Classical&Keynesian

Classical & Keynesian Economics
Classical Theory:
A system or school of economic thought developed by Adam
Smith, Jeremy Bentham, Thomas Malthus, and David Ricardo,
advocating minimum governmental intervention, free enterprise,
and free trade, considering labor the source of wealth and dealing
with problems concerning overpopulation.
Keynesian Theory:
Keynesian economics was developed by the British economist
John Maynard Keynes during the 1930s in an attempt to understand
the Great Depression. Keynes advocated increased government
expenditures and lower taxes to stimulate demand and pull the
global economy out of the depression.
Differences between Classical &
Keynesian Economics
The differences between Keynesian theory and classical economy

theory affect government policies, among other things. One side
believes government should play an active role in controlling the
economy, while the other school thinks the economy is better left
alone to regulate itself. The implications of both also have
consequences for small business owners when trying to make
strategic decisions to develop their companies.
Full Employment:
The classicists believed in the existence of full employment in
the economy and a situation of less than full employment was
regarded, as abnormal. They, therefore, never thought it necessary
to have a special theory of employment.
On the other hand, Keynes considered the existence of full
employment in the economy as a special case. He put forth a general
theory of employment applicable to every capitalist economy. His
notion of underemployment equilibrium is indeed revolutionary
and has stood the test of the time.
Say’s Law:
The classical analysis was based on Say’s Law of Markets that
“supply creates its own demand.” The classicists thus ruled out the
possibility of over production.
Keynes propounded the opposite view that demand creates its
own supply. Unemployment results from the deficiency of effective
demand because people do not spend the whole of their income on
consumption.
Saving:
The classicists emphasized the importance of saving or thrift in
capital formation for economic growth. To Keynes, saving was a
private virtue and a public vice. Increase in aggregate saving leads to
a decline in aggregate consumption and demand thereby decreasing
the level of employment in the economy.
Keynes thus advocated public spending instead of public
saving to remove unemployment. He thus ‘smashed the last pillar of
the bourgeois argument’ that unequal income led to increased
saving and to capital formation for growth. This view might be
termed revolutionary.
Monetary Theory:
The classicists artificially separated the monetary theory from
the value theory. Keynes, on the other hand, integrated monetary
theory and value theory. He also brought interest theory into the
domain of monetary theory. He regarded the rate of interest as a
purely monetary phenomenon.
He emphasized the demand for money as an asset and
separated it into transactions demand, precautionary demand and
speculative demand to explain the determination of the rate of
interest in the short-run. By integrating the value theory and
monetary theory through the theory of output, Keynes made money
non-neutral as opposed to the classical view of neutrality of money.
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.
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.
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 labor would cause a fall in
wages. This decline in wages would ensure that full employment
was maintained and markets ‘clear’.
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 labor, trade unions would reject nominal wage cuts;
therefore, in the Keynesian model, it is easier for labor 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.
Saving-Investment Equality:
The classicists believed that saving and investment were equal
at the full employment level and in case of any divergence the
equality was brought about by the mechanism of rate of interest.
Keynes held that the level of saving depended upon the level of
income and not on the rate of interest. Similarly investment is
determined not only by rate of interest but by the marginal
efficiency of capital.
Macro Analysis:
The classical economics was a microeconomic analysis which
the orthodox economists tried to apply to the economy as a whole.
Keynes, on the other hand, adopted the macro approach to economic
problems. But the Keynesian revolution lies in its macro-dynamic
orientation of aggregate income, employment, output, consumption,
demand, supply, saving and investment. As rightly pointed out by
Prof. Hansen, “The General Theory has helped to make us think of
economics in dynamic rather than in static terms.”
Difference in policy recommendations
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.
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.
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.
The Keynesian view suggests that government borrowing may
be necessary because it helps to increase overall aggregate demand.
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
emphasizes 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&Keynesian

Uploaded by

Copyright:

Available Formats

Classical&Keynesian

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Classical&Keynesian

Uploaded by

Copyright:

Available Formats

Classical & Keynesian Economics

The differences between Keynesian theory and classical economy

Flexibility of prices and wages:

You might also like