Classical Versus Keynesian The classical approach and the Keynesian approach are the two major intellectual traditions in macroeconomics. We discuss the differences between the two approaches briefly here and in much greater detail later in the book. The Classical Approach. The origins of the classical approach go back more than two centuries, at least to the famous Scottish economist Adam Smith. In 1776 Smith published his classic, The Wealth of Nations, in which he proposed the concept of the “invisible hand.
The idea of the invisible hand is that, if there are free markets and individuals conduct their economic affairs in their own best interests, the overall economy will work well. As Smith put it, in a market economy, individuals pursuing their own self-interests seem to be led by an invisible hand to maximize the general welfare of everyone in the economy. However, we must not overstate what Smith claimed: To say that an invisible hand is at work does not mean that no one in a market economy will be hungry or dissatisfied; free markets cannot insulate a nation from the effects of drought, war, or political instability.Nor does the invisible hand rule out the existence of great inequalities between the rich and the poor, because in Smith’s analysis he took the initial distribution of wealth among people as given. Rather, the invisible-hand idea says that given a country’s resources (natural, human, and technological) and its rattail distribution of wealth, the use of free markets will make people as economically well off as possible.
Validity of the invisible-hand idea depends on a key assumption: The various markets in the economy, including financial markets, labor markets, and markets for goods ND services, must function smoothly and without impediments such as minimum wages and interest rate ceilings. In particular, wages and prices must adjust rapidly enough to maintain equilibrium a situation in which the quantities demented and supplied are equal in all markets. In markets where quantity demented exceeds quantity supplied, prices must rise to bring the market into equilibrium.In markets where more of a good is available than people want to buy, prices must fall to bring the market into equilibrium. Wage and price flexibility is crucial to the invisible-hand idea, because in a remarked system, changes in wages and prices are the signals that coordinate the actions of people in the economy. To illustrate, suppose that war abroad disrupts oil imports.
This drop in supply will drive up the price of oil. A higher oil price will make it profitable for domestic oil suppliers to pump more oil and to drill more wells.The higher price will also induce domestic consumers to conserve oil and to switch to alternative sources of energy. Increased demand for alternative energy sources will raise their prices and stimulate their production, and so on. Thus, in the absence of free-market economy respond in a constructive and coordinated way to the initial disruption of supplies. The classical approach to macroeconomics builds on Smith’s basic assumptions that people pursue their own economic self-interests and that prices adjust reasonably quickly to achieve equilibrium in all markets.With these two assumptions as a basis, followers of the classical approach attempt to construct models of the macroeconomic that are consistent with the data and that can be used to answer the questions raised at the beginning of this chapter.
The use of the classical approach carries with it some strong policy implications. Because the classical assumptions imply that the invisible hand works well, classical economists often argue (as a normative proposition) that the government should have, at most, a limited role in the economy.As a positive proposition, classical economists also often argue that government policies will be ineffective or counterproductive at achieving their stated goals. Thus, for example, most classical believe that the government should not try actively to eliminate business cycles. The Keynesian Approach.
Compared with the classical approach, the Keynesian approach is relatively recent. The book that introduced it, The General Theory of Employment, Interest, and Money, by British economist John Maynard Keynes, appeared in 1936 160 years after Adam Smith’s The Wealth of Nations.In 1936 the world was suffering through the Great Depression: Unprecedented high rates of unemployment had afflicted most of the world’s economies for years, and the invisible hand of free markets seemed completely ineffective. From the viewpoint of 1936, the classical theory appeared to be seriously inconsistent with the data, aerating a need for a new macroeconomic theory. Keynes provided this theory. In his book, Keynes offered an explanation for persistently high unemployment.
He based this explanation on an assumption about wage and price adjustment that was fundamentally different from the classical assumption. Instead of assuming that wages and prices adjust rapidly to achieve equilibrium in each market, as in the classical tradition, Keynes assumed that wages and prices adjust slowly. Slow wage and price adjustment meant that markets could be out of equilibrium with quantities emended not equal to quantities supplied for long periods of time.In the Keynesian theory, unemployment can persist because wages and prices don’t adjust quickly enough to equalize the number of people that firms want to employ with the number of people who want to work. Kennedy’s proposed solution to high unemployment was to have the government increase its purchases of goods and services, thus raising the demand for output. Keynes argued that this policy would reduce unemployment because, to meet the higher demands for their products, businesses would have to employ more workers.
In addition, Keynes suggested, the newly hired workers would have more income to further. More generally, in contrast to classical, Keynesian tend to be skeptical about the invisible hand and thus are more willing to advocate a role for government in improving macroeconomic performance. The Evolution of the Classical-Keynesian Debate. Because the Great Depression so strongly shook many economists’ faith in the classical approach, the Keynesian approach dominated macroeconomic theory and policy from World War II until about 1970.At the height of Keynesian influence, economists widely believed that, through he skillful use of macroeconomic policies, the government could promote economic growth while avoiding inflation or recession. The main problems of macroeconomics apparently had been solved, with only some details to be filled in. However, in the asses the United States suffered from both high unemployment and high inflation called stagflation, or stagnation plus inflation.
This experience weakened economists’ and policymakers’ confidence in the traditional Keynesian approach, much as the Great Depression had undermined the traditional classical approach.In addition, the Keynesian assumption that prices and wages adjust slowly, so that markets may be out of equilibrium, was criticized as being without sound theoretical foundations. While the Keynesian approach was coming under attack, developments in economic theory made classical macroeconomics look more interesting and attractive to many economists. Starting in the early asses, a modernized classical approach enjoyed a major resurgence among macroeconomic researchers, although classical macroeconomics did not achieve the dominance that Keynesian had enjoyed in the early postwar years.
In the past three decades, advocates of both approaches have reworked them extensively to repair their weaknesses. Economists working in the classical tradition have improved their explanations of business cycles and unemployment. Keynesian have worked on the development of sound theoretical foundations for the slow adjustment of wages and prices, and Keynesian models can now accommodate stagflation.
Currently, excellent research is being conducted with both approaches, and substantial communication and cross- fertilization are occurring between them.