Question

Explain Keynesian Economic theory and discuss why stagflation was so problematic for this theory?

Answer 1

Keynesian theory evolved during the time of Great economic depression. The entire classical postulates and theories were proven wrong during great depression. Keynes gave predominant role to aggregate demand in the economy. Keynes states that deficiency of aggregate demand was the reason for great economic depression.

The Keynesian ideas were incorporated in Philips curve that shows negetive relationship between inflation and unemployment. According to Keynes , an economy will never experience high inflation and higher level of unemployment at a time.

During the early 1970's, the so called stagflation occurred in several economies. It was a newer experience for the entire world. The stagflation proved that inflationary recession can happen in economy. Thus 1970's witnessed the growth of new school of thought called monetsrism. Stagflation reject the notion of Philips curve. An economy can experience inflation and unemployment at same time. It was a great set back for Keynesian demand side policies and supply side theories took the advantage.