Classical Versus Keynesian Economics:
Definition of Classical and
The economists who generally oppose government intervention in the
functioning of aggregate economy are named as classical economists. The main
classical economists are Adam Smith, J. B, Say, David Ricardo, J. S. Mill.
The economists who are in favor of general intervention by the state in
the aggregate economy are named as Keynesian economists (Alvin Nansen, Paual
Samuelson, Tinburgen, R. Frisch etc.,).
Classical and Keynesian Economics:
The main points of contrast
between the classical and Keynesian theories of income and employment
are discussed in brief as under:
The classical economists explained
unemployment using traditional partial equilibrium supply and demand analysis.
According to them:
"Unemployment results when there is an excess supply of
labor at a particular
higher wage level. By accepting lower wages, the unemployed workers will go back
to their jobs and the equilibrium between demand for labor and supply of labor
will be established in the labor market in the long period. This equilibrium in
the economy is always associated with full employment level. According to the
classical economists, unemployment results when the wage level of the workers is
above the equilibrium wage level and as a result, thereof, the quantity of
labor supplied is higher than quantity of labor demanded. The difference between
the two (supply and demand) is unemployment.
J. M. Keynes and his followers, however, reject the fundamental classical
theory of full employment equilibrium in the economy. They consider it as
unrealistic. According them:
"Full employment is a rare phenomenon in the
capitalistic economy. The unemployment occurs, they say, when the aggregate
demand function intersects the aggregate supply function at a point of less than
full employment level. Keynes suggested that in the short period, the government
can raise aggregate demand in the economy through public investment programs
to reduce unemployment".
(2) Says Law of Market:
According to Say's Law 'Supply creates its own demand', is central to the classic vision of
the economy. According to French classical economist, J. B. Say, the production
of goods and services generates expenditure sufficient to ensure that they are
sold in the market. There is no deficiency of demand for goods and hence no need
to unemployed workers. According to him, full employment is a normal condition of
J. M. Keynes has strongly refuted Say's Law of Market with the help of
effective demand. Effective demand is the level of aggregate demand which is
equal to aggregate supply. Whenever there is deficiency in aggregate demand (C +
I), a part of the goods produced remain unsold in the market which lead to
general over production of goods and services in the market. When all the goods
produced in the market are not sold, the firms lay off workers. The deficiency
in demand for goods create unemployment in the economy.
(3) Equality Between
Saving and Investment:
The classical economists are of the view that saving and investment are equal
at the full employment level. If at any time, the flow of savings is greater
than the flow of investment, then the rate of interest declines in the money
market. This leads to an increase in investment. The process continues till the
flow of investment equals the flow of saving. Thus, according to the classical
economists, the equality between saving and investment is brought about through
the mechanism of rate of interest.
J. M. Keynes is, however, of the view
that equality between saving and investment is brought about through changes in
income rather than the changes in interest rate.
(4) Money and Prices:
The classical economists are of the opinion that price level varies in
response to changes in the quantity of money. The quantity theory of money seeks
to explain the value of money in terms of changes in its quantity.
J. M. Keynes has rejected the simple quantity theory of money. According to
him, if there is recession in the economy, and the resources are lying idle and
unutilized, an increased spending of money may lead to substantial increase in
real output and employment without affecting the price level.
(5) Demand For Money:
According to classical economists, money is only demanded to make
regular expenditure under the need transactions demand.
The Keynesian economists are of the view that people hold money for
transaction as well as speculative purposes. So far 'transaction demand' for
money is concerned, it is a function of income. The higher the income, the
higher is the transaction demand for money and vice versa. The speculative
demand for money is a function of rate of interest. The higher the interest
rate, the lower is the money balances which the nation holds for speculative
purposes and vice versa.
(6) Short and Long Run
The classicists believed that a market economy, through flexible interest rates, wages, and prices, return to a state of full employment in the
J. M. Keynes played a major role in suggesting as to how the government can
reduce cyclical fluctuations through stabilization policies. Keynes analysis of
economic problems is confined to short run. Keynes says, 'Let us forget the long
run and focus on the short run. In the long run, we are all dead'.
(7) Role of State in
Achieving High Level of Income and Employment:
The classical economists are of the view that in commodity and
the price mechanism works with reasonable promptness. The supply adjusts to
demand through the flexible interest rates, wages and prices and the economic
system returns to a state of full employment in the long run without government
J. M. Keynes puts less faith in market forces. He stressed and argued for
more direct intervention by the state to increase/decrease aggregate demand to
achieve certain national economic goals. J. M. Keynes considered fiscal policy
as a steering wheel for moving the economy to a state of higher level of
employment and price stability more quickly. If aggregate income is low and
below the target national income, then appropriate expansionary fiscal policy
should be adopted. Expansionary fiscal policy involves decreasing taxes and
increasing government spending. In case the aggregate income is higher or above
the potential level, then contractionary fiscal policy i.e. increasing taxes and
decreasing government spending should by taken up by the state.
(8) General Versus Special
The classical theory is based on four unrealistic assumptions (i) role of the
government in the economy should be minimum (ii) all prices and wages and
markets are flexible (iii) any problem in the macro economic is temporary (v)
the market force come to the rescue and correct itself. The market mechanism
eliminates over production and unemployment and establishes full employment in
the long run. The classical theory relates only to the special case of full
J. M. Keynesian theory is a general theory. It has a wider application on all
such situations of unemployment, partial employment and near full employment.