumes that prices are flexible and quickly adjust to equilibrium, Keynesian economics assumes that prices are inflexible and do not quickly adjust to equilibrium. Whereas classical economics assumes that supply creates its own demand, termed Say's law, Keynesian economics assumes that demand, especially consumption expenditures, depends on actual income received by the household sector. Whereas classical economics assumes that saving and investment achieve equality through flexible adjustment of the interest rate, Keynesian economics assumes that saving and investment depend on factors other than the interest rate and might not achieve equilibrium.

A Keynesian Overview

Keynesian economics dominated the study of economics for 40 years after it was introduced. It fell out of favor in the 1980s largely because it did not adequately explain the simultaneous occurrence of high rates of unemployment and inflation that came to be known as stagflation.

Highlights of Keynesian economics include:

• One, Keynesian economics offers a theoretical explanation of, and a remedy for, persistent unemployment problems, especially those occurring during the Great Depression.


• Two, the theoretical structure of Keynesian economics is based on a view that the macroeconomy is a distinct entity operating accord a set of principles distinct from those governing microeconomic phenomena. The macroeconomy is more than just a collection of markets.


• Three, these macroeconomic principles of Keynesian economics indicate that aggregated markets, especially resource markets, do not automatically achieve equilibrium, meaning full employment is not guaranteed.


• Four, Keynesian economics indicates that the recommended way to achieve full employment is through government intervention, especially fiscal policy.

Rigid Prices

Rigid prices can exist for a number of reasons. First, producers often have long-term, multi-year contracts with resource suppliers that specify resource prices. These agreements prevent prices for changing. Second, workers tend to view wages as an indication of intrinsic self-worth and thus resist attempts to lower wages. Workers might opt for temporary unemployment, rather than working at lower wages.

Third, the employment and payment system is guided by inertia. Employers are often reluctant to change wages because doing so can be costly. Fourth, firms often reduce employment rather than wages to "clean house" and get rid of the least productive workers. Fifth, many firms, especially small ones, are price takers in resource markets. They have NO control over the resource prices set by the market.

Effective Demand

This assumption means that changes in income, especially disposable income, are the prime influence on consumption expenditures. If the household sector has more income because the economy is expanding, then they increase consumption expenditures. If the household sector has less income because the economy is contracting and a large group of workers is unemployed, then they decrease consumption expenditures.

This effective demand proposition is embodied in a key Keynesian principle, termed the consumption function, which is the relation between household consumption expenditures and household income. More specially, as specified by the so-called psychological law, the consumption function indicates that people use only a fraction of any extra income for consumption.

Saving and Investment Determinants

The most important non-interest-rate determinant of household saving is disposable income. As the disposable income changes, not only does the household sector change consumption expenditures, it also changes saving. Keynesian economics assumes that the relation between saving and income is a great deal more important than that between saving and the interest rate. Another key non-interest-rate determinant of saving is expectations. That is, the household is motivated to save in anticipation of future spending (saving for college, saving for retirement, saving to buy a house, etc.), regardless of the interest rate.