What Is Demand-Side Economics?

Because聽Keynesian economists聽believe the primary factor driving economic activity and short-term fluctuations is the demand for goods and services, the theory is sometimes called demand-side economics. This perspective is at odds with classical economic theory, or聽supply-side economics, which states the production of goods or services, or supply, is of primary importance in聽economic growth.

Economist聽John Maynard Keynes聽developed his economic theories in large part as a response to the聽Great Depression聽of the 1930s. Before the Great Depression,聽classical economics聽was the dominant theory, with the belief that through the market forces of聽supply and demand, economic equilibrium would be restored naturally over time. However, the Great Depression and its long-running, widespread unemployment defied classical economic theories, which could not explain why the mechanisms of the聽free market聽were not restoring balance to the economy.

Key Takeaways

  • Demand-side economics refer to Keynesian economists' belief that demand for goods and services drive economic activity.
  • A core characteristic of demand-side economics is aggregate demand.
  • Government can generate demand for goods and services if people and businesses are unable to.

Insufficient Demand Causes Unemployment

Keynes maintained that unemployment is the result of inadequate demand for goods. During the Great Depression, factories sat idle, and workers were unemployed because there was not enough of a demand for those products. In turn, factories had insufficient demand for workers. Because of this lack of聽aggregate demand, unemployment persisted and, contrary to classical theories of economics, the market was not able to self-correct and restore balance.

One of the core characteristics of Keynesian or demand-side economics is the emphasis on aggregate demand. Aggregate demand is composed of four elements: consumption of goods and services; investment by industry in聽capital goods; government spending on聽public goods聽and services; and聽net exports. Under the demand-side model, Keynes advocated for government intervention to help overcome low aggregate demand in the short-term, such as during a聽recession聽or depression, to reduce unemployment and stimulate growth.

How the Government Can Generate Demand

If the other components of aggregate demand are static, government spending can mitigate these issues. If people are less able or willing to consume, and businesses are less willing to invest in building more factories, the government can step in to generate demand for goods and services. It can achieve this goal through its control of the聽money supply聽by聽altering聽interest rates聽or selling or buying government-issued bonds.

Keynesian economics supports heavy government spending during a national recession to encourage economic activity. Putting more money in the pockets of the middle and lower classes has a greater benefit to the economy than saving or stockpiling the money in a wealthy person's account. Increasing the flow of money to lower and middle classes聽increases the velocity of money or the frequency at which $1 is used to buy domestically produced goods and services. Increased聽velocity of money聽means more people are consuming goods and services and, thus, contributing to an increase in aggregate demand.