Classical Economics vs Keynesian Economics

This 'Classical economics vs Keynesian economics' article should help most students. I was also there once, a
troubled (obviously) and insane (for taking on a double economics major with 8 different economics subjects) varsity
student, trying to cope with the vagrancies of Classical economics and Keynesian economics. This is a 3 part article
on (i)Classical Economics (ii)Keynesian Economics and (iii)Classical Economics vs Keynesian Economics.

Economics is a very interesting subject, but unfortunately, you either get it or you don't. It is really not
something you can learn by heart, and can only be tackled with a thorough understanding of the subject. I
attempt to throw light on the two main theories of economics: Classical economics and Keynesian
economics. Though there are many many other theories, they are all related in some or the other way to
these two major schools of thought. It may be very difficult to understand them without diagrams (since
economics = diagrams, lots and lots of diagrams), I will try to give a simple overview of both these
theories, before ending with a comparative analysis of Keynesian economics vs Classical economics.

Classical Economics Explained

Classical economics is considered to be the first school of economic thought. Let us start with a general
overview of what this school of thought propagates. By the way, I am an out and out Classical economist,
so forgive any biases that might creep in. Also understand, that even if it may seem so in this particular
article at times, one cannot conclude that Keynesian economics is flawed or classical economics is flawed
(there's no absolute right and wrong in economics, different theories are applicable under different
economic assumptions).

Classical Economics Definition and Groundwork for the Classical Economics Model
"By pursuing his own interest, he (man) frequently promotes that (good) of the society more effectually
than when he really intends to promote it. I (Adam Smith) have never known much good done by those
who affected to trade for the public good." - Adam Smith (1776), An excerpt from 'An Enquiry into The
Nature and Causes of The Wealth of Nations'.

Adam Smith is the great economist, who is known as the founder of the classical economics school of
thought. Though many others (David Ricardo, Thomas Malthus, John Stuart Mill, William Petty, Johann
Heinrich Von Thunen, etc.) have come and gone, and added a few things here and there, to the classical
theories, we will only be stressing on Adam Smith's version in this article.

The Classical economics theory is based on the premise that free markets can regulate themselves if left
alone, free of any human intervention. Adam Smith's book, 'The Wealth of Nations', that started a
worldwide Classical wave, stresses on there being an invisible hand (an automatic mechanism) that
moves markets towards a natural equilibrium, without the requirement of any intervention at all. In better
economic words, the division of labor and the free market will automatically tend toward an equilibrium
that advances public interests. Sounds fascinating? Let us see how.

Classical Economics Assumptions

Before working our way towards the workings of the Classical economics model, let us first know and
understand the classical economics assumptions. The idea, is that like any theory, if the founding
assumptions do not hold, the theory based on them is bound to fail. There are three basic assumptions of
Classical Economics theories. They are:

• Flexible Prices: The prices of everything, the commodities, labor (wages), land (rent), etc. must
be both upwardly and downwardly mobile. Unfortunately, in reality, it has been observed that
these prices are not as readily flexible downwards as they are upwards, due a variety of market
imperfections, like laws, unions, etc.
• Say's Law: 'Supply creates its own demand'. The Say's law suggests that the aggregate
production in an economy must generate an income enough to purchase all of the economy's
output. In other words, if a good is produced, it has to be bought. Unfortunately, this assumption
also does not hold good today, as most economies today are demand driven (production is based
on demand. Demand is not based on production or supply).
 • Savings - Investment Equality: This assumption requires the household savings to equal the
capital investment expenditures. Now it takes no genius to know, that this is rarely the case. Yet,
should the savings not equal the investment, the 'flexible' interest rates should be able to restore
the equilibrium.

Classical Economics - The Workings of An Economy

"Civil government, so far it is instituted for the security of property, is in reality instituted for the defense of
the rich against the poor, or of those who have some property against those who have none at all." -
Adam Smith from 'The Wealth of Nations', 1776.
All the normal principles of economics apply to classical economics as well. If all the assumptions hold,
classical economics works as follows.

Wage Markets
Classical economics negates the fact that there can be some unemployment (especially involuntary) in an
economy, because classical economists believe in the self correcting mechanism of an economy. Their
contention is based on the following:

• Whenever there is unemployment in an economy, it is usually a temporary disequilibrium

because it is an equilibrium caused by excess labor available at the current wage rate.
• Whenever wages are high, there are always more people willing to work at that ongoing rate and
this is termed as unemployment.
• In an unregulated, classical economy, where wages are perfectly flexible, the wage rates fall,
eliminating the excess labor available and reducing the unemployment back to equilibrium levels.
• How exactly does this happen? This happens because all hirers favor their self interest motives.
When laborers are still available when he pays them a lower wage, why should he pay more. He
thus adjusts his wage rates downwards, acting in the overall welfare of society, without knowing
it.

Commodity Markets
The Say's law that equates the demand and supply in an economy actually applies to aggregates and not
single goods and commodities. Classical economists believe that the commodities markets will also
always be in equilibrium, due to flexible prices. If the supply is high and there is inadequate demand for it,
it is a temporary situation. The prices for the commodity in question, lower down, to equate the demand
and supply and bring the situation back to equilibrium. How does this work? Well, what would you do if
you had a commodity that you needed to sell but weren't able to secure a buyer. You'd obviously reduce
the prices step by step, in a trial and error manner and finally reach a price that might tempt a buyer to
buy. It is a similar case with the aggregate demand and supply, say the classical theorists.

Capital Markets
In the beautiful free world of classical economics, no human intervention is required to lead the capital
markets to equilibrium as well. If the economy does not follow the last assumption and shows a mismatch
in savings and investments, the classical economists provide the evergreen solution - do nothing, it is
temporary and will correct itself. If savings exceed investment, the interest rates fall and the market
achieves equilibrium again. On the other hand, if savings fall short of investments, the interest rates rise
and once again, the economy reaches its own equilibrium. Let us now see how all the markets come
together in the classical economics model.

One potential problem with the classical theories is that Say's law may not be true. This may happen
because not all the income earned goes towards consumption expenditures. The totals savings thus
saved, translate into the missing potential demand, which is the cause of the disequilibrium. When supply
falls short of effective demand like this, several things spiral downwards: producers reduce their
production, workers are laid off, wages fall resulting in lower disposable incomes, consumption declines
reducing demand by further more and starting a self sustaining vicious cycle. However, classical
economists argue that what happens to the savings that started to the whole chain is the key solution
here. If all of these savings go in as investments, the interest rates adjust to bring the economy back to
equilibrium once again, with absolutely no problems at all. The only glitch, are all savings actually
invested in reality? By investment, classical economists mean capital generation, so I doubt it! But as one
can see, according to classical theories, there is really no need for any government intervention. No
wonder then, that they are against it, for they can provide good backing to all the arguments that state,
that government intervention cannot help, but can actually harm the economy in the long run.

We will contemplate this later, in the comparison of Classical economics vs Keynesian economics
section. For now, we will move on to the next economic theory, Keynesian economics.

Keynesian Economics Theory Explained

Keynesian economics is the brain child of the great economist, John Maynard Keynes. The Keynesian
school of economics considers his book, 'The General Theory of Employment, Interest and Money' (1936)
as its holy Bible. Let us have an overview of this theory, which contradicts and confronts the classical
theory on almost all counts.

Keynesian Economics Definition and Groundwork for the Keynesian Economics Model
"Long run is a misleading guide to current affairs. In the long run we are all dead." - John Keynes's most
famous quote, to stop the Classical economists from rapping about the 'long run'.

Keynesian economics is wholly based on a simple logic, that there is no divine entity, nor some invisible
hand, that can tide us over economic difficulties, and we must all do so ourselves. Keynesian economic
models stress on the fact that Government intervention is absolutely necessary to ensure growth and
economic stability. While classical economists believe that the best monetary policy is no monetary policy,
Keynesian economists believe otherwise. In the Keynesian economic model, the government has the very
important job of smoothening out the business cycle bumps. They stress on the importance of measures
like government spending, tax breaks and hikes, etc. for the best functioning of the economy.

Keynesian Economics Assumptions

Like all economic theories, the Keynesian Economics school of thought is based on a few key
assumptions. Let us have a look at them first, before we progress on to the application of Keynesian
economics in the actual economy.

• Rigid or Inflexible Prices: Mostly we see that while a wage hike is easier to take, wage falls hit
some resistance. Likewise, while for a producer, commodity prices are easily upwardly mobile, he
is extremely reluctant for any reductions. For all such prices, it is easily notable that they are not
actually as flexible as we'd like, due to several reasons, like long term wage agreements, long
term supplier contracts, etc.
• Effective Demand: Contrary to Say's law, which is based on supply, Keynesian economics
stresses the importance of effective demand. Effective demand is derived from the actual
household disposable incomes and not from the disposable income that could be gained at full
employment, as the classical theories state. Keynesian economics also recognizes that only a
fraction of the household income will be used for consumption expenditure purposes.
• Savings and Investment Determinants: Keynesian economics directly contradicts the savings-
investment proponent of Classical economics, because of what it believes to be the savings and
investment determinants. While classical economists believe that savings and investment is
triggered by the prevailing interest rates, Keynesian economists believe otherwise. They believe
that household savings and investments are based on disposable incomes and the desire to save
for the future and commercial capital investments are solely based on the expected profitability of
the endeavor.

Keynesian Economics - The Workings of An Economy

"The biggest problem is not to let people accept new ideas, but to let them forget the old ones." - John
Maynard Keynes.

As classical economics and the Great Depression did not go so well together, with the latter exposing
several flaws in the former, but Keynesian economics came up with a solution. Keynesian economics and
the Great depression worked well together, with in fact the former giving ways to avoid and escape the
latter. Keynesian economics is equipped to teach everyone about how to survive an economic depression.
Let us have a look at how the Keynesian theory works.

Keynesian economists believe that the macroeconomic economy is more than just an aggregate of
markets. Also, these individual commodity and resource markets are not capable of achieving an
automatic equilibrium and it is quite possible that such disequilibriums last for very long. As full
employment is not guaranteed automatically, Keynesian economics advocates the use of beneficial
government policies in order to give the economy a helping hand.

Commodity Markets
The Keynesians start with a graph showing a 45 degree line starting at the intersection of both the axis.
This line depicts all the points where the aggregate expenditure equal the aggregate production. In other
words, the economy is at a full employment equilibrium. They then chart a real aggregate expenditures
line, an aggregated amount of all the macroeconomic sector expenditures (Household Consumption,
Investment, Government Spending, etc.) and capture the effective demand. When the economy is below
or above the intersection between these two lines, there is an obvious disequilibrium or imbalance.

If aggregate production is more than the aggregate expenditures, there is excess supply. Inventories
increase and businesses reduce their production to stop these. On the other hand, when the demand is
more than the supply (aggregate expenditure supersedes aggregate production) the accumulated
inventories of businesses decrease and there is an incentive to increase production. Through this
mechanism of inventories, the commodity markets find their equilibrium.

Employment Markets
When there is a recessionary gap, that is when the actual aggregate production in an economy is less
than the aggregate production that should have come off full employment and there is rampant
unemployment in the economy. On the other hand, under an inflationary gap, the actual aggregate
production exceeds the aggregate production that should have come off full employment. Both the
situations cannot be solved automatically, contrary to the classical economics fundamentals.

The solution to all the economic problems lie in the manipulation of some key indicators, say the
Keynesian economists. These indicators include interest rates (increase in interest rates, decrease in
aggregate expenditures), confidence or expectations (pessimistic economic outlook, fall in aggregate
expenditures) and Government Policies and Federal Deficit (Increase in taxes or fall in Government
spending, fall in aggregate expenditures). The government can manipulate these variables (and even
many others) through the two market intervention tools that it has at its disposal, namely the fiscal policy
and the monetary policy. I will not go into the details of these policies and leave them for another article.
Hope you have understood the basic foundation of Keynesian economics and the reasons why
Government intervention is necessary.

Classical Economics vs Keynesian Economics: Comparison and Contrast

The following are some of the basic comparisons for a Keynesian economics vs Classical economics
study.

• Keynes refuted Classical economics' claim that the Say's law holds. The strong form of the Say's
law stated that the "costs of output are always covered in the aggregate by the sale-proceeds
resulting from demand". Keynes argues that this can only hold true if the individual savings
exactly equal the aggregate 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. Keynesian
economics does not believe that price adjustments are possible easily and so the self-correcting
market mechanism based on flexible prices also obviously doesn't. The Keynesian economists
 actually explain the determinants of saving, consumption, investment and production differently
than the classical economists.
• Classical economists believe that the best monetary policy during is a crisis is no monetary
policy. The Keynesian theorist on the other hand, believe that Government intervention in the
form of monetary and fiscal policies is an absolute must to keep the economy running smoothly.
• Classical economists believed in the long run and aimed to provide long run solutions at short run
losses. Keynes was completely opposed to this, and believed that it is the short run that should
be targeted first.
• Keynes thought of savings beyond planned investments as a problem, but Classicalists didn't
think so because they believed that interest rate changes would sort this surplus of loanable
funds and bring the economy back to an equilibrium. Keynes argued that interest rates do not
usually fall or rise perfectly in proportion to the demand and supply of loanable funds. They are
known to overshoot or undershoot at times as well.
• Both Keynes and the Classical theorists however, believed as fact, that the future economic
expectations affect the economy. But while, Keynes argued for corrective Government
intervention, Classical theorists relied on people's selfish motives to sort the system out.