“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 Inquiry 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 working of this model, let us first know and understand the 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. They are:
Flexible Prices: The prices of everything, the commodities, labor (wages), land (rent), etc. must be both upwardly and downward 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 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).
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, decrease, 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.
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 total 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 and 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.
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 (Alvin Hansen, R. Frisch, Tinbergen, Paul Samuelson etc.) believe otherwise. In the Keynesian economic model, the government has the very important job of smoothing 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 the former giving ways to avoid and escape the latter. Keynesian economics is equipped to teach everyone about surviving 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 disequilibrium 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.
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 equals 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.
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 lies 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.