Classical Economics vs Keynesian Economics

This 'Classical economics vs Keynesian economics' article should help most students. I was also there once, a troubled (obviously) and insane (for taking on a double economics major with 8 different economics subjects) varsity student, trying to cope with the vagrancies of Classical economics and Keynesian economics. This is a 3 part article on (i)Classical Economics (ii)Keynesian Economics and (iii)Classical Economics vs Keynesian Economics.

Economics is a very interesting subject, but unfortunately, you either get it or you don't. It is really not something you can learn by heart, and can only be tackled with a thorough understanding of the subject. I attempt to throw light on the two main theories of economics: Classical economics and Keynesian economics. Though there are many many other theories, they are all related in some or the other way to these two major schools of thought. It may be very difficult to understand them without diagrams (since economics = diagrams, lots and lots of diagrams), I will try to give a simple overview of both these theories, before ending with a comparative analysis of Keynesian economics vs Classical economics. Classical Economics Explained Classical economics is considered to be the first school of economic thought. Let us start with a general overview of what this school of thought propagates. By the way, I am an out-and-out Classical economist, so forgive any biases that might creep in. Also understand, that even if it may seem so in this particular article at times, one cannot conclude that Keynesian economics is flawed or classical economics is flawed (there's no absolute right and wrong in economics, different theories are applicable under different economic assumptions). Classical Economics Definition and Groundwork for the Classical Economics Model "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." - Adam Smith (1776), An excerpt from 'An Inquiry into The Nature and Causes of The Wealth of Nations'. Adam Smith is the great economist, who is known as the founder of the classical economics school of thought. Though many others (David Ricardo, Thomas Malthus, John Stuart Mill, William Petty, Johann Heinrich Von Thunen, etc.) have come and gone, and added a few things here and there, to the classical theories, we will only be stressing on Adam Smith's version in this article. The Classical economics theory is based on the premise that free markets can regulate themselves if left alone, free of any human intervention. Adam Smith's book, 'The Wealth of Nations', that started a worldwide Classical wave, stresses on there being an invisible hand (an automatic mechanism) that moves markets towards a natural equilibrium, without the requirement of any intervention at all. In better economic words, the division of labor and the free market will automatically tend toward an equilibrium that advances public interests. Sounds fascinating? Let us see how. Classical Economics Assumptions Before working our way towards the workings of the Classical economics model, let us first know and understand the classical economics assumptions. The idea, is that like any theory, if the founding assumptions do not hold, the theory based on them is bound to fail. There are three basic assumptions of Classical Economics theories. They are:

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Flexible Prices: The prices of everything, the commodities, labor (wages), land (rent), etc. must be both upwardly and downwardly mobile. Unfortunately, in reality, it has been observed that these prices are not as readily flexible downwards as they are upwards, due a variety of market imperfections, like laws, unions, etc. Say's Law: 'Supply creates its own demand'. The Say's law suggests that the aggregate production in an economy must generate an income enough to purchase all the economy's output. In other words, if a good is produced, it has to be bought. Unfortunately, this assumption also does not hold good today, as most economies today are demand driven (production is based on demand. Demand is not based on production or supply). Savings - Investment Equality: This assumption requires the household savings to equal the capital investment expenditures. Now it takes no genius to know, that this is rarely the case. Yet, should the savings not equal the investment, the 'flexible' interest rates should be able to restore the equilibrium.

Classical Economics - The Workings of An Economy "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." - Adam Smith from 'The Wealth of Nations', 1776. All the normal principles of economics apply to classical economics as well. If all the assumptions hold, classical economics works as follows.

Wage Markets Classical economics negates the fact that there can be some unemployment (especially involuntary) in an economy, because classical economists believe in the self-correcting mechanism of an economy. Their contention is based on the following:

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Whenever there is unemployment in an economy, it is usually a temporary disequilibrium because it is an equilibrium caused by excess labor available at the current wage rate. Whenever wages are high, there are always more people willing to work at that ongoing rate and this is termed as unemployment. In an unregulated, classical economy, where wages are perfectly flexible, the wage rates fall, eliminating the excess labor available and reducing the unemployment back to equilibrium levels. How exactly does this happen? This happens because all hirers favor their self-interest motives. When laborers are still available when he pays them a lower wage, why should he pay more. He thus adjusts his wage rates downwards, acting in the overall welfare of society, without knowing it.

Commodity Markets The Say's law that equates the demand and supply in an economy actually applies to aggregates and not single goods and commodities. Classical economists believe that the commodities markets will also always be in equilibrium, due to flexible prices. If the supply is high and there is inadequate demand for it, it is a temporary situation. The prices for the commodity in question, decrease, to equate the demand and supply and bring the situation back to equilibrium. How does this work? Well, what would you do if you had a commodity that you needed to sell but weren't able to secure a buyer. You'd obviously reduce the prices step by step, in a trial and error manner and finally reach a price that might tempt a buyer to buy. It is a similar case with the aggregate demand and supply, say the classical theorists. Capital Markets In the beautiful free world of classical economics, no human intervention is required to lead the capital markets to equilibrium as well. If the economy does not follow the last assumption and shows a mismatch in savings and investments, the classical economists provide the evergreen solution - do nothing, it is temporary and will correct itself. If savings exceed investment, the interest rates fall and the market achieves equilibrium again. On the other hand, if savings fall short of investments, the interest rates rise and once again, the economy reaches its own equilibrium. Let us now see how all the markets come together in the classical economics model. One potential problem with the classical theories is that Say's law may not be true. This may happen because not all the income earned goes towards consumption expenditures. The total savings thus saved, translate into the missing potential demand, which is the cause of the disequilibrium. When supply falls short of effective demand like this, several things spiral downwards: producers reduce their production, workers are laid off, wages fall resulting in lower disposable incomes, consumption declines reducing demand by further more and starting a self-sustaining vicious cycle. However, classical economists argue that what happens to the savings that started to the whole chain is the key solution here. If all of these savings go in as investments, the interest rates adjust to bring the economy back to equilibrium once again, with absolutely no problems at all. The only glitch, are all savings actually invested in reality? By investment, classical economists mean capital generation, so I doubt it! But as one can see, according to classical theories, there is really no need for any government intervention. No wonder then, that they are against it, for they can provide good backing to all the arguments that state, that government intervention cannot help, but can actually harm the economy in the long run. We will contemplate this later, in the comparison of Classical economics vs Keynesian economics section. For now, we will move on to the next economic theory, Keynesian economics. Keynesian Economics Theory Explained Keynesian economics is the brain child of the great economist, John Maynard Keynes. The Keynesian school of economics considers his book, 'The General Theory of Employment, Interest and Money' (1936) as its holy Bible. Let us have an overview of this theory, which contradicts and confronts the classical theory on almost all counts. Keynesian Economics Definition and Groundwork for the Keynesian Economics Model "Long run is a misleading guide to current affairs. In the long run we are all dead." - John Keynes's most famous quote, to stop the Classical economists from rapping about the 'long run'. Keynesian economics is wholly based on a simple logic, that there is no divine entity, nor some invisible hand, that can tide us over economic difficulties, and we must all do so ourselves. Keynesian economic models stress on the fact that Government intervention is absolutely necessary to ensure growth and economic stability. While classical economists believe that the best monetary policy is no monetary policy, Keynesian economists (Alvin Hansen, R. Frisch, Tinbergen, Paul Samuelson etc.) believe otherwise. In the Keynesian economic model, the government has the very important job of smoothening out the business cycle bumps. They stress on the importance of measures like government spending, tax breaks and hikes, etc. for the best functioning of the economy. Keynesian Economics Assumptions Like all economic theories, the Keynesian Economics school of thought is based on a few key assumptions. Let us have a look at them first, before we progress on to the application of Keynesian economics in the actual economy.

Rigid or Inflexible Prices: Mostly we see that while a wage hike is easier to take, wage falls hit some resistance. Likewise, while for a producer, commodity prices are easily upwardly mobile, he is extremely reluctant for any reductions. For all such prices, it is easily notable that they are not actually as flexible as we'd like, due to several reasons, like long-term wage agreements, longterm supplier contracts, etc. Effective Demand: Contrary to Say's law, which is based on supply, Keynesian economics stresses the importance of effective demand. Effective demand is derived from the actual household disposable incomes and not from the disposable income that could be gained at full employment, as the classical theories state. Keynesian economics also recognizes that only a fraction of the household income will be used for consumption expenditure purposes. Savings and Investment Determinants: Keynesian economics directly contradicts the savings-investment proponent of Classical economics, because of what it believes to be the savings and investment determinants. While classical economists believe that savings and investment is triggered by the prevailing interest rates, Keynesian economists believe otherwise. They believe that household savings and investments are based on disposable incomes and the desire to save for the future and commercial capital investments are solely based on the expected profitability of the endeavor.

Keynesian Economics - The Workings of an Economy "The biggest problem is not to let people accept new ideas, but to let them forget the old ones." - John Maynard Keynes. As classical economics and the Great Depression did not go so well together, with the latter exposing several flaws in the former, but Keynesian economics came up with a solution. Keynesian economics and the Great depression worked well together, with the former giving ways to avoid and escape the latter. Keynesian economics is equipped to teach everyone about how to survive an economic depression. Let us have a look at how the Keynesian theory works. Keynesian economists believe that the macroeconomic economy is more than just an aggregate of markets. Also, these individual commodity and resource markets are not capable of achieving an automatic equilibrium and it is quite possible that such disequilibriums last for very long. As full employment is not guaranteed automatically, Keynesian economics advocates the use of beneficial government policies in order to give the economy a helping hand. Commodity Markets The Keynesians start with a graph showing a 45 degree line starting at the intersection of both the axis. This line depicts all the points where the aggregate expenditure equals the aggregate production. In other words, the economy is at a full employment equilibrium. They then chart a real aggregate expenditures line, an aggregated amount of all the macroeconomic sector expenditures (Household Consumption, Investment, Government Spending, etc.) and capture the effective demand. When the economy is below or above the intersection between these two lines, there is an obvious disequilibrium or imbalance. If aggregate production is more than the aggregate expenditures, there is excess supply. Inventories increase and businesses reduce their production to stop these. On the other hand, when the demand is more than the supply (aggregate expenditure supersedes aggregate production) the accumulated inventories of businesses decrease and there is an incentive to increase production. Through this mechanism of inventories, the commodity markets find their equilibrium. Employment Markets When there is a recessionary gap, that is when the actual aggregate production in an economy is less than the aggregate production that should have come off full employment and there is rampant unemployment in the economy. On the other hand, under an inflationary gap, the actual aggregate production exceeds the aggregate production that should have come off full employment. Both the situations cannot be solved automatically, contrary to the classical economics fundamentals. The solution to all the economic problems lies in the manipulation of some key indicators, say the Keynesian economists. These indicators include interest rates (increase in interest rates, decrease in aggregate expenditures), confidence or expectations (pessimistic economic outlook, fall in aggregate expenditures) and Government Policies and Federal Deficit (Increase in taxes or fall in Government spending, fall in aggregate expenditures). The government can manipulate these variables (and even many others) through the two market intervention tools that it has at its disposal, namely the fiscal policy and the monetary policy. I will not go into the details of these policies and leave them for another article. Hope you have understood the basic foundation of Keynesian economics and the reasons why Government intervention is necessary. Classical Economics vs Keynesian Economics: Comparison and Contrast The following are some of the basic comparisons for a Keynesian economics vs Classical economics study.

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Keynes refuted Classical economics' claim that the Say's law holds. The strong form of the Say's law stated that the "costs of output are always covered in the aggregate by the sale-proceeds resulting from demand". Keynes argues that this can only hold true if the individual savings exactly equal the aggregate investment. While Classical economics believes in the theory of the invisible hand, where any imperfections in the economy get corrected automatically, Keynesian economics rubbishes the idea. Keynesian economics does not believe that price adjustments are possible easily and so the self-correcting market mechanism based on flexible prices also obviously doesn't. The Keynesian economists actually explain the determinants of saving, consumption, investment and production differently than the classical economists. Classical economists believe that the best monetary policy during a crisis is no monetary policy. The Keynesian theorists on the other hand, believe that Government intervention in the form of monetary and fiscal policies is an absolute must to keep the economy running smoothly. Classical economists believed in the long run and aimed to provide long run solutions at short run losses. Keynes was completely opposed to this, and believed that it is the short run that should be targeted first. Keynes thought of savings beyond planned investments as a problem, but Classicalists didn't think so because they believed that interest rate changes would sort this surplus of loanable funds and bring the economy back to an equilibrium. Keynes argued that interest rates do not usually fall or rise perfectly in proportion to the demand and supply of loanable funds. They are known to overshoot or undershoot at times as well. Both Keynes and the Classical theorists however, believed as fact, that the future economic expectations affect the economy. But while, Keynes argued for corrective Government intervention, Classical theorists relied on people's selfish motives to sort the system out.

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There are many, many more Classical economics vs Keynesian economics comparison pointers, but I will leave you with the above mentioned basic ones. If I get a good response from all of you readers, maybe I will write another individual article on whatever it is that you require. Till then, I hope I have provided you with some reading material for your term papers.

Keynesians - Introduction Keynesian economists are, not surprisingly, so named because they are advocates of the work of John Maynard Keynes (if only all economics was that easy!). Much of his work took place at the time of the Great Depression in the 1930s, and perhaps his best known work was the 'General Theory of

Employment, Interest & Money' which was published in 1936. In this section we look more generally at the work of Keynesian economists. Follow the links below or at the foot of the page to find out more detail about what they believed in and the policies they proposed. * * * * * Beliefs Theories AS & AD Policies Virtual Economy policies

Keynesians - Beliefs Keynes didn't agree with the Classical economists!! In fact the easiest way to look at Keynesian theory is to see the arguments he gave for Classical theory being wrong. In essence Keynes argued that markets would not automatically lead to full-employment equilibrium, but in fact the economy could settle in equilibrium at any level of unemployment. This meant that Classical policies of non-intervention would not work. The economy would need prodding if it was to head in the right direction, and this meant active intervention by the government to manage the level of demand. Follow the links in the navigation bar at the foot of the page or in the side panel to find out more detail on the sort of policies this may involve. Keynesian beliefs can be illustrated in terms of the circular flow of income. If there was disequilibrium between leakages and injections, then classical economists believed that prices would adjust to restore the equilibrium. Keynes, however, believed that the level of output (in other words National Income) would adjust. Say, for example, that there was for some reason an increase in injections (perhaps an increase in government expenditure). This would mean an imbalance between leakages and injections. As a result of the extra aggregate demand firms would employ more people. This would mean more income in the economy some of which would be spent and some saved (or paid in tax). The extra spending would prompt the firms in the economy to produce even more, which leads to even more employment and therefore even more income. This process would go on, and on, and on, and on until it stopped! It would eventually stop because each time income increased, the level of leakages (savings, tax and imports) also increased. Once leakages and injections were equal again, equilibrium was restored. This process is called the Multiplier effect.

Keynesians - Theories Keynes argued that relying on markets to get to full employment was not a good idea. He believed that the economy could settle at any equilibrium and that there would not be automatic changes in markets to correct this situation. The main Keynesian theories used to justify this view were: * * * * The labour market The market for loanable funds (money market) The Multiplier Keynesian inflation theory Monetarist The labour market Keynes didn't have the same confidence in the labour market as Classical economists. He argued that wages would be 'sticky downwards'. In other words

workers would not be happy about taking wage cuts and would resist this. This would mean that wages would not necessarily fall enough to clear the market and unemployment would linger. We can see this in the diagram below:

[The labour market]

When the demand for labour falls from D1 to D2 (maybe due to the onset of a recession), the wage rate should fall, so that the market clears. However, Keynes argued that because wages were sticky downwards, this would not happen and unemployment of ab would persist. This unemployment he termed demand deficient unemployment. The market for loanable funds (money market) Classical economists were of the view that savings would need to be increased to provide more funds for investment. Keynes disputed this assumption - once again because he had less faith in markets as the economics 'miracle cure'. He argued that any increase in savings would mean that people spent less. This would mean a decrease in aggregate demand. This would just make things worse and firms would be even less inclined to invest because they would find the demand for their products decreasing. He felt that investment depended much more on business expectations. The Multiplier Any increase in aggregate demand in the economy would result, according to Keynes, in an even bigger increase in National Income. This process came about because any increase in demand would lead to more people being employed. If more people were employed, then they would spend the extra earnings. This in turn led to even more spending, which led to even more employment which led to even more income which then led to even more spending which then led to ................. The length of time this process went on for would depend on how much of the extra income was spent each time. If the initial recipients of the extra income saved it all, then the process would stop very quickly as no-one else would get their hands on the extra income. However, if they spent it all the knock-on effects of the extra spending would carry on for some time. Therefore the higher the level of leakages, the lower the Multiplier would be. The precise formula for calculating the multiplier is: Multiplier = 1 ------------------------------------------------1 - Marginal propensity to consume

Keynesian view of inflation The key to the classical view of inflation was the Quantity Theory of Money . This theory revolved around the Fisher Equation of Exchange :

MV = PT where: M is the amount of money in circulation V is the velocity of circulation of that money P is the average price level and T is the number of transactions taking place Keynes once again rejected this theory (you may be getting the idea that he didn't agree much with classical economics!!). He argued that increases in the money supply would not inevitably lead to increases in inflation. Increasing M may instead lead to a decrease in V. In other words the average speed of circulation of money would fall because there was more of it about.

Alternatively, the increase in M may lead to an increased in T (number of transactions), because as we have seen Keynes disputes the assumption that the economy will find its own equilibrium. It may be in a position where there is insufficient demand for full-employment equilibrium , and in that case increasing the money supply will fund extra demand and move the economy closer to full employment. Keynesians tend to argue that inflation is more likely to be cost-push inflation or from excess levels of demand. This is usually termed demand-pull inflation

Keynesians - AS & AD Keynes didn't distinguish between the short-run and the long-run as Classical economists tend to. He argued that the economy could settle at any equilibrium level of income at any time, and it was the government job to use appropriate policies to ensure that this equilibrium was a good one for the economy. This can be illustrated on an aggregate supply and demand diagram:

[Aggregate supply and demand]

The economy could settle at any of the 4 equilibria shown (Q1 - Q4). Clearly Q1 is not a very desirable equilibrium as the level of output is very low and there would be high levels of unemployment. Nevertheless this situation could, according to Keynes, persist in the long-term unless the government did something to stimulate the economy. This something would have to be some sort of reflationary policy, which boosted the level of aggregate demand (see the next section on policies for more details on the type of policies that could be used). As aggregate demand grows so does the level of output, but as the economy nears full employment the dark spectre of inflation emerges - in other words the price level starts to increase! This inflation is due to an excess level of demand and so is called demand-pull inflation. At the same time there will be increased pressure on the labour market as nearly everyone has a job, and so wages will begin to rise as firms have to offer more to get the people they want. This in turn will cause costs to increase, and result in cost-push inflation.

Keynesians - Policies The other sections about Keynesians show that they believe that the economy can settle at any equilibrium. This means that they recommend that the government gets

actively involved in the economy to manage the level of demand. You will then be stunned to learn that these policies are known as demand-management policies. Demand management means adjusting the level of demand to try to ensure that the economy arrives at full employment equilibrium. If there is a shortfall in demand, such as in a recession (a deflationary gap) then the government will need to reflate the economy. If there is an excess of demand, such as in a boom, then the government will need to deflate the economy. Reflationary policies Reflationary policies to boost the level of economic activity might include: * Increasing the level of government expenditure * Cutting taxation (either direct or indirect) to encourage spending * Cutting interest rates to encourage saving * Allowing some money supply growth The first two policies would be considered expansionary fiscal policies, while the second two are expansionary monetary policies. The impact of them should be to reduce aggregate demand and therefore the level of output. The diagram below shows this:

[Reflationary policies]

The reflationary policies have boosted the level of output from Q1 to Q2. The impact on the price level has been small, though if demand increased any more it may well be inflationary. Deflationary policies Deflationary policies to dampen down the level of economic activity might include: * Reducing the level of government expenditure * Increasing taxation (either direct or indirect) to discourage spending * Increasing interest rates to discourage saving * Reducing money supply growth The first two policies would be considered contractionary fiscal policies, while the second two are contractionary monetary policies. The impact of them should be to reduce aggregate demand and therefore the level of output. The diagram below shows this:

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[Deflationary policies]
The initial level of aggregate demand was inflationary - prices were increasing rapidly. However, the deflationary policies have reduced demand to AD2 and thus reduced the level of inflation.