Keynesian Theory: 

According to Keynesian theory, changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-run effect on real output and employment, not on prices. Keynesians' belief in aggressive government action to stabilize the economy is based on value judgments and on the beliefs that (a) macroeconomic fluctuations significantly reduce economic well-being and (b) the government is knowledgeable and capable enough to improve on the free market. This idea is portrayed, for example, in Phillips curves that show inflation rising only slowly when unemployment falls. Keynesians believe that what is true about the short run cannot necessarily be inferred from what must happen in the long run, and we live in the short run. Keynesians believe that, because prices are somewhat rigid, fluctuations in any component of spending consumption, investment, or government expenditures cause output to fluctuate. If government spending increases, for example, and all other components of spending remain constant, then output will increase. Keynesian models of economic activity also include a so-called multiplier effect; that is, output increases by a multiple of the original change in spending that caused it. Thus, a ten-billion-dollar increase in government spending could cause total output to rise by fifteen billion dollars (a multiplier of 1.5) or by five billion (a multiplier of 0.5). Contrary to what many people believe, Keynesian analysis does not require that the multiplier exceed 1.0. For Keynesian economics to work, however, the multiplier must be greater than zero. Keynesian economics is a theory of total spending in the economy (called aggregate demand) and its effects on output and inflation. Although the term has been used to describe many things over the years, six principal tenets seem central to Keynesianism. According to Keynesian economics, aggregate demand is influenced by a host of economic decisions both public and private and sometimes behaves erratically. The public decisions include, most prominently, those on monetary and fiscal (i.e., spending and tax) policies. The multiplier is an important concept in Keynesian economics.