Classical economics places little emphasis on the use of fiscal policy to manage aggregate demand. There are a number of important differences between classical and Keynesian economics, but in general classic theory teaches that things in the marketplace like economic growth and investment capital are most effectively driven by consumers and free choice, while the Keynesian school of thought spends more time considering government regulation and oversight. The use of capital receipts for meeting the extra consumption expenditure leads to an inflationary situation. The new classical explain the forces at work in terms of rational choices made by households and firms. The major difference is the role government plays in each. The three theories of interest, i.e., the classical capital theory, the neoclassical loanable funds theory and the Keynesian liquidity preference theory, have been differentiated below: Difference # Classical Theory: 1. By the term full employment of the available resources, the classical economists meant that ‘there is no involuntary unemployment’. Consumers would save today to pay off future debt. In conclusion, due to V and Y being stable, M and P have a direct and proportional relationship. Classicals further believed that involuntary unemployment could be easily cured by cutting wages down through office and perfect competition which always exists in the labour market. Keynesian economics argues that the driving force of an economy is aggregate … The choice, according to classsicals, was not between employment and unemployment but between employment here and employment there, i.e., increase in production in one direction could be achieved only at the cost of some decrease in another direction in the economy. The only way to reduce inflation was to abandon the full employment commitment. None of these theories are completely invalid, they just work in certain conditions with certain assumptions. Also if the Government is spending, it should try to provide employment to build roads, flyovers, infrastructure or any productive activity or investment, this will cause a multiplier effect in the economy, generating income far greater than the initial investment. Although there may be temporary periods where the demand is less than supply for goods or a specific commodity, market forces will adjust the same. The following points highlight the six main points of differences between Classical and Keynes Theory. Macro Economics- Classical vs Keynes Theory (Hindi) Part-1 - Duration: 1:49:24. The reason, pointed out by Friedman in 1968, was that inflation resulted from the full employment commitment itself. To reach that level, According to Keynes, the government should increase its expenditure. Ideal Coaching 93,772 views. Demand for labour depends on marginal revenue productivity. Due to flexibility of wages, there would be an automatic restoration of equilibrium at full employment level. When wages are high, the supply of labourers is high. Central banks don’t need politicians’ help to manage the economy. They see issues short-term as just bumps on the road tha… Assumption of Neutral Money 6. It argues that unfettered capitalism will create a … The Keynesian theory of the determination of equilibrium output and prices makes use of both the income‐expenditure model and the aggregate demand‐aggregate supply model, as shown in Figure . The economy consists of cyclic booms and busts, and prolonged booms lead to a rise in prices. J. M. Keynes and his followers, however, reject the fundamental classical theory of full employment equilibrium in the economy. The Keynesian full employment commitment of the 1950s and 1960s played a central role in saving capitalism from state socialism and Marxism. That unemployment of resources could also persist to pose a problem did not occur to them at all. In fine, an important distinction between the Keynesian and classical theories of interest is that the former theory is completely stock theory whereas the latter is a completely flow theory. Government spending is dangerous because it crowds out private 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. Suppose that the economy is initially at the natural level of real GDP that corresponds to Y 1 in Figure . British economist John Maynard Keynes is the father of modern macroeconomics, developing his own school of economic thought. 12.What about the policy implication of classical economics? Welcome to EconomicsDiscussion.net! The value of money differs from the value of any other object in one fundamental respect, namely, the fact that the value of money repre­sents general purchasing power or … Smith, Marx and Mill are good examples. Keynesian economics served as the standard economic model in the developed nations during the later part of The Great Depression, World War II, and post-war economic expansion. Classical economics places little emphasis on the use of fiscal policy to manage aggregate demand. As a result, Interest rates will rise, making borrowing more expensive. Y= Output ( In nominal/physical terms, by multiplying this with P, we get the monetary value of output). For example, if money supply triples, the general price level will triple. The classical theory of interest is a special theory because it presumes full employment of resources. Thus, in the money economy of the present world, the Keynesian theory is more realistic than the classical theory of interest. The classical economic theory promotes laissez-faire policy. If done right, expansionary monetary policy would negate the need for deficit spending. In contrast to this view, Keynes considered money on as on active force that in influences total output. Keynesian economics is essentially “Demand-side full employment economics, which asserts that demand creates its own supply, viz., “demand would get supplied” against the classical dictum of “supply would get demanded,” i.e., supply creating its own demand. The differences between classical and Keynesian economics are so vast that to accept one version of how an economy works means you must reject the other. In other words, classicals fell there could not be any significant misallocation of resources as the price mechanism, acting as an ‘invisible hand’ would achieve the best, the most efficient allocation of resources. Full employment refers to the situation where all those who are willing to work at the prevailing wage rate are employed. (Since producers will not be willing to pay such a high wage rate to all labourers). And so does our understanding of those policies. He did not directly challenge the conventional wisdom of the period that favoured laissez-faire (Classical Theory)— only slightly tempered by public policy — as the best of all possible social arrangements. When they were unemployed, they would have taken a loan to sustain themselves, so the moment the government injects money in their hands, they will use that sudden increase in their income for saving, so that they can pay off their old loans. The Keynesian theory is strictly short-run economics. For example, suppose that the economy is going through a downturn so the demand in the market has fallen. Production process generates income equivalent to the value of goods produced, thus creating demand due to purchasing power (Circular flow of Income). Share Your PPT File, Keynes’s Criticism on Classical Theory of Market: 6 Criticisms | Say’s Law. Keynes’s early-1900s economic theories had a huge impact on economic theory and the economic policies of global governments. Thus it is only through government intervention, that employment level can be raised. The differences are: 1. Classicals did not give much importance to money treating it only as a medium of exchange its role as a store of value was not considered. Trying to deeply understand the Theory of Income and Employment led me to read ‘The General Theory of Employment, Interest and Money’ By John Maynard Keynes. Slowly, the unemployment target was replaced by the Inflation target and unemployment was left to settle at its natural rate. Aggregate Demand- The total Value of final goods and services which all the sectors of an economy are planning to buy at a given level of income during the period of one accounting year. There are certain situations where classical theory and the market correction by free-market forces fits best. They said that monetary policy is more potent than fiscal policy. In a recession, if the government did force lower wages, this might be counterproductive because lower wages would lead to lower spending and a further fall in aggregate demand. As a result of all this, more will be produced as more is demanded and employment would increase because workers are employed at lower wages to increase production. To them, money facilitated the transactions of goods but had no effect on income, output and employment. Classical economics places little emphasis on the use of fiscal policy to manage aggregate demand. Assumption of Neutral Money 6. But, I do believe that excessive government spending will cause inflation (due to high capital receipts and other reasons), so the expenditure should be just the right amount, with a major focus on monetary policies to correct excess and deficient demand. However, Keynesians argue that in the real world, wages are often inflexible. 1. They argued that so long as labour does not demand more than what it is ‘worth’ or more than its marginal productivity, there in no possibility of persistent unemployment in the economy. They would merely adjust the money supply. It means that the cyclical upward and downward movement of employment and output adjust by itself. While Keynes differs from Smith, he and nearly all economic philosophers who followed Smith agree with some of that thinker's founding principles. TOS4. They consider it as unrealistic. Workers resist nominal wage cuts. Wages would stay at W1, and unemployment would result. Changes in government spending and taxes can be used to correct deficient and excess demand and close off inflationary and deflationary gaps in the short run. The rational expectations theory inspired the New Keynesians. Share Your Word File Wage-cuts, thus occupied a central place in the classical scheme of reasoning for automatic functioning of the capitalist economy at full employment. (see diagram below), Short-termism: Quarterly Earnings, Accountable Capitalism and the “death” of public equity markets, The educational irony of China-US trade war, Trump Sends Global Markets into Tailspin, US Jobs Data in Focus, US-China Spat Makes the Front Page Again, BoC Decides on Rates, Strange Economic Times Demand Strange Economic Assets. That is the primary difference between them and modern economics. The Keynesian theory view on the cause of unemployment varies from the classical view of unemployment. But that only happens when the economy is not in a recession. In short, they never recognised that money could also influence the level of income, output and employment. Keynesian and monetarist theories offer different thoughts on what drives economic growth and how to fight recessions. M= Money Supply (M1-most liquid form of money supply). These politicians, mostly in Britain, totally disregarded the Phillips Curve trade-off between inflation and employment. But, in a situation of economic normalcy, I believe an optimal mix of both theories should be used to shape fiscal and monetary policy. Classicals believed that employment is determined by the wage bargains between the workers and employers, therefore, wage-cuts will reduce unemployment; such a policy if pursued vigorously can restore full employment as well. The supply of loanable funds from all these sources is a positive function of rate of interest. 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