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Keynesian Versus Classical Economics
Topic Twenty-Three

Previous - Investments

Classical and Keynesian Theories of Economics

Throughout the last few decades, the two main lines of economic thought were the classical or monetarist and the Keynesian economic thought. The classical school is largely credited to the works of Milton Friedman and Adam Smith. Classical economists believe that the role of government is to control inflation by controlling the money supply. They believe that markets are typically clear and that participants have rational expectations. The classical economists also believe in flexible factor prices that will restore equilibrium. They believe in the free market system without government intervention. Keynesian economics was largely founded on the basis of the works of John Maynard Keynes. Keynesians focus on aggregate demand as the principal factor in issues like unemployment. Keynesian economists believe that the economy can be managed by active government intervention through fiscal policy.

Classical Economic Thought

Many of the fundamental concepts and principles of classical economics were set forth in Smith’s “The Wealth of Nations”. Smith argued that free competition and free trade would best promote a nation’s economic growth and development. Smith stated that the entire community benefits most when each of its members follows his or her own self-interest. The classical economists therefore favoured a free market system without government intervention through the invisible hand.

Say’s Law

Classical economists agree with Say's law which states that supply causes demand and that there is never excess supply. The Law states that people will supply things to the economy so that they can get money to buy other goods that are of the same value they have supplied. Also the amount of supply will always be at full employment such that producers will not change the level of supply but will adjust the price levels to achieve the required demand level. Therefore, because supply creates its own demand, in the long run the economy will be at equilibrium and this means very low or no unemployment.

Keynes Economic Thought

Keynes stated that the level of output and employment in the economy is determined by aggregate demand and that the aggregate demand can be increased through an increase in government expenditure. Keynes therefore supported government intervention in guiding the economy and unemployment can be solved by the government intervening by increasing its expenditures. On the other hand, classical economists argued that the government should not interfere in the functioning of the economy. Both the classical and Keynesian approaches to economics differ in the handling of unemployment; Keynesian economists believe that unemployment can be solved by government intervention while the classical economists believe that unemployment can be addressed by leaving the economy to adjust itself until equilibrium is attained at full employment.

The Role of Flexible Prices

The classical economists further believed that even if the rate of interest fails to equate saving and investment, any resulting decline in total spending would be neutralized by proportionate decline in the price level. That is, consumer A’s $200.0 can buy 4 pants at $50.00 each but consumer B $100.00 can buy 4 pants if the price falls to $25.00 a pants. Therefore, if consumers save more than firms wish to invest, the resulting fall in spending will not result in a decline in real output, real income and the level of employment once product prices also fall in the same proportion.

The Role of Flexible Wages

Classical economists also believed that a decline in product demand would lead to a fall in the demand for labour which will result in unemployment. However, the wage rate would also fall and competition among unemployed workers would force them to accept lower wages rather than remain unemployed. The process will continue until the wage rate falls enough to clear the labour market of the excess supply of labour. A new lower equilibrium wage rate will be established which will result in there being no surplus or shortage of labour. Therefore, involuntary unemployment was logical impossibility in the classical model.

Saving-Investment Equality in the Money Market

The classical economists also argued that capitalism contained a very special market which is the money market. According to the classical economics, this money market will ensure saving and investment equality and will ensure full employment. The explanation is that the rate of interest was determined by the demand for and supply of capital. The demand for capital is investment and its supply is saving. The equilibrium rate of interest is determined by the saving-investment equality. Any imbalance between saving and investment would be corrected by the rate of interest. If saving exceeds investment, the rate of interest will fall. This will stimulate investment because it will now be cheaper to borrow to invest and the process will continue until the equality is restored. On the other hand, it there is a shortage of savings, the rate of interest will rise making borrowing more expensive and so investments will fall leading to a balance or equality of savings and investments.

Next - Monetary Policy