Keynesian Economics
From Wikipedia (I have cut this and edited out the more confusing aspects - read it carefully, but it is still confusing towards the end)
Keynesian economics is a macroeconomic theory based on the ideas of 20th-century British economist John Maynard Keynes. Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and therefore advocates active policy responses by the public sector, including both monetary policy actions by the central bank and fiscal policy actions by the government to stabilize the business cycle. The theories forming the basis of Keynesian economics were first presented in The General Theory of Employment, Interest and Money, published in 1936.
Keynesian economics advocates a mixed economy—predominantly the private sector, but with a large role taken by government (the public sector). This economic model was used during the latter part of the Great Depression, World War II, and the post-war Golden Age of Capitalism, 1945–1970, though it lost some influence following the stagflation of the 1970s. As a middle way between laissez-faire capitalism and socialism, it has been and continues to be attacked from both the right and the left.
The advent of the global financial crisis in 2007 has caused a resurgence in Keynesian thought. Keynesian economics has provided the theoretical underpinning for the plans of American President Barack Obama, UK Prime Minister Gordon Brown, and other global leaders to rescue the world economy [Pumping in the money, or as they like to call it, Quantative Easing].
Keynes sought to develop a theory that would explain the whys of: saving, consumption, investment and production. In that theory, the interaction of demand and supply determines the level of output and employment in the economy.
Wages and Spending
During the Great Depression, classical theory defined economic collapse as simply a lost incentive to produce. Mass unemployment was caused only by high and rigid real wages. To Keynes, the determination of wages is more complicated. First, he argued that it is not real but nominal wages that are set in negotiations between employers and workers, as opposed to a barter relationship. Second, nominal wage cuts would be difficult to put into effect because of laws and wage contracts. Even classical economists admitted that these exist; unlike Keynes, they advocated abolishing minimum wages, unions, and long-term contracts, thereby increasing labor-market flexibility. However, to Keynes, people will resist nominal wage reductions, even without unions, until they see other wages falling and a general fall of prices. He also argued that to boost employment, real wages had to go down: nominal wages would have to fall more than prices. However, doing so would reduce consumer demand, so that the demand for goods would drop. This would in turn reduce business sales revenues and expected profits. Investment in new plants and equipment—perhaps already discouraged by previous excesses—would then become more risky, less likely. Instead of raising business expectations, wage cuts could make matters much worse. Further, if wages and prices were falling, people would start to expect them to fall. This could make the economy spiral downward as those who had money would simply wait as falling prices made it more attractive to buy later.
The Classicalists wanted to balance the government budget. To Keynes, this would exacerbate the underlying problem. Keynes′ theory suggested that active government policy could be effective in managing the economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated what has been called countercyclical fiscal policies, that is policies which acted against the tide of the business cycle: deficit spending when a nation's economy suffers from recession or when recovery is long-delayed and unemployment is persistently high—and the suppression of inflation in boom times by either increasing taxes or cutting back on government outlays. He argued that governments should solve problems in the short run rather than waiting for market forces to do it in the long run, because "in the long run, we are all dead."
This contrasted with the classical and neoclassical economic analysis of fiscal policy. Fiscal stimulus (deficit spending) could actuate production. But to these schools, there was no reason to believe that this stimulation would outrun the side-effects that "crowd out" private investment: first, it would increase the demand for labor and raise wages, hurting private profitability; Second, a government deficit increases the stock of government bonds, reducing their market price and encouraging high interest rates, making it more expensive for business to finance fixed investment. Thus, efforts to stimulate the economy would be self-defeating.
A Keynesian economist might point out that classical and neoclassical theory does not explain why firms acting as "special interests" to influence government policy are assumed to produce a negative outcome, while those same firms acting with the same motivations outside of the government are supposed to produce positive outcomes. Libertarians counter that because both parties consent, free trade increases net happiness, but government imposes its will by force, decreasing happiness. Therefore firms that manipulate the government do net harm, while firms that respond to the free market do net good.
In Keynes' theory, there must be significant slack in the labor market before fiscal expansion is justified. Both conservative and some neoliberal economists question this assumption, unless labor unions or the government "meddle" in the free market, creating persistent supply-side or classical unemployment. Their solution is to increase labor-market flexibility, e.g., by cutting wages, busting unions, and deregulating business.
Deficit spending is not Keynesianism. Keynesianism recommends counter-cyclical policies to smooth out fluctuations in the business cycle. An example of a counter-cyclical policy is raising taxes to cool the economy and to prevent inflation when there is abundant demand-side growth, and engaging in deficit spending on labor-intensive infrastructure projects to stimulate employment and stabilize wages during economic downturns. Classicalists, on the other hand, argue that one should cut taxes when there are budget surpluses, and cut spending—or, less likely, increase taxes—during economic downturns. Keynesian economists believe that adding to profits and incomes during boom cycles through tax cuts, and removing income and profits from the economy through cuts in spending and/or increased taxes during downturns, tends to exacerbate the negative effects of the business cycle. This effect is especially pronounced when the government controls a large fraction of the economy, and is therefore one reason fiscal conservatives advocate a much smaller government.
Post War
In the post-WWII years, Keynes's policy ideas were widely accepted. Governments prepared good quality economic statistics on an ongoing basis and tried to base their policies on the Keynesian model that had become orthodox. In the early era of new liberalism and social democracy, most western capitalist countries enjoyed low, stable unemployment and modest inflation. Through the 1950s, moderate degrees of government demand leading industrial development, and use of fiscal and monetary counter-cyclical policies continued, and reached a peak in the "go go" 1960s, where it seemed to many Keynesians that prosperity was now permanent. In 1971, Republican US President Richard Nixon even proclaimed "we are all Keynesians now". However, with the oil shock of 1973 and the economic problems of the 1970s, modern liberal economics began to fall out of favor. During this time, many economies experienced high and rising unemployment, coupled with high and rising inflation. This stagflation meant that the simultaneous application of expansionary (anti-recession) and contractionary (anti-inflation) policies appeared to be necessary, a clear impossibility. This dilemma led to the end of the Keynesian near-consensus of the 1960s, and the rise throughout the 1970s of ideas based upon more classical analysis, including monetarism, supply-side economics, and new classical economics. At the same time, Keynesians began to reorganize their thinking (some becoming associated with New Keynesian economics); one strategy, utilized also as a critique of the notably high unemployment and potentially disappointing GNP growth rates associated with the latter two theories by the mid-1980s, was to emphasize low unemployment and maximal economic growth at the cost of somewhat higher inflation (its consequences kept in check by indexing and other methods).