Differences in Ideas of Keynes and Classical Economists

The upcoming discussion will update you about the difference in ideas of Keynes and classical Economists.

1. The classicals believed in laissez faire policy. But according to Keynes free enterprise system leads to fluctuations in trade cycles, so government intervention is a must.

2. The classicals assumed full employment and there is no deviation from full employment. Even if there are temporary deviations, the economy has the tendency to reach full employment. Whereas Keynes stated that under employment equilibrium is in the reality and full employment is a distant goal. Achievement of full employment is very difficult and maintenance of it on a permanent basis is still more difficult.

3. The classicals said that there exists in the economy a state of perfect competition which allocates resources ideally and ensures maximisation of output and welfare. But Keynes argued that perfect competition is a myth. Today’s market structure is characterised by imperfect market which restricts output leads to wastage of resources, and exploitation of consumers. Ideal allocation of resources is not ensured.

4. The classicals believed in invisible hand or flexible price mechanism which ensures maximisation in all market and also in allocation of resources and distribution of resources and national income. Keynes said that private motives do not coincide with public welfare. Indiscriminate attachment to profit leads to depression, unemployment and other evil consequences. So there are no invisible hands, or automatic price mechanism which ensures the welfare of one and all in society. Artificial hindrances in the price mechanism has led to exploitation, misallocation and improper distribution of income.

5. According to the classical economists there is automatic self-adjusting character of the economy. There is no such automatic or self-adjusting system in Keynesian economics. If such a force is there, depressions and booms can be easily avoided and fluctuations averted.

6. The classical contributions constitute the core of ‘Micro Economics’. The classicals assumed a fixed quantity of resources and concentrated on ideal allocation among firms, industries and individual units in the economy. They studied ‘micro elements’ and implicitly believed that what principles and rules govern the micro problems are completely valid for macro problems also.

Therefore no separate theory is required for macro problems. Keynesian contribution relates to macro problems and according to him, micro problems require one set of policies and for macro problems, another set of policies is required. The same policy tools or instruments cannot be applied for both. Macro is not a mere addition of micro elements. The nature, magnitude and intensity of macro problems vary from that of micro problems.

7. Wage-price flexibility is advocated by classicals for solving unemployment problem. If at any-time the economy slips down from the level of full employment it can be restored by cutting down real wages. Since wages are determined by marginal physical product of labour and MPC is subject to the operation of the Law of diminishing returns, more labour can be employed only if wages are reduced.

As long as wages are flexible downwards, full employment can be easily achieved. The classical school assumed that workers will accept a lower wage. Thus wages are flexible both ways for them. According to Keynes, wage flexibility is not found in the modern economy, especially downward flexibility of wages. Modern trade unions never accept wage cut for solving disequilibrium.

Keynes has explained the following consequences if real wages are reduced:

(a) In modern economy where there are strong trade unions, workers will not accept a reduction in real wage. The union may resort to strike in which case production will be completely affected.

(b) When wages are reduced, it may affect the consumption level of workers. A distribution of income takes place from wage earners, whose MPC is high, to propertied class (low MPC) which means overall reduction in consumption. Since consumption is an important element of aggregate demand, effective demand will fall short of aggregate supply and employment, instead of increasing, will decline further.

(c) Even accepting that wage reductions can solve unemployment, this reduction in real wage can be accomplished in a different and painless manner than what the classical school thinks of. By keeping the money wage constant, a gradual and unnoticeable increase in price level will bring down the level of real wage and such a reduction in real wage will promote employment.

The workers will be happy that they continue to get the same money income and feel that they are not aware of the fact that because of the gradually increasing price levels, their real income has come down. When people have such a false satisfaction, they are said to be subject to ‘money’ illusion. Taking advantage of this illusion the economy can reach full employment.

(d) Keynes raises one more objection to wage cut policy of the classicals. When wages are cut, more employment is offered, output increases and prices fall. If the fall in prices is in proportion to the fall in money wage, then real wages of workers will remain the same. When there is no fall in real wage how can the economy reach a state of full employment. So for Keynes wage cut is not an advisable policy for removal of unemployment or for reaching full employment.

8. The classical school believed in the flexibility of interest rate in bringing about an equilibrium between savings and investment. Saving is a function of interest rate and higher the rate of interest higher will be the level of savings and vice versa. Investment is also a function of interest rate, lower the interest, higher the level of investment and vice versa. Interest rate because of its flexibility restored equilibrium between S and I at full employment equilibrium. Too much importance was given by classical for interest rate mechanism.

Keynes explained that neither savings nor investment are functions of interest rate. Savings depend on the capacity of the people to save and this capacity is determined by income. So S= f (y) and not interest rate. Just because the rate of interest is high, people will not starve and save money when their incomes are low.

Investment is also not a function of interest rate. It is the rate of return or profit which determines the level of investment. Investment is a function of MEC and not interest. So mere interest rate flexibility cannot bring about an equality between savings and investment.

9. Money plays a passive role for classicals. It has only one function, viz., medium of exchange. The ‘store of value function’ of money was not given due attention. Moreover money being a precious commodity can never be kept idle as liquid cash. Either it should be spent for consumption or invested immediately. Money is demanded for three motives for Keynes—transaction motive, precautionary motive and for speculative motive. No asset is as liquid as cash.

So if interest rates are very low people may prefer to hold their savings in the form of idle cash than in the form of interest earning assets like bonds and shares. Their expectations about future changes in the rate of interest, influence this volume of liquid cash which in turn exercise tremendous influence on the level of investment, employment and output in the economy.

10. The classical economists did not integrate the theory of value with the theory of prices or money. By inventing the concept of speculative demand for money, Keynes successfully integrated the theory of value with the theory of prices. Both money and real markets are interdependent and not independent. Money causes many confusions in the economy. Liquidity preference has a major impact on the level of investment and other variables in the system. So money plays a very active role and not a passive role.

11. The classicals considered only real variables like MPP, real profit, real wage and real sacrifice. Keynes considered monetary variables and at the same time connected them with real variables.