John Petroff's Macroeconomics: "Chapter 7: Classical/Keynesian Controversy"

Read this chapter to learn about some of the differences among various schools of thought with respect to the role of government, the nature of adjustments in equilibrium, the level of unemployment, and so forth. Those perspectives can affect the timing and effectiveness of government actions or inactions.

In this article we show two alternative views of the business cycle and the major problems of unemployment and inflation. We present classical theory and the Keynesian view as a critique.

Classical Theory

The classical theory is the laissez faire belief of pure capitalism. In this view, business cycles are natural processes of adjustment which do not require government action. The market or invisible hand will resolve any problems naturally.

In Adam Smith's concept of the invisible hand, government is not necessary because companies will produce what people want: the economy works out societal problems.

Say's Law

Say's law proposes that supply creates its own demand. This means the income people earn from producing goods, allows them to purchase goods others produce. Since everyone needs to buy goods, people will produce goods in order to derive the income they need to buy what they want. The market will always be in equilibrium.

Workers who earn income, earn money to buy a variety of products they want. By working and producing goods, workers generate the income to purchase goods.

Classical Money Market

Income that is not immediately consumed enters the money market as savings. Savings are put back into the economy as investment (i.e. an increase in capital) when someone borrows the money from the person who is saving it. The interest borrowers pay to savers assures no savings will be idle. The money market equilibrates through an adjustment in the interest rate.

The interest paid to those who save provides an inducement to lend money. When the interest rate is high, people want to save or lend more. On the other side of the market, a high interest rate discourages borrowers from borrowing too much money. Consequently,  the market tends to re-equilibrate under the influence of the interest rate.

Price and Wage Flexibility

The classical theory proposes that all markets re-equilibrate due to adjustments in prices and wages which are flexible. For example, if an excess in the labor force or products exists, the wage or price of these will adjust to absorb the excess.

When prices and wages are flexible, markets re-equilibrate. For example, If many people are unemployed, companies are able to hire workers at lower wages; but, hiring more workers precisely reduces unemployment.

Involuntary Unemployment

The classical theory proposes that no involuntary unemployment will exist because an adjustment in the wage rate will assure the unemployed will be hired again. In addition, the need workers have to buy goods will encourage them to accept work, even at lower wage rates.

If wages are flexible as classical economists argue, a decrease in wages allows firms to hire more workers. Only those who are reluctant to work for lower wages will remain unemployed.

Classical Keynesian Controversy

Keynesian employment theory is built on a critique of the classical theory. Milton Keynes, the economist, argued that savers and investors have incompatible plans which may not assure an equilibrium will occur in the money market, that prices and wages tend to be rigid and equilibrium may not occur in the product and labor markets, and that countries often experience periods of severe unemployment (this should not occur according to classical theory).

Keynes created his theories in response to the great depression. Economists had a difficult time arguing that only voluntary unemployment exists when millions of workers were out of work.

Keynesian Savings-Investment Plans

Keynes showed that savers and investors are separate groups which do not necessarily interact: financial intermediaries (banks) have some contact with both. During a recession, investment may not equal saving because, although the interest rate is low, 1. borrowers have poor sales prospect, 2. banks are afraid to lend because they fear bankruptcy, and 3. savers fail to invest because they are waiting for higher returns. This causes a liquidity trap: some saving is idle.

Banks tend to be prudent when making loans to businesses when economic conditions are not promising. Their reluctance to make loans contributes to the economic slow down.

Keynesian Price-Wage Rigidity

Keynes argued that prices and wages are not as flexible as classical theorists assert. Wages tend to be rigid on the downside because workers will not accept wages that prevent them from living adequately; unions reinforced this reluctance. Unemployment results when wages are too low. In the case of prices, firms that produce high-priced items prefer to cut production and lay off workers than reduce prices. Their monopoly power allows them to keep prices high.

Although we can point to a few examples where employees have accepted wage reductions to preserve their jobs, such as the airline and steel industries in the 1980s, wage decreases are extremely rare. We generally see continual increases to match cost of living increases.

Aggregate Demand

Aggregate demand shown graphically represents the sum total of what household are willing and able to buy at different price levels.

Think of aggregate demand as the combination of all of the different products consumers want to buy.

Real Balance Effect

The Aggregate demand curve slopes downward due to the real balance effect. When prices are high, the purchasing power of monetary assets decreases: individuals feel poorer and buy less. If prices are low, the purchasing power of monetary assets increases: individuals feel wealthier and buy more.

There is an inverse mathematical relationship between interest rates and financial assets. Securities markets, such as the New York Stock Exchange, are sensitive to inflation, the major cause for increasing interest rates. We observed this sensitivity during a stock market crash on Oct. 19, 1987, and in a securities market reaction to a decision by the U.S. federal reserve bank to decrease interest rates in 2001.

Aggregate Supply

Aggregate supply includes three sections: the classical range is vertical, the Keynesian range is horizontal, and the intermediate range slopes upward.

Graph G-MAC7.1

Graph of aggregate supply.

Think of the aggregate supply as the combination of all goods companies produce: it is gross national product GNP we ignore all government interventions.

Classical Range

The classical range of aggregate supply is vertical because of the proposition of the classical theory that prices will adjust so that output is always at full employment. In this range, expanding aggregate demand will cause inflation, while contracting aggregate demand will reduce inflation.

There are many sectors of the economy where all adjustments take place through price changes. One can think of all goods related to fashion: if a dress is in high demand, it will be priced very high; but if the dress is out of fashion, the price will be very low and, eventually, it will not be produced at all.

Keynesian Range

The Keynesian range of aggregate supply corresponds to the proposition that when price are very low, firms will prefer to cut production rather than sell at a loss. In this range, any change in aggregate demand will produce a change in output. Thus, in the case of a recession the correct government policy is to expand aggregate demand.

Numerous sectors of the economy have very few changes in price but sizable changes in the volume of production and the number of employees. For example, car manufacturers offer rebates which do not amount to even 10% of the value of a car. Compared to changes in price of 50% or more in clothing for instance, the car rebates are very small. The reason is the large fixed costs. Closings of entire car manufacturing plants are not uncommon during recessions.

Intermediate Range

This intermediate range of aggregate supply represents the case of preliminary inflation (or sectoral inflation): when demand and output expand, some sectors of the economy may experience bottlenecks and require that prices increase because output cannot.

Some sectors of the economy tend to experience price and quantity changes at the same time. This would seem to be true of all the consumer goods sectors such as radios and televisions, or sport equipment.

Aggregate Demand Policies

When the intersection of aggregate demand and aggregate supply occurs in the Keynesian horizontal range a recession and excessive unemployment are present: the recommended policy would be to stimulate aggregate demand. When the intersection is in the classical vertical range, inflation is present: the recommended policy would be to contract aggregate demand.

Graph G-MAC7.2

Graph of policy choice.

Throughout the 1960s and the 1970s, the American government tried to stimulate aggregate demand to control unemployment. Inflation was controlled with tax incentives and by implementing price and wage controls.

Supply-Side Policies

Supply-side economists believe that you can alleviate periods of stagflation (high prices and low levels of output) by shifting aggregate supply upward. They recommended shifting aggregate supply upward by cutting costs of production, rather than increasing aggregate demand, which adds to inflation.

During the 1980s, the Reagan administration tried to control the economy by focusing on the "supply side," and trying to increase production and supply. Congress took steps to reduce government regulations, restrictions, and subsidies which they argued were stifling innovation and the costs of production.

Last modified: Friday, October 18, 2019, 2:14 PM