What is the Keynesian solution to a recession or depression?
John Maynard Keynes was a firm believer in the government's role in stabilizing the economy and in minimizing unemployment. In contrast to many free-market theorists, who held to the belief that the market, operating independent of government intrusion, was the most reliable means of ensuring economic growth and stability, Keynes argued that only the central government was possessed of the means of addressing persistently high unemployment levels. Reductions in demand for goods that invariably accompanied economic downturns--in effect, nervous or financially-constrained consumers seriously reduced spending on goods and services, thereby placing downward pressure on manufacturing and on the service sector--created a vicious cycle that depressed wages and reduced employment levels as business cut staff due to the decreased demand for goods.
Keynes's name became synonymous with the notion of government involvement in the economy because of his arguments that the government had a responsibility, as well as the means, to alleviate economic turmoil. Recessions and depressions, then, necessitate, in his view, an increased role in facilitating increased economic activity, and the main instrument for that is the central bank's (in the United States, the Federal Reserve) role in establishing monetary policy. By increasing the supply of money available to businesses and to consumers through low-interest loans, economic activity is spurred. With the availability of cash, businesses can invest in recapitalization and consumers can spend. As business recapitalizes and grows, it hires more workers, thereby decreasing the rate of unemployment.
In addition to influencing economic growth via control of monetary supply, central governments can also grow employment rates through government-sponsored enterprises, such as the plethora of federal programs that helped lift the United States out of the depths of the Great Depression. There will probably always be debates regarding the government's role in reversing the effects of the Great Depression, but there is little doubt that programs such as the Works Projects Administration helped address the dire need for jobs during a period when such assistance was definitely most in demand.
In conclusion, Keynes's approach to recessions or depressions involved increased government intervention in the economy. Keynes's greatest concern was for the need to ensure full employment, and market mechanisms by themselves, he believed, were insufficient to address that problem.
The typical Keynesian solution to a recession or a depression is to cut taxes and/or increase government spending. Keynesians argue that this will stimulate aggregate demand (AD) and cause gross domestic product (GDP) to rise.
Keynesians argue that the government must spend more and/or tax less in bad times. The reason for this is that it will put more money into the hands of consumers. Keynesians believe that recessions and depressions are caused largely by inadequate AD and, therefore, that increasing AD will get the economy out of the slump. In this view, the government starts to pay people to do things like, for example, building roads. Importantly, the money the government spends will multiply itself and have a much larger impact on the level of AD. If the government spends $100 million on road building, the people who get that money will save a bit, but they will spend most of it. That means businesses will have gotten perhaps $90 million (if people saved 10%). The businesses will save some of that, but they will also spend most of it. This cycle keeps on occurring over and over and the original government spending is multiplied many times (the exact multiplier depends on how much people save). In this way, the AD curve will be shifted to the right and GDP will rise.