Demand-Side Economics Definition, Examples of Policies

What Is Demand-Side Economics?

Keynesian economists believe that 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 that the production of goods or services, or supply, is of primary importance in economic growth.

Understanding Demand-Side Economics

Keynes maintained that unemployment is the result of inadequate demand for goods. During the Great Depression, factories sat idle. Due to a lack of demand for products, factories had insufficient need for workers.

This lack of aggregate demand contributed to unemployment and, contrary to classical theories of economics, the economy was not able to self-correct and restore balance.

One of the core characteristics of Keynesian economics 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. This could reduce unemployment and stimulate economic growth.

John Maynard Keynes

Economist John Maynard Keynes developed his economic theories in part as a response to the Great Depression of the 1930s. Before the Great Depression, classical economics was the dominant theory. It held that through the market forces of supply and demand, economic equilibrium would be restored naturally over time.

However, Keynes believed that the Great Depression and its long-running, widespread unemployment defied classical economic theories. His theories tried to explain why the mechanisms of the free market were not restoring balance to the economy.

Keynes' book,The General Theory of Employment, Interest, and Money, was written in 1936 and reflected his experience as a witness to the Great Depression. In it, he rejects the aforementioned belief that an economy in a downturn would right itself. Instead, he believed that action by the government was called for. It should intervene with increased spending and lower taxes to stimulate consumption.

Types of Demand-Side Economic Policies

Government Spending

If the other components of aggregate demand are static, government spending can help. If people are less able or willing to consume, and businesses are less willing to hire workers and invest in building more factories, the government can step in. It can increase government spending to generate demand for goods and services.

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 Money Supply

Central banks can also achieve this goal by altering interest rates or selling or buying government-issued bonds. This type of intervention is part of what is known as monetary policy. These actions, such as changing interest rates, can be used to increase the total money supply in the economy or the velocity of money flowing through the economy.

Increasing the flow of money correspondingly 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.

Example of Demand-Side Economic Policies

The financial crisis of 2008 sparked the use of demand-side economic policy by the U.S. government. The Obama administration lowered interest rates. It also cut taxes for the middle class. It put together a $787 billion stimulus package. What's more, the government intervened to overhaul the financial industry in a way not seen since the days of Franklin D. Roosevelt in the 1930s.