The Basics of Keynesian Economics for the GED Social Studies Test

By Achim K. Krull, Murray Shukyn

The GED Social Studies test may ask a few questions about Keynesian economics. Keynesian economics is a special case. John Maynard Keynes developed his famous theory in England during the Great Depression.

He was trying to understand why the Depression happened and how to solve the problem. He could see that classic economics didn’t work to solve the crisis. In recession or depression, demand drops. People are reluctant to buy, fearing unemployment and the resulting lack of income. As demand continues to drop, companies lay off workers. However, prices are sticky, meaning they don’t drop as the classic economic model would predict.

Wages are also sticky because most workers won’t agree to wage cuts. When companies lay off workers, unemployment and fear of unemployment cause demand for goods to drop even farther. Production continues to drop, unemployment continues to rise, and recovery from that cycle is much more difficult. In effect, recession and depression form a downward spiral in which reduced demand leads to unemployment, which leads to further reduction in demand, and so on.

Keynes argued that the traditional conservative way of cutting costs and instituting austerity (cost-cutting) programs isn’t the way to get the economy running again. Austerity programs generally result in more layoffs. He argued that governments should encourage spending, increase hiring, and even use deficit financing to spur the economy.

After the recession of 2008, the U.S. federal government used that approach. The administration supported the banking sector (avoiding a collapse), invested billions in public-works programs, and even bailed out manufacturing companies including General Motors and Chrysler, saving tens of thousands of jobs.

By 2015, unemployment in the United States was at 5.6 percent, a historic low; weekly earnings had started to climb again, corporate profits tripled, and the stock market recovered all the losses of 2008. However, the recovery was uneven. People at the lower end of the economic scale saw few benefits, even as more than 6 million jobs were created.

The major criticism of Keynesian economics is that it provides little guidance on how to end government spending when the recession or depression ends. Large government stimulus spending increases the risk of inflation. The question, then, is when and how to cut back on that spending and recover the money spent stimulating the economy. Governments are reluctant to raise taxes, and the economy may not yet be able to accept cutbacks to balance the books.

What do economists mean when they refer to sticky prices?

  • (A) prices that have too many agencies involved in their management

  • (B) prices that tend to remain low even when they should be rising

  • (C) the tendency for prices to change much more slowly than demand would suggest

  • (D) prices that “stick” to changes in the value of currency

The term sticky prices refers to the stability of prices despite changes in demand. Your best answer is Choice (C). Choice (B) is partially true but not the best answer. Nothing in the passage supports Choice (A) or Choice (D).