Debate between Classical and Keynesian Economists

One of the major important questions that macro economics deals with is what determines the levels of employment in an economy. There are many opinions and suggestions regarding this issue. Opinions also differ as whether the Government should play an active role in managing the economy or its role is limited to simple monitoring. These different opinions are inspired by different schools of economy viz. the Keynesian school and the Classical school. The Classical school believed that capitalistic, market oriented economics naturally tended to operate at full employment, where as the other Keynesian school deals with the different views relating to how aggregate demand is determines and its relation with full employment in an economy.

 Classical view of Employment

 The debate regarding the Government role in the market economy’s movement towards long-run, full-employment, equilibrium has been going for more than two centuries.

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Some economists like Adams smith, J. B. Says, etc. stressed the role of self collecting forces in the economy. These economists are known as classical economists. According to the classical approach prices and wages are flexible to one another and the economy is stable. The economy moves automatically and quickly to full employment equilibrium without any intervention from the government. Thus the basic contention of Classical economists was, that if wages and prices were flexible, a competitive market economy would always operate at or near full employment – i.e. economic forces would always be generated so as to ensure that the demand for labor was always, equal to its supply. In Classical model the equilibrium levels of income and employment were supposed to be determined largely in the labor market

The demand curve for labor shows the relationship between real wage (equal to the value of marginal product of a labor in a competitive economics) and the demand for labor by employers the lower the wage rate; the more the workers will be employed. This is why it is downward sloping. The supply curve of labor, on the other hand is upward sloping for obvious reasons – the higher the wage rate the supply if labor.

 The Classical economist assumed the flexibility of wages and prices (or of real wages). They believed that, if the wage rate was flexible, a competitive economics would be able to maintain full employment. In other words, aggregate demand would be sufficient to absorb the full capacity output in economy. In fact, whatever the full employment level of output, income generated in creating full employment will necessarily lead to spending which will be sufficient to by the goods produced. In other words the classical economists denied the possibility of under spending and over producing.

The classical economists were highly inspired by the impact of the industrial revolution on the economy, i.e., division of labor, capital accumulation, and growth of international trade. They viewed business cycles as temporary and self correcting movements in the economy. J.B.Say, a prominent classical economist argued that over production is impossible. This forms the basis of what is known today as "supply creates its own demand". Say’s Law is based on the premise that no difference exists between a monetary economy and a barter economy. Say's Law assumes that workers can afford to consume whatever the factories produce.

Prominent economists like Ricardo, J.S. Mill, and Alfred Marshall agreed with the classical view that overproduction are impossible. This view was expressed forcefully by eminent economist A.C. Pigou. During the Great Depression, when 25% of the American labor force was jobless, Pigou wrote that when there is perfect free competition, the tendency will be towards full employment. If there is any unemployment, it would be because of frictional resistances that would prevent any adjustments being made in wages and prices. From Pigou's words we can infer that wages and prices are flexible and the market would soon return to equilibrium. The adjustment in prices and wages in the short run will be so short that it can be ignored. Thus, according to the classical economists economy operates at full employment or at its potential output.

The classical approach and Say's law in particular is depicted in Figure (1). The figure shows prices and real wages in competitive markets, and their movements to eliminate any excess demand and supply in the economy. The figure depicts a downward sloping aggregate demand (AD) curve and vertical aggregate supply (AS) curve.

If the aggregate demand falls as a result of tight money, decreasing exports, or other forces then the AD curve shifts leftward to AD1. At the original price level P, the total spending falls to point B, and a small fall in the output is seen at this point. The shift in demand is followed by changes in wages and prices and the price level falls from P to P1. As a result of the fall in prices, the total output returns to its full capacity and at point C there is full employment.

The classical view of macroeconomics is based on the belief that though changes in aggregate demand affect the price level, it has no long-term impact on output and employment. There exists flexibility in the prices and wages, and this flexibility ensures that full employment is maintained and output yield is at its full capacity. From the classical approach two conclusions can be drawn which are important for economic policy. Unemployment and underutilization of capacity in the economy are temporary and for a brief period. The economy will not experience any sustained depression or recession and qualified workers will find job at the prevailing market wage. The classical approach does not rule out frictional unemployment, underutilized resources, distortions and inefficiencies. What it says is that there cannot be pervasive and persistent unemployment, and underutilization of resources, because of insufficient aggregate demand.

 Crisis began

Employment was not considered to be a serious problem in an economy until the Grate Depression of 1930s. A huge portion of total labor force becomes unemployed in many European countries. It was a matter of concern for both the economists and the Government. In an economy if the price system can provide a reasonable efficient allocation of resources, then what is to prevent it from providing for full utilization of societies available resources. Most economists before the Grate Dip ration were of the view that while short term periods of unemployment may occur, market forces would ensure a speedy recovery and therefore, employment would reach a high level. But this view was challenged by British economists John Maynard Keynes. Keynes put forward his views in his renowned book “The General Theory of Employment, Interest and Money’. Keynes theory were widely accepted and provided the basic foundation for the modern theory of employment.

Till early 1930s, classical economy advocated that, an economy would not reach equilibrium until full-employment is restored. But the Great Depression of 1930s, proved the theory wrong.

Keynesian View of Employment

Against this back droop, Keynes come up with an alternative to the classical approach to Study the impact of economy, policies and external shocks on macro economy. According to Keynes, an economy can achieve equilibrium without reaching full employment. They tried to explain the reasons for the Great Depression mainly through the concepts of aggregate demand, aggregate supply and effective demand.  Effective is the Aggregate demands that is created when the government intervenes in the economy to achieve a full-employment equilibrium. While the classical theory was based on the premises that price and wages are flexible and the aggregate supply curve was vertical as in figure 2, Keynes insisted that prices and wages are inflexible and the aggregate supply curve is flat or upward sloping. In his approach, supply can not create its own demand and there can be a deviation in output from its potential for a long indefinite period of time. Keynes’ first observation was that a modern market economy could get trapped in underemployment equilibrium i.e., a balance of aggregate supply and demand where the output is far below potential and a significant fraction of the workforce is involuntarily unemployed. If the intersection of the AD and AS curves takes place far to the left, as shown in Figure 2, it can be inferred that the equilibrium output is much below the potential output. According to Keynes, due to the inflexibility in the wages and prices there is a lack of an economic mechanism to ensure quick restoration of full employment and production at full capacity. A nation's low output may continue for a long time because of the non-existence of a self-correcting mechanism or an invisible hand that can pull the economy back to its full-employment.

Keynes’ second observation is based on the first. According to him the government can help in the maintaining optimum output and employment through the efficient implementation of monetary and fiscal policies. In Figure 14.2, if the government increases its purchases, then the aggregate demand would increase from AD to AD1.  The increase in aggregate demand would result in an increase in output from Q to Q1 and the gap between the actual GDP and the potential GDP would narrow down. Thus, it can be said that with the help of economic policies the government can help generate high output and provide maximum employment. Keynes called this newly created aggregate demand Effective Demand. i.e., effective demand tends to create full-employment equilibrium

The Final Debate

In economics, the perception and analysis of a particular situation depends heavily on the inclination towards a particular school of thought. Economists, who are more influenced by the classical school of thought, are always skeptical about the need for government intervention to stabilize the business cycle. According to them, government intervention to increase aggregate demand would lead to increased inflation. They also feel that Keynes’ remedies would slow down the economic growth. Classical economists give more importance to the long-term consequences of government intervention on potential output and aggregate supply. On the contrary, Keynesian economists have a completely different view of business cycles.

According to Keynesian economists, business cycles are a common phenomenon in an economy with alternate periods of high unemployment followed by speculation and inflation. They argue that the government can alter the aggregate demand with the help of monetary and fiscal policies. While emphasizing on the monetary policy, Keynesians also give importance to fiscal automatic stabilizers. These according to them, help reduce the multiplier effect of unforeseen shocks.

The fundamental point of difference between Keynesian and classical schools of thought is whether there exists in the economy strong self correcting forces such as flexible wages and prices that help maintain full employment. Classical economists give importance to long-run economic growth and do not pay much attention to stabilization policies for business cycles. Keynesian economists on the other hand feel that growth policies need to be supplemented with monetary and fiscal policies, in order to maintain stability in the business cycle.

Reference

Mitra, J.K. 1990, Economics, 7th Edition, World Press Pvt. Ltd

Mukherjee, S. 1996, Modern Economic Theory, 3rd Edition, London, Wishwa Prakashan,

(ISBN: 81-7328-067-3)

Richard, G. L. & Colin, H 1994, First Principles of Economics, 2nd Edition, Oxford University Press, ISBN (0-297-82128-8)

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