Difference between Classical Theory and Keynes Theory

This article will help you to learn about the difference between Classical Theory and Keynes Theory.

Difference between Classical Theory and Keynes Theory

The following points highlight the six main points of differences between Classical and Keynes Theory. The differences are: 1. Assumption of Full Employment 2. Emphasis on the Study of Allocation of Resources Only 3. Policy of ‘Laissez Faire’ 4. Wage-Cut Policy as a Cure for Unemployed Resources 5. Assumption of Neutral Money 6. Interest Rate as the Equilibrating Mechanism between Saving and Investment.

Difference # 1. Assumption of Full Employment:

Classical theorists always assumed full employment of labour and other resources.

To them, full employment was a normal situation and unemployment was an abnormal situation.

According to Classicals, even if there is less than full employment in the economy, there is always a tendency towards full employment.

By the term full employment of the available resources, the classical economists meant that ‘there is no involuntary unemployment’. If there is unemployment in the economy, classicists felt that it was due to the existence of monopoly in industry and governmental interference with the free play of the forces of competition in the market or it may be due to the imperfections of the market owing to immobility of the factors of production.

If these limitations could somehow be eliminated, full employment, according to classical economists, would always exist. Hence, the best way to ensure full employment for the Government was to pursue the policy of ‘laissez faire’ capitalism under which free competitive market forces were allowed to have full and free play.

Difference # 2. Emphasis on the Study of Allocation of Resources Only:

The existence of ‘full employment’ being a normal situation in the classical scheme, it followed that factors of production are always fully employed and there is no further scope for additional employment of resources in new industries. The choice, according to classsicals, was not between employment and unemployment but between employment here and employment there, i.e., increase in production in one direction could be achieved only at the cost of some decrease in another direction in the economy.

In other words, classicals fell there could not be any significant misallocation of resources as the price mechanism, acting as an ‘invisible hand’ would achieve the best, the most efficient allocation of resources. Since the optimum allocation of a given quantity of resources was the main subject-matter of classical economics, it was but natural that they did not discuss the problem of national output, income or employment.

With their assumption of full employment, there obviously could not be any change in the real national income of the community through additional employment of resources. What could possibly be done, given, the composition and volume of the real national income, was a more efficient allocation of the given resources.

As such, they remained concerned with the special case of full employment and not with the general factors that determine employment at any time. In brief, the well-known theory of value, distribution and production formed the ‘core’ of classical economics. That unemployment of resources could also persist to pose a problem did not occur to them at all.

Difference # 3. Policy of ‘Laissez Faire’:

Classicals had great faith in the philosophy of laisez-faire capitalism, which meant ‘leave alone’ or ‘let alone’ in business matters. Laissez-faire capitalism would not tolerate any kind of intervention by the Government in business matters; they rather considered it a positive hindrance in the free working of the market economy.

Classicals believed in Laissez-faire capitalism as it was the traditional model of study from the very’ beginning. Classicals had great faith in price mechanism, profit-motive, free and perfect competition and the self-adjusting nature of the system. They felt that if the system is allowed to work freely without any encroachments on the part of the state, it has potentialities to overcome the maladjustments in the economic system, if there are any.

Difference # 4. Wage-Cut Policy as a Cure for Unemployed Resources:

Classicals further believed that involuntary unemployment could be easily cured by cutting wages down through office and perfect competition which always exists in the labour market. They argued that so long as labour does not demand more than what it is ‘worth’ or more than its marginal productivity, there in no possibility of persistent unemployment in the economy.

Classicals believed that employment is determined by the wage bargains between the workers and employers, therefore, wage-cuts will reduce unemployment; such a policy if pursued vigorously can restore full employment as well. Basing their reasoning on the existence of free and perfect competition in the product and labour markets, classicals argued that the unemployed workers will cut down wages leading to a fall in prices, which, in turn, will encourage demand giving a fillip to sales.

As a result of all this, more will be produced as more is demanded and employment would increase because workers are employed at lower wages to increase production. Wage-cuts, thus occupied a central place in the classical scheme of reasoning for automatic functioning of the capitalist economy at full employment.

Difference # 5. Assumption of Neutral Money:

Classicals did not give much importance to money treating it only as a medium of exchange its role as a store of value was not considered. To them, money facilitated the transactions of goods but had no effect on income, output and employment. They considered it as a ‘veil’ which hides real things goods and services. In other words, they assumed that people have one motive for holding money, i.e. the transaction motive.

Classicals completely ignored the precautionary and speculative motives for holding money. In short, they never recognised that money could also influence the level of income, output and employment. In contrast to this view, Keynes considered money on as on active force that in influences total output.

Difference # 6. Interest Rate as the Equilibrating Mechanism between Saving and Investment:

Classicals would give the pride of place to the rate of interest as the equalizer of saving and investment at full employment of resources. The implied assumption was that both saving and investment are highly sensitive to changes in the rate of interest.

The belief was firmly rooted that saving and investment can be equal only at full employment, and that ‘under employment equilibrium’ is a disequilibrium situation which would not last long in an atmosphere of wage price flexibility under the pressure of competition.