Comparison Of Classical Theory and Keynesian Theory of Income and Employment

Indian Currency Notes

By Tanushree Verma

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. 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.

Classical economics is a broad term that refers to the dominant school of thought for economics that prevailed in the 18th and 19th centuries. Classical economic theory helped countries to migrate from monarch rule to capitalistic democracies with self-regulation.

Adam Smith’s 1776 release of the “Wealth of Nations” highlights some of the most prominent developments in classical economics. Many Economists have contributed to Classical Theory.

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.

The Keynesian full employment commitment of the 1950s and 1960s played a central role in saving capitalism from state socialism and Marxism.

After the oil shock and stagflation (stagnant demand combined with high inflation and unemployment) of the 1970s, this theory was questioned. Although, the financial crisis of 2008 rekindled Keynesian thought.

Classical Theory

Jean-Baptiste Say

• The Classical Theory States 3 Key ideas:

1. Say’s law of Market

• That the supply of goods/services creates its own demand for the same. Production process generates income equivalent to the value of goods produced, thus creating demand due to purchasing power (Circular flow of Income). 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. I.e producers will produce those goods that have a demand in the economy, or they will create demand for the good.
• Y=C+S (Income=Consumption+Saving)
• Saving=Investment (Interest rates ensure this, for example, when interest rates are high, people save more to get a return on their savings, and invest less because the cost of capital is high) or Y=C+I.
• When an economy does not have a demand problem, (since according to classical theory, supply creates its own demand) so producers are willing to invest, since there is demand in the economy. Producers will invest till the point where resources are available, i.e. productive resources (like labour). So producer’s will invest till the point of full employment, because investing after that point will only increase prices, not output since factors of production remain unchanged.
• In conclusion, according to Say’s law, the economy will always be at full employment equilibrium. It only allows for frictional and voluntary unemployment, not involuntary unemployment.

2. Wage Flexibility

• Full employment refers to the situation where all those who are willing to work at the prevailing wage rate are employed. I.e there is no involuntary unemployment.
• Supply of labour is ensured when disutility borne by labourer= Real wage. When wages are high, the supply of labourers is high.
• Demand curve is downward sloping since it is a summation of individual demand curves.
• Demand for labour depends on marginal revenue productivity. As long as MRP= wages or MPP= real wages, there will be a demand for labour.
• MRP= Marginal Physical productivity*Price
• MPP= W/P
• But W/P=real wages.
• When wages are high, the demand for labour is low, when wages are low, demand is high.
• At wage rate W1, Demand for labour is lesser than supply, so labourers will be willing to work at wage rate We, wages will fall to the previous wage rate, maintaining the level of full employment. Due to flexibility of wages, there would be an automatic restoration of equilibrium at full employment level.

• 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 were 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. (Since producers will not be willing to pay such a high wage rate to all labourers)
• 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 counterproductive because lower wages would lead to lower spending and a further fall in aggregate demand.

3. Quantity Theory of Money

• MV=PY
• P= General Price level
• Y= Output ( In nominal/physical terms, by multiplying this with P, we get the monetary value of output). This is a stable/constant factors in the short run.
• M= Money Supply (M1-most liquid form of money supply)
• V= Velocity of Circulation (How many transactions one unit of money is financing,
• for example, I have a 100 Rupee note, which I spent in the economy. Let’s say, this note went to persons A, B, C in different proportions, they further spent it on other things and so on. The Money supply has not increased, this note has just financed many transactions)
• Velocity of Circulation depends on:

1. Consumer Habits i.e the time gap between receipt of income, and disbursement of income.
2. Technology- with the availability of credit cards and net banking transfers, the velocity of circulation increases.

• In the short run, velocity of circulation remains constant.
• Implications of quantity theory:
• In conclusion, due to V and Y being stable, M and P have a direct and proportional relationship. For example, if money supply triples, the general price level will triple. Price can be regulated through Money Supply.
• Classical theory believes that money is demanded for transactional purposes alone.
• 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 the money supply, through monetary policy.
• Keynesian economics suggests governments need to use fiscal policy, especially in a recession.

Graphs that help in the understanding of classical theory:

Keynesian Theory of Income and Employment

John Maynard Keynes

• The situation of ‘Effective Demand’: According to Keynes, Equilibrium level of employment is determined when Aggregate Supply is equal to Aggregate Demand. This may be a position of full employment or not, it’s a matter of chance. Unlike classical theory, he believed the level of employment was determined by aggregate demand, and not the price of labour.
• 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.
• Aggregate Supply- The money value of final goods and services that all producers are willing to supply in an economy in a given time period.
• According to Keynes, Investment performs two functions in the economy, namely:

1. productive capacity expansion (In the long run)

2. Income generation (In the short run)

According to Keynes, the above situation was not the solution (read diagram above). Let us say ON1 is the level of full employment in the economy. To reach that level, According to Keynes, the government should increase its expenditure. The government could invest without any profit motive for the general welfare of the people (also known as autonomous investment). Due to this government investment, the employment level would rise to ON1 for ON*. Thus it is only through government intervention, that employment level can be raised. (see diagram below)

• According to Classical Theory, we should only rely on market forces and completely remove market distortions. This was on the precedent that the market does not have a demand problem, as supply creates its own demand. But, in a situation like COVID-19, where people are not stepping out of their homes, demand has fallen to a great extent. In such a situation, market distortions become necessary and good for employment in the short run. Keynes believed that market distortions were a part of the economic web. Government spending to close the deflationary gap and increase employment is the right way forward.
• Classical economic theory advocates for a limited government. It believes that the government 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. When an economy is not in recession, government borrowing will compete with corporate bonds. As a result, Interest rates will rise, making 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. This is why Keynesian theory works well in recession and depression related periods.
• I believe that the Keynesian Theory is more applicable than classical theory in a way. This is because the postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium.
• Although, a drawback of Keynesian theory is that the objective of obtaining full employment through government spending and closing the deflationary gap will cause inflation in the long run. Another price of this success is greatly enlarged deficit budgets and rising debts. The use of capital receipts for meeting the extra consumption expenditure leads to an inflationary situation. The Keynesian theory is strictly short-run economics. The economy consists of cyclic booms and busts, and prolonged booms lead to a rise in prices.
• Most Keynesian politicians/ governments of the 1950s and 60s made full employment their main goal, due to prevailing unemployment after the Great Depression. These politicians, mostly in Britain, totally disregarded the Phillips Curve trade-off between inflation and employment. British Keynesians’ solution to inflation was cost control, using Incomes policy (usually where governments establish prices below a free market level). This policy was tried in many countries from the 1960s to the end of the 1970s. At best, there were temporary successes, but the policies always broke down. The reason, pointed out by Friedman in 1968, was that inflation resulted from the full employment commitment itself. The only way to reduce inflation was to abandon the full employment commitment. Slowly, the unemployment target was replaced by the Inflation target and unemployment was left to settle at its natural rate.

New Keynesian Theory

• In the 1970s, rational expectations theorists argued against the Keynesian theory. They said that taxpayers would anticipate the debt caused by deficit spending. Consumers would save today to pay off future debt. Deficit spending would spur savings, not increase demand or economic growth. (The deficit means that the government is going to incur more expenditure over their revenue, this means there will be a lot of income in the hands of the people now and people will start buying things and consuming- which was Keynes’ theory. But the later Economists say that the people who were jobless before the government spending, are now getting a job due to increased government spending. 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. So Deficit financing by the government, instead of increasing consumption expenditure and going for a recovery path, will increase the savings of the people, and will not be able to expand the economy.)
• The rational expectations theory inspired the New Keynesians. They said that monetary policy is more potent than fiscal policy. If done right, expansionary monetary policy would negate the need for deficit spending. Central banks don’t need politicians’ help to manage the economy. They would merely adjust the money supply.

My concluding opinion

• None of these theories are completely invalid, they just work in certain conditions with certain assumptions. There are certain situations where classical theory and the market correction by free-market forces fits best. In times like a depression, Keynesian methods fit best. But, in a situation of economic normalcy, I believe an optimal mix of both theories should be used to shape fiscal and monetary policy. Methods like open market operations, bank rate, repo rate and other monetary policy can be used to expand and contract credit. 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. 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. Countries should also focus on obtaining an optimal trade-off point between inflation and employment.
• 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. Government expenditure should not be overdone, as reasons explained above, but it can work well to improve employment in times of recession. (At the same time, some vulnerable sections of society might require direct money from the government, which creates a direct effect in terms of consumption.)
• Lastly, I believe in a largely free-market system, laissez-faire Capitalism with adequate government constraints and intervention.