Readers Question: Could you give a summary of Keynesian and Classical views?
- Classical economics emphasises the fact that free markets lead to an efficient outcome and are self-regulating.
- In macroeconomics, classical economics assumes the long run aggregate supply curve is inelastic; therefore any deviation from full employment will only be temporary.
- The Classical model stresses the importance of limiting government intervention and striving to keep markets free of potential barriers to their efficient operation.
- Keynesians argue that the economy can be below full capacity for a considerable time due to imperfect markets.
- Keynesians place a greater role for expansionary fiscal policy (government intervention) to overcome recession.
Shape of long-run aggregate supply
A distinction between the Keynesian and classical view of macroeconomics can be illustrated looking at the long run aggregate supply (LRAS).
Classical view of Long Run Aggregate Supply
The Classical view is that Long Run Aggregate Supply (LRAS) is inelastic. This has important implications. The classical view suggests that real GDP is determined by supply-side factors – the level of investment, the level of capital and the productivity of labour e.t.c. Classical economists suggest that in the long-term, an increase in aggregate demand (faster than growth in LRAS), will just cause inflation and will not increase real GDP>
Keynesian view of Long Run Aggregate Supply
The Keynesian view of long-run aggregate supply is different. They argue that the economy can be below full capacity in the long term. Keynesians argue output can be below full capacity for various reasons:
- Wages are sticky downwards (labour markets don’t clear)
- Negative multiplier effect. Once there is a fall in aggregate demand, this causes others to have less income and reduce their spending creating a negative knock-on effect.
- A paradox of thrift. In a recession, people lose confidence and therefore save more. By spending less this causes a further fall in demand.
Keynesians argue greater emphasis on the role of aggregate demand in causing and overcoming a recession.
2. Demand deficient unemployment
Because of the different opinions about the shape of the aggregate supply and the role of aggregate demand in influencing economic growth, there are different views about the cause of unemployment
- Classical economists argue that unemployment is caused by supply side factors – real wage unemployment, frictional unemployment and structural factors. They downplay the role of demand deficient unemployment.
- Keynesians place a greater emphasis on demand deficient unemployment. For example the current situation in Europe (2014), a Keynesian would say that this unemployment is partly due to insufficient economic growth and low growth of aggregate demand (AD)
3. Phillips Curve trade-off
A classical view would reject the long-run trade-off between unemployment, suggested by the Phillips Curve.
Classical economists say that in the short term, you might be able to reduce unemployment below the natural rate by increasing AD. But, in the long-term, when wages adjust, unemployment will return to the natural rate, and there will be higher inflation. Therefore, there is no trade-off in the long-run
Keynesians support the idea that there can be a trade-off between unemployment and inflation. See: Phillips curve
In a recession, increasing AD will lead to a fall in unemployment, though it may be at the cost of higher inflation rate.
4. Flexibility of prices and wages
In the classical model, there is an assumption that prices and wages are flexible, and in the long-term markets will be efficient and clear. For example, suppose there was a fall in aggregate demand, in the classical model this fall in demand for labour would cause a fall in wages. This decline in wages would ensure that full employment was maintained and markets ‘clear’.
A fall in demand for labour would cause wages to fall from W1 to We
However, Keynesians argue that in the real world, wages are often inflexible. In particular, wages are ‘sticky downwards’. Workers resist nominal wage cuts. For example, if there were a fall in demand for labour, trade unions would reject nominal wage cuts; therefore, in the Keynesian model, it is easier for labour markets to have disequilibrium.Wages would stay at W1, and unemployment would result.
A Keynesian would argue in this situation the best solution is to increase aggregate demand. In a recession, if the government did force lower wages, this might be counter-productive because lower wages would lead to lower spending and a further fall in aggregate demand.
5. Rationality and confidence
Another difference behind the theories is different beliefs about the rationality of people.
- Classical economics assumes that people are rational and not subject to large swings in confidence. (see: Rational economic man)
- Keynesian economics suggests that in difficult times, the confidence of businessmen and consumers can collapse – causing a much larger fall in demand and investment. This fall in confidence can cause a rapid rise in saving and fall in investment, and it can last a long time – without some change in policy.
Difference in policy recommendations
1. Government spending
- The classical model is often termed ‘laissez-faire’ because there is little need for the government to intervene in managing the economy.
- The Keynesian model makes a case for greater levels of government intervention, especially in a recession when there is a need for government spending to offset the fall in private sector investment. (Keynesian economics is a justification for the ‘New Deal’ programmes of the 1930s.)
2. Fiscal Policy
- Classical economics places little emphasis on the use of fiscal policy to manage aggregate demand. Classical theory is the basis for Monetarism, which only concentrates on managing the money supply, through monetary policy.
- Keynesian economics suggests governments need to use fiscal policy, especially in a recession. (This is an argument to reject austerity policies of the 2008-13 recession.
3. Government borrowing
- A classical view will stress the importance of reducing government borrowing and balancing the budget because there is no benefit from higher government spending. Lower taxes will increase economic efficiency. (e.g. at the start of the 1930s, the ‘Treasury View‘ argued the UK needed to balance its budget by cutting unemployment benefits.
- The Keynesian view suggests that government borrowing may be necessary because it helps to increase overall aggregate demand.
4. Supply side policies
- The classical view suggests the most important thing is enabling the free market to operate. This may involve reducing the power of trade unions to prevent wage inflexibility. Classical economics is the parent of ‘supply side economics‘ – which emphasises the role of supply-side policies in promoting long-term economic growth.
- Keynesian don’t reject supply side policies. They just say they may not always be enough. e.g. in a deep recession, supply side policies can’t deal with the fundamental problem of a lack of demand.
Classical Economics vs. Keynesian Economics
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My research of Classical Economics and Keynesian Economics has given me the opportunity to form an opinion on this greatly debated topic in economics. After researching this topic in great lengths, I have determined the Keynesian Economics far exceeds greatness for America compared to that of Classical Economics. I will begin my paper by first addressing my understanding of both economic theories, I will then compare and contrast both theories, and end my paper with my opinions on why I believe Keynesian Economics is what is best for America.
Classical Economics is a theory that suggests by leaving the free market alone without human intervention; equilibrium will be obtained. This theory was the first school of thought for economists and one of the major theorists and founders of Classical Economics was Adam Smith. Smith stated, “By pursuing his own interest, he (man) frequently promotes that (good) of the society more effectually than when he really intends to promote it. I (Adam Smith) have never known much good done by those who affected to trade for the public good.”(Patil) Classical Economic theory assumes three basic ideas: Flexible Prices, Shay’s Law, and Savings-Investment equality. Flexible prices in Classical theory suggests prices will rise and fall as needed but is not always true, due to, the interference of government agencies including unions and laws. Smith stated in the Wealth of the Nation (1776), “Civil government, so far it is instituted for the security of property, is in reality instituted for the defense of the rich against the poor, or of those who have some property against those who have none at all.” (Patil) Shay’s Law implies supply creates its own demand and demand is not based on production or supply.
The last assumption is that savings will equal the investment which will lead to equilibrium; however, Classical theorist are realist and know this will not always happen, thus, they believe the flexible interest rates will help with the equilibrium.
Keynesian Economics was developed and founding by John Maynard Keynes. He believed and wrote in his book “The General Theory of Employment, Interest and Money” that it is essential for the Government to play a vital role in economic stability. Keynesian theorist believe Government spending, tax hikes or tax breaks are vital in economic success. Keynesian assumptions include: Rigid or Inflexible Prices, Effective Demand, and Savings-Investment Determinants. Rigid or Inflexible Prices suggest that wages increases are easier to take while wage decreases hits resistance; likewise, a producer will increase prices yet when needed will be reluctant to decrease prices.
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Effective Demand implies that only a portion of the household income will be used for consumption, leading the Keynesians theorist to believe that the effective demand can only be derived from the actual disposable income. Lastly, the Keynesian theorists believe savings and investments are based on one’s desire to save for the future and the expected profitability of the endeavor.
As stated above one can see there are great differences in Classical and Keynesian Economics. Classical Economic theorists believe the Government should have no role in the free market while Keynesians believe the Government is vital in maintaining equilibrium in the free market. Classical Economic theorists believe supply creates its own demand while Keynesians believe demand can only be derived from the actual disposable income. Another contrast between these two theories include: Classical Economic theorist believe flexible interest rates will help with the equilibrium of savings and investments, while, Keynesians believe equilibrium
of savings and investments can only be obtained with the will of the savor and the expected profitability of the endeavor. In “Economics in Crisis: Severe and Logical Contradictions of Classical, Keynesian, and Popular Trade Models” written by Ravi Batra it is reported that Classical Economics almost died until inflation became intolerable and the Keynesian Economics made an error causing the Classical Economics to easily be brought into the economy. (p.623-624)
This research has brought new light for me in how economics/politics is played in America. Looking at recent events with the American Government, I now have a better understanding of how and why economics is so important. Hearing the word deregulation throughout the 2008 Presidential election, I never quite understood what it meant; I now am gaining a better understanding. I believed in the Keynesian theory before I even knew it existed and now I can say I feel stronger about the Keynesian Economics and I recognize the importance of this kind of economics for America. In “The Relevance of Keynes”, Robert Skidelsky states, “the classical
theory of the self-regulating market rested on the epistemological claim that market participants have perfect information about future events. Grant this and the full employment assumption follows, deny it and it collapses. Keynes’ economy, on the other hand, is one in which our knowledge of the future is usually very slight and often negligible and expectations are frequently subject to disappointment.” (p. 3) I agree with this because even in my short life I have seen many natural things change the economy such as September 11th or the Tsunami in Japan. No one can predict the future and everyone must be prepared for the worse. The websites and articles I found were intriguing in that they mainly disagreed with the Keynesian Economic theory. McCoach even went as far as to use scare tactics including a quote from Adolf Hitler,
“Gold is not necessary. I have no interest in gold. We will build a solid state, without an ounce of gold behind it. Anyone who sells above the set prices, let him be marched off to a concentration camp. That's the bastion of money” and later comparing Keynes and Hitler as having the same economics in the same sentence. (McCoach)
In “The Transition from the Classical to the Keynesian Perspective” written by Hukukane Nikaido, I found many different graphs which I have came to conclude is very important in an economic study. I found it hard to really understand the graphs but what I did gain from this article is that Keynesian Economics will continue because the graphs showed a great gain in Economic growth. I have further gained a greater appreciation for Keynesian theory for in this article Nikaido reports, “Keynes’s philosophy of the economic world should not be thought to be
confined to a depression economics. Moreover, it should be deeply impressed on our mind that this discordance applies in the short-run, but also in the long-run, contrariwise to the prevailing view of almost all economists. For a long-run analysis to ignore short-run aspects would be very fictional to the real economic world.” (542-543) My hope is America never has another economic catastrophe as we did in 1930’s and nearly again in 2000’s.
Batra, Ravi. "Economics in Crisis: Severe and Logical Contradictions of Classical, Keynesian, and Popular Trade Models." Review of International Economics 10.4 (2002): 623-44. Print.
McCoach, Greg. "Keynesian Economics 101." Independent Investment Advice and Analysis. 11 Feb. 2011. Web. 11 Apr. 2011.