CLASSICAL VS KEYNESIAN

ECONOMICS
OVERVIEW
 These two schools of thought are branches from very
similar principles and are not entirely different from
each other. Especially since the Keynesian Economic
Theory developed much later, it recognizes many of
the Classical economic principles to be correct.
 These schools of thought establish their fundamental
ideological differences primarily over general economic
affairs and responses to economic recessions. The
nature, principle, cause and effect of the response and
restoration of full employment of resources suggested
by the two is what separates their identity.
 Both these macroeconomic schools of
thought also have a theoretical difference of
opinion over how the total output of an
economy is shaped by aggregate supply and
aggregate demand and which factors should
be stimulated to increase total output.
 Further on, they also differ on aspects like
control of an economy, factors that influence
the markets and role of the government in an
economy just to name a few.
CLASSICAL ECONOMICS
 Classical Economy is usually seen as the original established
economic school of thought (preceded by economic
principles of feudalism and guild organizations etc.).
 Adam Smith is considered as the father of classical
economic as Adam Smith's The Wealth of Nations published
in 1776 is usually considered to mark the beginning of
classical economics. Other notable contributors to classical
economics include David Ricardo, Thomas Malthus, Alfred
Marshall,, John Stuart Mill, Jean-Baptiste Say.
 Classical Economy’s basic principle is that it is best to leave
markets alone and let them be free (laissez-faire) . Such a
market will be guided by the market forces of demand and
supply and hence will be able to regulate itself. These two
market forces make what Adam Smith called as the
Invisible Hand. This invisible hand is capable of restoring
equilibrium through a price adjustment mechanism
whenever it is disrupted.
 This economic theory also pronounces the absence of governmental control or no
governmental interference in the market. It means that the market forces can
maintain the equilibrium in the market and also fix prices etc. Classical
Economists feel that in such a case, governmental intervention is not only
unrequired but also undesired.
 Classical economists assume that there is no unemployment in the economy or
that all resources of an economy are fully employed. Even when there is a
recession or unemployment it would be self-regulated by the market. As per this
view, unemployment primarily happens because of high wages. In the case of
recession or unemployment, prices, wages and interest rates would fall as
unemployed workers would be willing to work for less, sellers would be willing to
sell at lower prices and banks would be willing to give loans at lower rates of
interest. All of this would increase consumption, production and investment and
quickly return the economy back to its full employment equilibrium and hence
the recession would end through this self‐adjustment mechanism or the invisible
hand as proclaimed by Adam Smith.
 According to him, the entire community benefits most when each of its members
follows his or her own self-interest. Adam Smith famously exclaimed, “It is not
from the benevolence of the butcher, brewer or baker that we expect our dinner
but from their regard to their own interest.” Individuals spend money for these
goods because they want or need them. In such an exchange both the parties are
better off after the exchange. Such a market was self-regulating because
producers produced according to what people would buy and consumers
consumed according to what they wanted and could afford.
KEYNESIAN ECONOMICS
 John Maynard Keynes was a British economist, whose ideas
fundamentally changed the theory and practice of
macroeconomics and the economic policies of
governments.
 During the Great Depression of the 1930s, Keynes
spearheaded a revolution in economic thinking, challenging
the ideas of classical economics that held that free markets
would in the long run automatically provide full
employment. To this Keynes famously said, “In the Long
Run, we are all dead.” He argued that aggregate demand
determined the overall level of economic activity, and that
inadequate aggregate demand could lead to prolonged
periods of high unemployment.
 Keynesian economics is an umbrella of various
macroeconomic theories about how economic output is
strongly influenced by aggregate demand and its effects on
output, employment, and inflation.
 In the Keynesian view, aggregate demand does not
necessarily equal the productive capacity of the
economy (output or Real GDP). Instead, it is
influenced by a host of factors. According to Keynes,
the productive capacity of the economy sometimes
behaves erratically, affecting production,
employment, and inflation (usually causing a
recession).
 Keynesian economics is based on two main ideas.
First, aggregate demand is more likely than
aggregate supply to be the primary cause of a short-
run economic event like a recession. Second, wages
and prices can be sticky, and so, in an economic
downturn, unemployment can be a result.
 Keynes countered the price adjustment mechanism proposed
by Classical Economists. According to him, before price
adjustment mechanism can work, it is overpowered by an
"income adjustment mechanism. When an economy sinks into a
recession people’s incomes fall. They spend and save less while
businesses invest and produce less. This income adjustment
mechanism drives the economy further into recession rather
than back to full employment. Taking an example, say there are
four producers A, B, C and D. Producer A sells two units of his
produce to B, B sells two units to C, C sells to D and D in turn to
A. Hence the market works in perfect balance.
 Now for some reason the demand of one producer is
affected, say A and he starts to buy only 1 product from D.
Now D in turn reduces demand and buys only 1 unit of
produce from C. Due to a decreased demand, C also reduces
consumption of 1 unit from B and B in turn starts buying 1
less unit from A. A now feels happy about consuming less
because the demand for Now for some reason the demand
of one producer is affected, say A and he starts to buy only 1
product from D. Now D in turn reduces demand and buys
only 1 unit of produce from C. Due to a decreased demand, C
also reduces consumption of 1 unit from B and B in turn
starts buying 1 less unit from A. A now feels happy about
consuming less because the demand for
 Now, if the government was to intervene and buy, just to
pump the economy, one additional unit from one of the
producer say C, then C will raise his demand from B. B in
turn will now produce 2 units to meet the additional
demand and demand more from A. This cycle will continue
and each producer will increase their demand and their
production and will start operating at the optimum levels
once again. Now the government can cease buying any
more units from C and let the market run on its own. This is
the basic principle of the Keynesian Economy.
 Keynesian Economic thought was quickly
adopted by different governments in the
wake of the Great Depression. Though
initially seemed as controversial and opposed
for speaking against the government,
Keynesian theories provided a solution to an
unanticipated situation – the failure of the
Invisible Hand.
Comparative Analysis between the two
 Classical economists had argued that in any economic recession, businesses and
investors taking advantage of lower input prices in pursuit of their own self-interest
would return output and prices to a state of equilibrium, unless otherwise prevented
from doing so. Keynes believed that the Great Depression seemed to counter this
theory. Output was low and unemployment remained high during this time. The
physical capacity of the economy to supply goods had not altered much. No flood or
earthquake or other natural disaster ruined factories. No outbreak of disease
decimated the ranks of workers. The US economy in 1933 had just about the same
factories, workers, and state of technology as it had had four years earlier in 1929—
and yet the economy shrank dramatically. 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 consumer spending in order to stabilize aggregate demand. He
famously remarked, “Make them dig pits and fill them up.” Implying that the
government must do anything to employ people even if the total output was zero.
This is how Classical Economics gave way to Keynesian Economics.
 As can be inferred from the graph, in an economic recession, after a point the
price levels remain constant even with a change in demand. But the output of the
economy keeps dropping due to change in AD. According to the classical
approach, production can be increased by stimulating the aggregate supply. This
can be done by investing in technology, increase in population and resources and
cultural and institutional change, which happens automatically in due course. They
feel that employers will make use of the reducing wage levels and employ more
people and consumers will take advantage of the reduced prices and consume
more and this will automatically pull the economy out of recession in the long run.
According to the Keynesian thought, prices and wages are sticky and do not
decrease after a point. Production can be increased by stimulating aggregate
demand. This can be done by pumping more money into the economy or changing
fiscal policies etc. These are the basic principle differences between the two.