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Keynesian economics

During the Great Depression, the English economist John Maynard Keynes (1883–1946) gave the definitive liberal response to the economic crisis. Keynes had been "brought up" as a classical liberal, but especially after World War I, became increasingly a welfare or social liberal. A prolific writer, among many other works, he had begun a theoretical work examining the relationship between unemployment, money and prices back in the 1920s. Keynes was deeply critical of the British government's austerity measures during the Great Depression. He believed budget deficits were a good thing, a product of recessions. He wrote: "For Government borrowing of one kind or another is nature's remedy, so to speak, for preventing business losses from being, in so severe a slump as the present one, so great as to bring production altogether to a standstill". At the height of the Great Depression in 1933, Keynes published The Means to Prosperity, which contained specific policy recommendations for tackling unemployment in a global recession, chiefly counter cyclical public spending. The Means to Prosperity contains one of the first mentions of the multiplier effect.

Keynes's magnum opus, The General Theory of Employment, Interest and Money, was published in 1936 and served as a theoretical justification for the interventionist policies Keynes favoured for tackling a recession. The General Theory challenged the earlier neo-classical economic paradigm, which had held that the market would naturally establish full employment equilibrium if it were unfettered by government interference. Classical economists believed in Say's law, which states that " supply creates its own demand " and that in a free market, workers would always be willing to lower their wages to a level where employers could profitably offer them jobs. An innovation from Keynes was the concept of price stickiness, i.e. the recognition that, in reality, workers often refuse to lower their wage demands even in cases where a classical economist might argue it is rational for them to do so. Due in part to price stickiness, it was established that the interaction of " aggregate demand " and " aggregate supply " may lead to stable unemployment equilibria, and in those cases, it is the state and not the market that economies must depend on for their salvation. The book advocated activist economic policy by the government to stimulate demand in times of high unemployment, for example, by spending on public works. In 1928, he wrote: "Let us be up and doing, using our idle resources to increase our wealth.... With men and plants unemployed, it is ridiculous to say that we cannot afford these new developments. It is precisely with these plants and these men that we shall afford them". Where the market failed to allocate resources properly, the government was required to stimulate the economy until private funds could start flowing again—a "prime the pump" kind of strategy designed to boost industrial production.