COMPARISION BETWEEN THE CLASSICAL THEORY OF DEVELOPMENT

AND KEYNESIAN’S VIEW ON DEVELOPMENT

ECONOMICS-II

Submitted by

Moon Mishra

SF0117029

Submitted to :

Ms. Dipakshi Das

Assistant Professor of Economics

NATIONAL LAW UNIVERSITY, ASSAM

1
 Table of Contents

1. INTRODUCTION.......................................................................................................3

1.1 Literature Review................................................................................................3

1.2 Aims and Objective ..............................................................................................4

1.3 Research Questions.............................................................................................4

1.4 Research Methodology........................................................................................4

2. CLASSICAL THEORY OF DEVELOPMENT........................................................4

3. KEYNESIAN THEORY OF DEVELOPMENT........................................................15

4. COMPARISION BETWEEN CLASSICAL AND KEYNESIAN VIEWS ON

DEVELOPMENT...............................................................................................................19

5. CONCLUSION...............................................................................................................25

BIBLIOGRAPHY

2
 1. Introduction

The Classical school, which is regarded as the first school of economic thought, is associated
with the 18th Century Scottish economist Adam Smith, and those British economists that
followed, such as Robert Malthus and David Ricardo. The main idea of the Classical school
was that markets work best when they are left alone, and that there is nothing but the smallest
role for government. The approach is firmly one of laissez-faire and a strong belief in the
efficiency of free markets to generate economic development. Markets should be left to work
because the price mechanism acts as a powerful 'invisible hand' to allocate resources to where
they are best employed. In terms of explaining value, the focus of classical thinking was that
it was determined mainly by scarcity and costs of production. In terms of the macro-
economy, the Classical economists assumed that the economy would always return to the
full-employmentlevel of real output through an automatic self-adjustment mechanism. It is
widely recognised that the Classical period lasted until 1870.

Keynesian economics derives from John Maynard Keynes, and in particular his book, The
General Theory of Employment, Interest and Money (1936), which ushered in contemporary
macroeconomics as a distinct field. The book analyzed the determinants of national income,
in the short run, during a period of time when prices are relatively inflexible. Keynes
attempted to explain, in broad theoretical detail, why high labor-market unemployment might
not be self-correcting due to low "effective demand," and why neither price flexibility nor
monetary policy could be counted on to remedy the situation. Because of its impact on
economic analysis, this book is often called "revolutionary”.

a. Literature Review
 B. Greenwald and J. E. Stiglitz, Keynesian, New Keynesian and New
Classical Economics, Oxford University Press, Vol 39, No.1
This is an excellent account of the Keynesian Theory of development which
elaborately discusses the Keynesian views on development. This volume is a
great contribution to economics. It gives a great understanding of the
Keynesian Theory with a detailed and elongated approach to it.

 W. Eltis, The Classical Theory of Economic Growth, (2nd Edi, 2000)

This is an account of the theories of growth and distribution of Francois
Quesnay, Adam Smith, Robert Malthus, David Ricardo and Karl Marx. This

3
 edition has a new introduction setting the work in a broader context. The
author shows how each developed the work of his predecessors.

b. Aims and Objectives

 To study the Classical theory of development.
 To study the Keynesian theory of development.
 To compare the Classical theory of development and the Keynesian theory of
development.
c. Research Questions
• What is the Classical theory of development?
• What is the Keynesian theory of development?
• What is the difference between the Classical theory of development and the
Keynesian theory of development?

d. Research Methodology
In this research paper, doctrinal form of research has been applied wherein materials
form secondary sources such as libraries , archives, articles and the internet have been
used.

2. Classical Theory of Development

2.1 Adam Smith Theory of Development

Adam Smith is considered to be the father of economics. It is not so because he was first
explorer in the field of economics, also not because he revolutionized economic planning by
his maiden ideas, but because he abbreviated what he had received from his predecessors and
handed it down as a guide to the coming generations.1

He was the editor and not the author, organizer and not the originator of economic science

“He was the man of systematic work and balanced presentation, not of great new ideas but a
man who carefully investigates the given data, criticizes them cooly and sensibly, and
coordinates the judgements arrived at with others which have already been established”.2

1
Will Kenton, Classical Growth Theory (Updated on Apr 17, 2018), https: //www.invest opedia.com
/terms/c/class ical-growth-theory.asp
2
W. Eltis, The Classical Theory of Economic Growth, (2nd Edi, 2000)

4
Adam Smith contained all his ideas in his “Wealth of Nations”. The most important aspect of
this book was a Theory of Economic Development. Physiocracy came into existence due to
mercantilism. They believed in science of natural laws and emphasised the significance of
agriculture and contended that it is the only industry that can make country wealthy. Adam
Smith’s ‘Wealth of Nations’ was scientific not because it contained the absolute truth but
because it came as a turning point, the beginning of all that came after, as it was the end of all
that came before.

The main points of the theory are as under:

a. Natural Law:

Adam Smith proposes natural law in economic affairs. He advocated the philosophy of free
and independent action. If every individual member of society is left to peruse his economic
activity, he will maximize the output to the best of his ability. Freedom of action brings out
the best of an individual which increases society wealth and progress. Adam Smith opposed
any government intervention in industry and commerce.

He was a staunch free trader and advocated the policy of Laissez-Faire in economic affairs.
He opines that natural laws are superior to law of states. Statutory law or manmade law can
never be perfect and beneficial for the society, that is why Smith respects nature’s law
because nature is just and moral. Nature teaches man the lesson of morality and honesty.
These exercise favourable effects on the economic progress of society.

b. Laissez Faire:

Adam Smith’s theory is based on the principle of ‘Laissez-Faire’ which requires that state
should not impose any restriction on freedom of an individual. The theory of economic
development rests on the pillars of saving, division of labour and wide extent of market.
Saving or capital accumulation is the starting point of this theory. He believed that “there is a
set of rules or rights of justice and perhaps even of morality in general which are, or may be
known by all men by hello either or reason or of a moral sense, and which possesses an
authority superior to that of such commands of human sovereigns and such customary legal
and moral regulations as may contravene them”.3

3
W. Eltis, The Classical Theory of Economic Growth, (2nd Edi, 2000)

5
The policy of laissez-faire allows the producers to produce as much they like, earn as much
income as they can and save as much they like. Adam Smith believed that it is safe to leave
the economy to be propelled, regulated and controlled by invisible hand i.e. the forces of
competition motivated by self interest be allowed to play their part in minimizing the volume
of savings for development.

c. Production Function:

Adam Smith recognized three factors of production namely labour, capital and land i.e.

Y = f (K, L, N)

K = Stock of Capital

L = Labour force

N = Land

He emphasized labour as an important factor of production along with other factors and
observed, “The annual labour of nation is the fund which originally supplies it with all
necessaries and conveniences of life which it annually consumes and which consists always
either in immediate produce from other nations”. Since the growth is a function of capital,
labour, land and technology and land being passive element is least important. Prof. Adam
Smith regarded labour as father and land as mother. He wrote, “To him (farmer) land is the
only instrument which enables him to earn the wages of his labour and to make profits of this
stock”.

The production function does not conceive the possibility of diminishing marginal
productivity. It is subject to law of increasing returns to scale. Smith argued that real cost of
production shall tend to diminish with the passage of time, as a result the existence of internal
and external economies occurring out of the increases in market size.

Adam Smith asserted that division of labour does not depend merely on technological
feasibility, it greatly depends on the extent of the market as well and the size of market
depends on the available stock and the institutional restrictions placed upon both domestic
and international trade. Smith observes that, “when the market is small, no person can have
encouragement to dedicate himself entirely to one employment, for want of power to
exchange all the surplus part of production of his own labour, which is over and above his

6
own consumption, for such parts of the produce of other man’s labour as he has occasion
for”.

Smith also recognizes the importance of technological development for improvement in

productivity and which is possible only if sufficient capital is available. He wrote, “The
person who employs his stock in maintaining labour, endeavors, therefore, both to make
among his workmen the most proper distribution of employment and furnish them with the
best machines which he can either invent or afford to purchase. His ambition in both these
respects is generally in proportion to the extent of his stock or to the number of people which
it can employ”.4

d. Division of Labour:

The rate of economic growth is determined by the size of productive labour and productivity
of labour. The productivity of labour depends upon technological progress of a country and
which, in turn, depends upon the division of labour. This division of labour becomes the true
dynamic force in Adam Smith’s theory of growth. The only remarkable feature of Smith’s
account of division of labour is pointed by Prof.

Schumpeter as “nobody, either before or after Adam Smith ever thought of putting such a
burden upon division of labour. With Adam Smith it is practically the only factor in
economic progress”.

Division of labour increases the productivity of labour through specialization of tasks. When
a work is sub-divided into various parts and the worker is asked to perform small parts of
whole job, his efficiency increases as now he can focus his attention more carefully. Thus, the
concept of division of labour means the transference of a complex production process into
number of simpler process in order to facilitate the introduction of various methods of
production.

Adam Smith concentrated upon the social division of labour which emphasized the co-
operation of all for satisfaction of the desires of each. It is the process by which different
types of labour which produce goods to satisfy the individual needs of their producers are
transformed into social labour which produces goods for exchanging them for other goods.

Adam Smith in his book ‘Wealth of Nations’ pointed out three benefits of division of labour:
4
Will Kenton, Classical Growth Theory (Updated on Apr 17, 2018),
https://www.investopedia.com/terms/c/classical-growth-theory.asp

7
 1. Increase of dexterity of workers. 5
2. Saving time required to produce commodity.
3. Invention of better machines and equipment
e. Capital Accumulation:

It is the pivot around which the theory of economic development revolves. The growth is
functionally related to rate of investment. According to Smith, “any increase in capital stock
in a country generally leads to more than proportionate increase in output on account of
continually growing division of labour”.

Capital stock consists of:

(а) Goods for the maintenance of productive workers.

(b) Goods for helping the workers in their productive activities.

Adam Smith distinguished between non capital, circulating capital and fixed capital goods.
Non capital goods refer to those which are useful directly and immediately to their owner.
Fixed capital refers to those goods which are directly used in production processes, without
changing hands. Fixed capital consists of all the means of production.

Capital is increased by parsimony and diminished by prodigality and misconduct. The rate of
investment was determined by the rate of saving and savings were invested in full. The
classical economists also believed in the existence of wage fund. The idea is that wages tend
to equal to the amount necessary for the subsistence of labourers.

If the total wages at any time become higher than subsistence level, the labour force will
increase, competition for employment will become keener and the wages come down to the
subsistence level. Thus, Smith believed that, “under stationary conditions, wage rate falls to
the subsistence level, whereas in periods of rapid capital accumulation, they rise above this
level. The extent to which they rise depends upon the rate of population growth”. Thus, it can
be concluded that wage fund could be raised by increasing the rate of net investment.

According to Smith, “investments are made because the capitalist want to earn profits on
them. When a country develops and its capital stock expands, the rate of profit declines. The
increasing competition among capitalists raises wages and tends to lower profits”. So it is a
great difficulty of finding new profitable investment outlets that leads to falling profits.
5
W. Eltis, The Classical Theory of Economic Growth, (2nd Edi, 2000)

8
Regarding the role of interest, Smith postulated a negatively sloped supply curve of capital
implying that supply of capital increased in response to decline in interest rate. Smith wrote
that with the increase in prosperity, progress and population, the rate of interest falls and as a
result, capital is augmented. With the fall in interest rate, the money lenders will lend more to
earn more interest for the purpose of maintaining their standard of living at the previous level.

Thus, the quantity of capital for lending will increase with the fall in rate of interest. But
when the rate of interest falls considerably, the money lenders are unable to lend more in
order to earn more to maintain their standard of living. Under these circumstances, they will
themselves start investing and become entrepreneurs. Smith believed that economic progress-
involves rise in money as well as real rentals, and a rise in rental share of national income.
This is because the interest of land owners is closely related to general interest of the society.6

2.2 Ricardian Theory of Economic Development

Ricardo’s greatest contribution to economics is the provision of engine of analysis. By using

the technique of deductive or abstract reasoning, he constructed a rigorous model in which
some selected economic variables were systematically placed to form a logic. Such a
theoretical model helps to understand how a system works and how the change in variables
affects the working of the system.7

Ricardo propounded no theory of development. He simply discussed the theory of

distribution. This theory is based on the marginal and surplus principles. The marginal
principle explains the share of rent in national output and surplus principle explains the
division of the remaining share between wages and profits.

Assumptions:

The Ricardian theory is based on certain assumptions which are as under:

1. Supply of land is fixed.

2. Land is used for production of corn and the working force in agriculture helps in
determining the distribution in industry.

3. Law of diminishing returns operates on land.

6
W. Eltis, The Classical Theory of Economic Growth, (2nd Edi, 2000)
7
Will Kenton, Classical Growth Theory (Updated on Apr 17, 2018),
https://www.investopedia.com/terms/c/classical-growth-theory.asp

9
4. Demand for corn is perfectly inelastic

5. Labour and capital are variable inputs.

6. Capital consists of circulating capital.

7. There is capital homogeneity.

8. All workers are paid subsistence wages.

9. The state of technological knowledge is given.

10. There is perfect competition.

11. Demand for labour depends upon accumulation of capital.

12. Demand and supply price are independent of the marginal productivity of labour.

13. The supply price of labour is given and constant.

14. Capital accumulation results from profits.

Ricardian system considers agriculture as the most important sector of the economy. The
difficulty of providing food to expanding population is the main problem. According to
Ricardo, there are three major groups in the economy. They are landlords, capitalists and
labourers among whom the entire productive land is distributed. It is the capitalists who
initiate the process of economic development in the society by reinvesting profits and, thus,
increasing capital formation.8

The total national output is distributed among the three groups as rents, profits and wages,
respectively and the share of each group can be determined as under:

1. Rent per unit of labour is the difference between average and marginal product or
total rent equals the difference between average product and marginal product
multiplied by the quantity of labour and capital on land.9

2. 2. The wage rate is determined by wage fund divided by number of workers employed
at subsistence wage. Thus, output of total corn produced and sold, rent has the first

8
Will Kenton, Classical Growth Theory (Updated on Apr 17, 2018),
https://www.investopedia.com/terms/c/classical-growth-theory.asp
9
W. Eltis, The Classical Theory of Economic Growth, (2nd Edi, 2000)

10
 right and the residual is distributed among wages and profits, while interest is
included in profits.10

a. Production Function:
Ricardo’s production function assumes the existence of three factors-land, labour and
capital and it is subjected to the restriction of diminishing marginal productivity due to
perfectly inelastic of land and its variable quality He regarded economic development as
the process of these factors of production. The marginal productivity of land, labour and
capital declines with the increase in cultivation.

In agriculture, the rate of innovation introduced would be insufficient to affect the

tendency for diminishing returns to set in at either intensive or extensive margin of
cultivation. Thus, the introduction of improvements in the agriculture techniques might
check the progress of diminishing returns it could have temporary effect on cost of
agricultural production.

For the overall growth of the economy, it is necessary to examine as to which of these
patterns prevail with respect to the output of industry and agriculture together. Ricardo is
of the opinion that “Although, then it is probable that under the most favourable
circumstances, the power of production is still greater than that of population, it will not
long continue so, for the land being limited in quantity and differing in quality, with every
increased portion of capital employed on it there will be a decreased rate of production
while the power of population continues always to be the same”. As Smithian economy
grows at an accelerated rate, Ricardian economy develops at a progressively slower
pace.11

Ricardian production function is given as:

 Y = F (K ,N,L)

 K = Capital
 N = Labour

10
Will Kenton, David Ricardo’s Theory of Development, ( Updated on Jan 11, 2018)
https://www.investopedia.com/terms/d/david-ricardo.asp
11
Will Kenton, Classical Growth Theory (Updated on Apr 17, 2018),
https://www.investopedia.com/terms/c/classical-growth-theory.asp

11
  L = Land

b. Capital Accumulation:

Ricardo emphasized the rate of capital accumulation as capital acts as an engine of growth.
“Capital” is the part of the wealth of a country which is employed in production and consists
of food, clothing tools, raw materials, machinery etc., necessary to give effect to labour.

Capital accumulation depends upon two factors:

(a) Capacity to save.

(b) Will to save.

The capacity to save is more important in capital accumulation. This depends on the net
income of society which is a surplus out of the total output after meeting the cost of workers
subsistence. The larger the surplus, the larger will be the capacity to save. Landlords and
capitalists invest through this surplus and the size of this surplus depends upon the rate of
profit.

c. The Profit Rate:

The rate of profit is the ratio of profits to capital employed. But since capital consists of
working capital, it is equal to the wage bill. So, as long as rate of profit is positive, the
process capital accumulation will continue and the economy will progress. The labour force
will grow proportionately and the total wage fund will increase. The profit depends upon
wages, wages on price of the corn and price of the corn on the fertility of marginal land.
Hence, profits and wages are inversely proportional to each other.

When there is improvement in agriculture, the productivity power of land increases and there
is fall in the price of corn and as a result, subsistence wage also falls, but profits increase and
there is more capital accumulation. This will increase the demand of labour and wage rate
will rise, which will increase population and demand for corn and its price. Since the wages
rise, the profit will decline and there will be less capital accumulation.

12
The process of growth will continue till the profits fall to zero or the whole of the total
product less rent is used for the maintenance of labour at subsistence level. At this stage,
capital accumulation stops and the progress of the economy reaches a stationary state.12

d. Increase in Wages:

In Ricardian Scheme, wages play an active role in determining income between capital and
labour. The wage rate depends upon the number of workers and wage fund. The wage rate
falls with the increase in number of workers and vice-versa.13

If the wage rate is sufficient to enjoy the comforts of life by labourers, the population is
expected to increase and if the wage rate is the lowest the working class cannot meet the
necessities of life, the population will decrease. Thus, there is positive co-relation between
wage rate and size of population. The increase in wages with the increase in population
absorbs the rise in price of corn. Since wages also increase, profits decline. These opposite
tendencies ultimately retard the capital accumulation.

e. Declining Profits in Other Industries:

According to Ricardo, “The profits of the farmer regulate the profits of all other trades”.
Ricardo uses agricultural profits as a basis and it is the agricultural profit which determines
the industrial profit. The money rate of profit earned on capital must be equal in equilibrium
in both agriculture and industry.

The rate of profit in the agricultural sector determines the rate of profit in the industrial sector
of an economy. Thus, when the profit declines in the agricultural sector, it also declines in the
industrial sector. The industry would have to raise the wages of labourers with the increase in
price of corn and which in turn, reduces the profit. Thus, the price of corn determines the rate
of profit in an industry. When profit declines in agricultural sector, it declines in all trades.

f. Other Sources of Capital Accumulation:

Ricardo is of the view that economic development depends upon the difference between
production and consumption. He stresses on increasing production and reducing unproductive
consumption. The productivity of labour can be increased through technological changes and
better organisation and thereby stimulating capital accumulation. But the use of machines
12
W. Eltis, The Classical Theory of Economic Growth, (2nd Edi, 2000)
13
Will Kenton, David Ricardo’s Theory of Development, ( Updated on Jan 11, 2018)
https://www.investopedia.com/terms/d/david-ricardo.asp

13
will employ less workers which will lead to unemployment and reduced wages since the
economic condition of workers decreases with the employment of more machines. So Prof.
Ricardo regards the technological conditions as given and constant.

Taxes are the source of capital accumulation in the hands of the government. According to
Ricardo, taxes are levied only to reduce conspicuous consumption, otherwise the imposition
of taxes on capitalists, landlords and labourers will transfer resources from these groups to
government. Taxes adversely affect the investment. Therefore, Ricardo is not in favour of
imposition of taxes, as taxes reduce income, profit and capital accumulation.

Prof. Ricardo is in favour of free trade as it is an important factor of development of the

country. Free trade provides vast opportunities of investment to capitalists. The capitalists can
make investment in export oriented industries and earn profits. The re-investment of profit by
the capitalists will further enhance the developing activities.

The capital accumulation can be raised by importing corn. But the import of corn leads to fall
in demand for labour which deteriorates the economic conditions of labourers. On the other
hand, landlords and capitalists do not think it fit to import cheap corn from the foreign
countries, as a result, their profits decline. Ricardian theory has been illustrated with the help
of a diagram (Fig 2).14

Stationary State:

When the economic development proceeds real wage rate remains at the subsistence level
and profit tends to fall. When the capital accumulation rises with increase in profit, total
output increases which raises the wage fund. With the increase in the wage fund’ population
14
Will Kenton, Classical Growth Theory (Updated on Apr 17, 2018),
https://www.investopedia.com/terms/c/classical-growth-theory.asp

14
increases which raises the demand for corn and its price. As population increases, inferior
grade lands are cultivated to meet increasing demand of corn. Ricardo assumes that labourers
and landlords spend all their income on consumption and hence, save nothing.

The saving is done by the capitalist for profit earners. But as the society progresses, the share
of profit begins to decline. Fall in the rate of profit slackens the process of capital
accumulation and the development receives a set back and at this stage, there is no further
increase in capital and the economy enters in a stationary state.15

In this state, capital accumulation stops, population does not grow, the wage rate is at
subsistence level and technological progress ceases. “The basic casual force in this scheme is
the fact of diminishing returns in agriculture, a grim tendency which can be postponed
temporarily by technical progress. But technical progress cannot prevent the ultimate
disappearance of profit and the onset of stationary state”. The phenomenon of stationary state
is explained with the help of a diagram 3.16

With the increase in capital accumulation, profits and wages tend to increase and the rise in
wages bring about a decline in profits. The decline in profits will continue till a stage comes
when the net product curve intersects the wage line OW at P. At this point, wages are equal to
net product and the profit is nil. Any disturbance to the right of point P, will make the net
product less than wage level which is impossible. So P is the point at which economy is in a
stationary state.

15
Will Kenton, David Ricardo’s Theory of Development, ( Updated on Jan 11, 2018)
https://www.investopedia.com/terms/d/david-ricardo.asp
16
Will Kenton, Classical Growth Theory (Updated on Apr 17, 2018),
https://www.investopedia.com/terms/c/classical-growth-theory.asp

15
Thus, “Ricardian system of development formulated certain interrelations among capital,
population and output on the basis of these relations, it traces the course of rent, wages and
profits every time and finally it concedes with the celebrated forecast of the eventual advent
of a stationary state”.

3. Keynesian Theory of Development

Keynesian economics is an economic theory of total spending in the economy and its effects
on output and inflation. Keynesian economics was developed by the British economist John
Maynard Keynes during the 1930s in an attempt to understand the Great Depression. Keynes
advocated for increased government expenditures and lower taxes to stimulate demand and
pull the global economy out of the depression.

Subsequently, Keynesian economics was used to refer to the concept that optimal economic
performance could be achieved -– and economic slumps prevented – by influencing
aggregate demand through activist stabilization and economic intervention policies by the
government. Keynesian economics is considered a "demand-side" theory that focuses on
changes in the economy over the short run.

 Keynesian Economics focuses on using active government policy to manage

aggregate demand in order to address or prevent economic recessions.
 Keynes developed his theories in response to the Great Depression, and was highly
critical of classical economic arguments that natural economic forces and incentives
would be sufficient to help the economy recover.
 Activist fiscal and monetary policy are the primary tools recommended by Keynesian
economists to manage the economy and fight unemployment.

Keynesian economics represented a new way of looking at spending, output and inflation.
Previously, classical economic thinking held that cyclical swings in employment and
economic output would be modest and self-adjusting. According to this classical theory, if
aggregate demand in the economy fell, the resulting weakness in production and jobs would
precipitate a decline in prices and wages. A lower level of inflation and wages would induce
employers to make capital investments and employ more people, stimulating employment
and restoring economic growth. The depth and severity of the Great Depression, however,
severely tested this hypothesis.17
17
• Vol 39, Issue.1, B. Greenwald and J. E. Stiglitz, Keynesian, New Keynesian and New Classical
Economics, Oxford University Press

16
Keynes maintained in his seminal book, The General Theory of Employment, Interest, and
Money and other works that during recessions structural rigidities and certain characteristics
of market economies would exacerbate economic weakness and cause aggregate demand to
plunge further.

For example, Keynesian economics disputes the notion held by some economists that lower
wages can restore full employment, by arguing that employers will not add employees to
produce goods that cannot be sold because demand is weak. Similarly, poor business
conditions may cause companies to reduce capital investment, rather than take advantage of
lower prices to invest in new plants and equipment. This would also have the effect of
reducing overall expenditures and employment. 18

a. Keynesian Economics and the Great Depression

Keynesian economics is sometimes referred to as "depression economics," as Keynes's

General Theory was written during a time of deep depression not only in his native land of
the United Kingdom but worldwide. The famous 1936 book was informed by directly
observable economic phenomena arising during the Great Depression, which could not be
explained by classical economic theory.

In classical economic theory, it is argued that output and prices will eventually return to a
state of equilibrium, but the Great Depression seemed to counter this theory. Output was low
and unemployment remained high during this time. The Great Depression inspired Keynes to
think differently about the nature of the economy. From these theories, he established real-
world applications that could have implications for a society in economic crisis.

Keynes rejected the idea that the economy would return to a natural state of equilibrium.
Instead, he argued that once an economic downturn sets in, for whatever reason, the fear and
gloom that it engenders among businesses and investors will tend to become self-fulfilling
and can lead to a sustained period of depressed economic activity and unemployment. In
response to this, Keynes advocated a countercyclical fiscal policy in which, during periods of
economic woe, the government should undertake deficit spending to make up for the decline
in investment and boost consumption spending in order to stabilize aggregate demand.

Keynes was highly critical of the British government at the time. The government cut welfare
spending and raised taxes to balance the national books. Keynes said this would not
18
Ibid

17
encourage people to spend their money, thereby leaving the economy unstimulated and
unable to recover and return to a successful state. Instead, he proposed that the government
spend more money, which would increase consumer demand in the economy. This would in
turn lead to an increase in overall economic activity, the natural result of which would be
recovery and a reduction in unemployment.

Keynes also criticized the idea of excessive saving, unless it was for a specific purpose such
as retirement or education. He saw it as dangerous for the economy because the more money
sitting stagnant, the less money in the economy stimulating growth. This was another of
Keynes's theories geared toward preventing deep economic depressions.

Both classical economists and free-market advocates have criticized Keynes' approach. These
two schools of thought argue that the market is self-regulating and businesses responding to
economic incentives will inevitably return it to a state of equilibrium. On the other hand,
Keynes, who was writing while the world was mired in a period of deep economic
depression, was not as optimistic about the natural equilibrium of the market. He believed the
government was in a better position than market forces when it came to creating a robust
economy.

b. Keynesian Economics and Fiscal Policy

The multiplier effect is one of the chief components of Keynesian countercyclical fiscal
policy. According to Keynes's theory of fiscal stimulus, an injection of government spending
eventually leads to added business activity and even more spending. This theory proposes
that spending boosts aggregate output and generates more income. If workers are willing to
spend their extra income, the resulting growth in gross domestic product( GDP) could be
even greater than the initial stimulus amount.

The magnitude of the Keynesian multiplier is directly related to the marginal propensity to
consume. Its concept is simple. Spending from one consumer becomes income for another
worker. That worker's income can then be spent and the cycle continues. Keynes and his
followers believed individuals should save less and spend more, raising their marginal
propensity to consume to effect full employment and economic growth.

In this way, one dollar spent in fiscal stimulus eventually creates more than one dollar in
growth. This appeared to be a coup for government economists, who could provide
justification for politically popular spending projects on a national scale.

18
This theory was the dominant paradigm in academic economics for decades. Eventually,
other economists, such as Milton Friedman and Murray Rothbard, showed that the Keynesian
model misrepresented the relationship between savings, investment and economic growth.
Many economists still rely on multiplier-generated models, although most acknowledge that
fiscal stimulus is far less effective than the original multiplier model suggests.

The fiscal multiplier commonly associated with Keynesian theory is one of two broad
multipliers in macroeconomics. The other multiplier is known as the money multiplier. This
multiplier refers to the money-creation process that results from a system of fractional reserve
banking. The money multiplier is less controversial than its Keynesian fiscal counterpart.

c. Keynesian Economics and Monetary Policy

Keynesian economics focuses on demand-side solutions to recessionary periods. The

intervention of government in economic processes is an important part of the Keynesian
arsenal for battling unemployment, underemployment, and low economic demand. The
emphasis on direct government intervention in the economy places Keynesian theorists at
odds with those who argue for limited government involvement in the markets. Lowering
interest rates is one way governments can meaningfully intervene in economic systems,
thereby generating active economic demand. Keynesian theorists argue that economies do not
stabilize themselves very quickly and require active intervention that boosts short-term
demand in the economy. Wages and employment, they argue, are slower to respond to the
needs of the market and require governmental intervention to stay on track.

Prices also do not react quickly, and only gradually change when monetary policy
interventions are made. This slow change in prices, then, makes it possible to use money
supply as a tool and change interest rates to encourage borrowing and lending. Short-term
demand increases initiated by interest rate cuts reinvigorate the economic system and restore
employment and demand for services. The new economic activity then feeds continued
growth and employment. Without intervention, Keynesian theorists believe, this cycle is
disrupted and market growth becomes more unstable and prone to excessive fluctuation.
Keeping interest rates low is an attempt to stimulate the economic cycle by encouraging
businesses and individuals to borrow more money. When borrowing is encouraged,
businesses and individuals often increase their spending. This new spending stimulates the
economy. Lowering interest rates, however, does not always lead directly to economic
improvement.

19
Keynesian economists focus on lower interest rates as a solution to economic woes, but they
generally try to avoid the zero-bound problem. As interest rates approach zero, stimulating
the economy by lowering interest rates becomes less effective because it reduces the
incentive to invest rather than simply hold money in cash or close substitutes like short term
Treasuries. Interest rate manipulation may no longer be enough to generate new economic
activity if it cannot spur investment, and the attempt at generating economic recovery may
stall completely. This is know as a liquidity trap.

Japan's Lost Decade during the 1990s is believed by many to be an example of this liquidity
trap. During this period, Japan's interest rates remained close to zero but failed to stimulate
the economy.

When lowering interest rates fails to deliver results, Keynesian economists argue that other
strategies must be employed, primarily fiscal policy. Other interventionist policies include
direct control of the labor supply, changing tax rates to increase or decrease the money supply
indirectly, changing monetary policy, or placing controls on the supply of goods and services
until employment and demand are restored.

4. Comparison of the Classical and Keynesian Theories of Development

Economics is the quantitative and qualitative study on the allocation, distribution and
production of economic resources. Economics often studies the monetary policy of a
government and other information using mathematical or statistical calculations. Qualitative
analysis is made by making judgments and inferences from fiscal information. Two economic
schools of thought are classical and Keynesian. Each school takes a different approach to the
economic study of monetary policy, consumer behavior and government spending. A few
basic distinctions separate these two schools.19

Basic Theory

Classical economic theory is rooted in the concept of a laissez-faire economic market. A

laissez-faire--also known as free--market requires little to no government intervention. It also
allows individuals to act according to their own self interest regarding economic decisions.
This ensures economic resources are allocated according to the desires of individuals and
businesses in the marketplace. Classical economics uses the value theory to determine prices

19
Keynesian vs Classical models and policies, Economics Help, https://www.economicshelp.org/keynesian-vs-
classical-models-and-policies/

20
in the economic market. An item’s value is determined based on production output,
technology and wages paid to produce the item. Keynesian economic theory relies on
spending and aggregate demand to define the economic marketplace. Keynesian economists
believe the aggregate demand is often influenced by public and private decisions. Public
decisions represent government agencies and municipalities. Private decisions include
individuals and businesses in the economic marketplace. Keynesian economic theory relies
heavily on the fact that a nation’s monetary policy can affect a company’s
economy.

1. Shape of long run aggregate supply.

The most basic distinction between the Keynesian and classical view of macroeconomics, can
be illustrated looking at the long run aggregate supply.

The Classical view is that Long Run Aggregate Supply (LRAS) is inelastic.

Classical view of Long Run Aggregate Supply

This has important implications. The classical view suggests that Real GDP is determined by
supply side factors – the level of investment, the level of capital and the productivity of
labour e.t.c. Classical economists suggest that in the long-term an increase in aggregate
demand (faster than growth in LRAS) will just cause inflation.20

20
Keynesian vs Classical models and policies, Economics Help, https://www.economicshelp.org/keynesian-vs-
classical-models-and-policies/

21
The Keynesian view of long run aggregate supply is different. They argue that the economy
can be below full capacity in the long term.21

Therefore, a Keynesian plays greater emphasis on the role of aggregate demand in causing
and overcoming a recession.

2. Demand deficient Unemployment

 Because of the different opinions about the shape of the aggregate supply and the role
of aggregate demand in influencing economic growth, there are different views about
the cause of unemployment
Classical economists argue that unemployment is caused by supply side factors – real
wage unemployment, frictional unemployment and structural factors. They downplay
the role of demand deficient unemployment.
 Keynesians place a greater emphasis on demand deficient unemployment. For
example the current situation in Europe (2014), a Keynesian would say that this
unemployment is partly due to insufficient economic growth and low growth of
aggregate demand (AD)22

3. Phillips Curve trade off

21
Vol 39, Issue.1, B. Greenwald and J. E. Stiglitz, Keynesian, New Keynesian and New Classical Economics,
Oxford University Press
22
Keynesian vs Classical models and policies, Economics Help, https://www.economicshelp.org/keynesian-vs-
classical-models-and-policies/

22
A classical view would reject the long run trade off between unemployment, suggested by
the Phillips Curve.

Classical economists say that in the short term, you might be able to reduce
unemployment below the natural rate by increasing AD. But, in the long-term, when
wages adjust, unemployment will return to the natural rate, and there will be higher
inflation. Therefore, there is no trade off in the long-run.

Keynesians support the idea that there can be a trade off between unemployment and
inflation.

4. Flexibility of prices and wages

In the classical model, there is an assumption that prices and wages are flexible, and in
the long-term markets will be efficient and clear. For example, suppose there was a fall in
aggregate demand, in the classical model, this fall in demand for labour would cause a

23
 fall in wages. This decline in wages would ensure that full employment was maintained
and markets ‘clear’.23

A fall in demand for labour would cause wages to fall from W1 to W2 .24

However, Keynesians argue that in the real world, wages are often inflexible. In particular,
wages are ‘sticky downwards’. Workers resist nominal wage cuts. For example, if there was a
fall in demand for labour, trade unions would reject nominal wage cuts, therefore, in the
Keynesian model it is easier for labour markets to have disequilibrium.Wages would stay at
W1, and unemployment would result.

A Keynesian would argue in this situation, the best solution is to increase aggregate demand.
In a recession, if the government did force lower wages, this might be counter-productive
because lower wages would lead to lower spending and a further fall in aggregate demand.

5. Rationality and confidence

Another difference behind the theories is different believes about the rationality of people

Classical economics assumes that people are rational and not subject to large swings in
confidence.

Keynesian economics suggests that in difficult times, the confidence of businessmen and
consumers can collapse – causing a much larger fall in demand and investment. This fall in

23
Keynesian vs Classical models and policies, Economics Help, https://www.economicshelp.org/keynesian-vs-
classical-models-and-policies/
24
Vol 39, Issue.1, B. Greenwald and J. E. Stiglitz, Keynesian, New Keynesian and New Classical Economics,
Oxford University Press

24
confidence can cause a rapid rise in saving and fall in investment and it can last a long time –
without some change in policy.25

Difference in policy recommendations

1. Government spending
 The classical model is often termed ‘laissez faire’ because there is little need
for the government to intervene in managing the economy.
 The Keynesian model makes a case for greater levels of government
intervention, especially in a recession when there is a need for government
spending to offset the fall in private sector investment. (Keynesian economics
is a justification for the ‘New Deal’ programmes of the 1930s.)
2. Fiscal Policy
 Classical economics places little emphasis on the use of fiscal policy to
manage aggregate demand.Classical theory is the basis for Monetarism, which
only concentrates on managing money supply, through monetary policy.
 Keynesian economics suggests governments need to use fiscal policy,
especially in a recession. (This is an argument to reject austerity policies of
2008-13 recession.
3. Government borrowing.
 A classical view will stress the importance of reducing government borrowing
and balancing the budget, because there is no benefit from higher government
spending. Lower taxes will increase economic efficiency. (e.g. at the start of
the 1930s, the ‘Treasury View‘ argued the UK needed to balance its budget by
cutting unemployment benefits.
 The Keynesian view suggests that government borrowing may be necessary
because it helps to increase overall aggregate demand.
4. Supply side policies
 The classical view suggests the most important thing is enabling the free
market to operate. This may involve reducing the power of trade unions to
prevent wage inflexibility. Classical economics is the parent of ‘supply side
economics‘ – which emphasises the role of supply side policies in promoting
long term economic growth.
25
Keynesian vs Classical models and policies, Economics Help, https://www.economicshelp.org/keynesian-vs-
classical-models-and-policies/

25
  Keynesian don’t reject supply side policies. They just say they may not always
be enough. e.g. in a deep recession, supply side policies can’t deal with the
fundamental problem of a lack of demand.26

5. Conclusion

Classical economic theory promotes laissez-faire policy. It says the free market allows the
laws of supply and demand to self-regulate the business cycle. It argues that unfettered
capitalism will create a productive market on its own. It will enable private entities to own
the factors of production. These four factors are entrepreneurship, capital goods, natural
resources, and labor. In this theory, business owners use the most efficient practices to
maximize profit.

Keynes advocated deficit spending during the contractionary phase of the business cycle. But
in recent years, politicians have used it even during the expansionary phase. President Bush's
deficit spending in 2006 and 2007 increased the debt. It also helped create a boom that led to
the 2007 financial crisis. President Trump is increasing the debt during stable economic
growth. That will also lead to a boom-and-bust cycle.

Classical economic theory advocates for a limited government. It should have a balanced
budget and incur little debt. Government spending is dangerous because it crowds out private
investment. But that only happens when the economy is not in a recession. In that case,
government borrowing will compete with corporate bonds. The result is higher interest rates,
which make borrowing more expensive. If deficit spending only occurs during a recession, it
will not raise interest rates. For that reason, it also won't crowd out private investment.

26
Keynesian vs Classical models and policies, Economics Help, https://www.economicshelp.org/keynesian-vs-
classical-models-and-policies/

26
 BIBLIOGRAPHY

Books Referred

• W. Eltis, The Classical Theory of Economic Growth, (2nd Edi, 2000)

Articles Referred

 Vol 39, Issue.1, B. Greenwald and J. E. Stiglitz, Keynesian, New Keynesian and
New Classical Economics, Oxford University Press
 Will Kenton, David Ricardo’s Theory of Development, ( Updated on Jan 11,
2018) https://www.investopedia.com/terms/d/david-ricardo.asp
 Keynesian vs Classical models and policies, Economics Help,
https://www.economicshelp.org/keynesian-vs-classical-models-and-policies/
 Will Kenton, Classical Growth Theory (Updated on Apr 17, 2018),
https://www.investopedia.com/terms/c/classical-growth-theory.asp

27