What is demand-side economics?

Because Keynesian economists 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 supply-side economics, which states the production of goods or services, or supply, is of primary importance in economic growth.

Economist John Maynard Keynes developed his economic theories in large part as a response to the Great Depression of the 1930s. Prior to the Great Depression, classical economics was the dominant theory, with the belief that through the market forces of 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 free market were not restoring balance to the economy.

Keynes maintained that unemployment is the result of an insufficient 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 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 capital goods; government spending on public goods and services; and 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 recession or depression, to reduce unemployment and stimulate growth.

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 money supply by altering interest rates 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 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 increases the velocity of money, or the frequency at which $1 is used to buy domestically produced goods and services. Increased velocity of money means more people are consuming goods and services and, thus, contributing to an increase in aggregate demand. (For related reading, see: How Money Makes the Economy Move.)