If you are are looking for a simple, jargon-free explanation of Keynesian economics and the debate on what government should do about the recession, you've come to the right place. It will still be hard work if you haven't studied this stuff (it's not the easiest concept in the world), but you certainly don't need an economics degree or advanced training to understand any of it.



The central Keynesian insight is this: when you decide to hoard some extra cash rather than spend it, income in the rest of the economy goes down by the exact same amount, which then has a knock-on effect on your income. A recession ensues: a period when we work and produce less than we would like, and as a result get paid less too.



To illustrate the point while keeping things simple, let's say there are just two people in the world - me and you. This is an unrealistically small economy, but as we will see, the basic lesson applies to economies of any size.



In this make believe world, I make £100 a week by selling bread to you at £1 a loaf, and you make £100 a week by selling chocolate to me at £1 a bar. The total income in this economy (its Gross Domestic Product or GDP) is £200, which corresponds to 100 loaves of bread and 100 bars of chocolate.



Now, let's say that one fine day you decide to save £20 out of your £100 and keep it in cash. As a result, my income falls to £80, and the total income in the economy is now £180 - with the economy producing 20 chocolate bars fewer than before. In the following week, I only have £80 to spend, which means that your income also falls to £80, and you end up buying fewer of my loaves.



In the end, both our incomes are lower, and we produce and consume less than our potential. Our economy is in recession.





How does this carry forward to the real, larger, economy? Just think of me and you as blocks of people: essentially, when too many individuals decide to increase their cash holdings simultaneously - perhaps because they turn pessimistic about the future - a recession ensues. As Paul Krugman puts it beautifully (in mild economese):





The key to Keynes’s contribution was his realization that liquidity preference — the desire of individuals to hold liquid monetary assets — can lead to situations in which effective demand isn’t enough to employ all the economy’s resources.



So, this is how a recession starts; the question is, how can we climb back out of it?Our first option is to do nothing. If you paid close attention to the story above, you will have noticed that despite the slump in demand (you now only demand 80 loaves of bread rather than 100), I kept my price fixed at £1 per loaf. But I would really like to sell more bread to you because I can then have more income. Eventually I will start lowering my prices so that I can go back to selling all 100 loaves I can produce.By exactly the same logic, you will do the same and we will be back where we started - producing at our full potential of 100 loaves of bread and 100 bars of chocolate. Recession kaput.And here's where the difference between neoclassical and Keynesian economics lies.The former school of thought assumes that the adjustment process is instantaneous: if you decide to hold £20 extra in cash, neoclassical economics assumes that we bothlower our prices to £0.80 so that nothingchanges: the economy keeps producing (and consuming) 100 loaves and 100 bars of chocolate, and there's never any recession.(This is not strictly true. Neoclassical economics doesn't say GDP can never fall - to stick with our example, you might fall sick and not be able to work, or decide to work less because you want to spend time with the kids, leading to less chocolate, bread and incomes all round. What youhave with neoclassical economics, however, is a demand-driven recession: a fall in economic activity simply because too many people decide to increase their cash holdings and consume less at a point in time)Recessions, then, are generally self-correcting: prices will eventually adjust, and the economy will go back to producing at potential. And while this offers some consolation, we would still like to lessen the pain by either avoiding or speeding up the process of adjustment.In our simple example, there is an obvious solution. Let's say that when you first made your decision to hold £20 in cash rather than spend it to buy my loaves, the government printed an extra £20 and used it to buy my unsold produce. My income at the end of that week would be £100 just as it was before, and because my income is your income (remember, I spend my income on your chocolate bars and you spend yours on my loaves) the economy doesn't go through a period of under-producing at all. There is no recession, there is no need for a lengthy period when prices adjust, and we happily keep producing at our potential.This is as far as our simple story will take us. Recessions can ensue for as silly a reason as people wanting to hold more cash, and the government can in principle take action to correct the situation.If you found this post worthwhile, let me know and I will build on this basic story to cover the action government can take (fiscal and monetary policy), the complications that arise in practice, and the role of banks and financial markets.