Classical, New Classical, Keynesian and New Keynesian Economics

For more than two centuries, there have been two opposing views of the capitalist economy. One, which usually attributes its origins to Adam Smith, emphasizes the efficiency of the market economy, the ability of the price system to transmit vital information from producers to consumers, and vice versa, and to coordinate allocation decisions, in a manner far beyond the capacity of any central planner. The other has focused its concern on the shortcomings of capitalism, particularly on the periodic episodes of massive unemployment of capital and labour. Adherents of this view claim, these cannot be the manifestations of an efficient economic system. Under these two opposing views come four different economic theories: Classical Economics New Classical Economics Keynesian Economics New Keynesian Economics

Definitions 1. Classical Economics: The fundamental principle of the classical theory is that the economy is self-regulating. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed. While circumstances arise from time to time that cause the economy to fall below or to exceed the natural level of real GDP, self-adjustment mechanisms exist within the market system that work to bring the economy back to the natural level of real GDP. The classical doctrinethat the economy is always at or near the natural level of real GDPis based on two firmly held beliefs: Say's Law and the belief that prices, wages, and interest rates are flexible. According to Say's Law, when an economy produces a certain level of real GDP, it also generates the income needed to purchase that level of real GDP. In other words, the economy is always capable of demanding all of the output that its workers and firms choose to produce. Hence, the economy is always capable of achieving the natural level of real GDP. The achievement of the natural level of real GDP is not as simple as Say's Law would seem to suggest. While it is true that the income obtained from producing a certain level of real GDP must be sufficient to purchase that level of real GDP, there is no guarantee that all of this income will be spent. Some of this income will be saved. Income that is saved is not used to purchase consumption goods and services, implying that the demand for these goods and services will be less than the supply. If aggregate demand falls below aggregate supply due to aggregate saving, suppliers will cut back on their production and reduce the number of resources that they employ. When employment of the economy's resources falls below the full

employment level, the equilibrium level of real GDP also falls below its natural level. Consequently, the economy may not achieve the natural level of real GDP if there is aggregate saving. The classical theorists' response is that the funds from aggregate saving are eventually borrowed and turned into investment expenditures, which is an area component of real GDP. Hence, aggregate saving need not lead to a reduction in real GDP. The flexibility of the interest rate as well as other prices is the self-adjusting mechanism of the classical theory that ensures that real GDP is always at its natural level. The flexibility of the interest rate keeps the money market, or the market for loanable funds, in equilibrium all the time and thus prevents real GDP from falling below its natural level. Similarly, flexibility of the wage rate keeps the labour market or the market for workers, in equilibrium all the time. If the supply of workers exceeds firms' demand for workers, then wages paid to workers will fall so as to ensure that the work force is fully employed. Classical economists believe that any unemployment that occurs in the labour market or in other resource markets should be considered voluntary unemployment. Voluntarily unemployed workers are unemployed because they refuse to accept lower wages. If they would only accept lower wages, firms would be eager to employ them. 2. New Classical Economics: The new classical economics is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework (Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by cost-constrained firms employing available information and factors of production, in accordance with rational choice theory) New classical theory argues that what is wrong with macroeconomics is its absence of rigorous micro foundations. Its advocates set out on an ambitious research program, entailing deriving the dynamic, aggregative behaviour of the economy from the basic principles of rational, maximizing firms and individuals. The School recognizes the importance of dynamics for understanding macro-behaviour, and it recognizes the central role of expectations in determining dynamic behaviour. It focuses its attention, then, on the consequences of rational expectations formation, and it is this aspect of their work which has given the School its alternative name. The central doctrines of the approach derive from its old classical assumptions of market clearing. And with those assumptions, the conclusion is that there is no unemployment, and the irrelevance of government macro-policy, follow as trivial consequences. 3. New Keynesian Economics: New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms

of Keynesian macroeconomics by adherents of New Classical macroeconomics. This theory sees unemployment, credit rationing business cycles as real economic problems, phenomena which cannot be reconciled with the standard micro-theory, and therefore seeks as its objective the development of a micro-theory which can explain these phenomena. . Work in this area has centred on understanding the consequences of imperfect information and incomplete markets, both for micro economics and for macroeconomics. Like the New Classical Economics, it seeks a single theory, but unlike the New Classical Economics, it seeks to explain unemployment, rather than to deny its existence. And unemployment is shown to be just one manifestation of a much wider set of market failures.

Classical vs Keynesian Economic Theories

The main classical economists are Adam Smith, J. B, Say, David Ricardo, J. S. Mill. Thomas. The main keynesian economists are Alvin Nansen, Paual Samuelson, Tinburgen, R. Frisch

Classical Theory Assumptions are

Flexible Prices: The prices of everything, the commodities, labor (wages), land (rent), etc. must be both upwardly and downwardly mobile. Unfortunately, in reality, it has been observed that these prices are not as readily flexible downwards as they are upwards, due a variety of market imperfections, like laws, unions, etc. Say's Law: 'Supply creates its own demand'. The Say's law suggests that the aggregate production in an economy must generate an income enough to purchase all the economy's output. In other words, if a good is produced, it has to be bought. Unfortunately, this assumption also does not hold good today, as most economies today are demand driven (production is based on demand. Demand is not based on production or supply). Savings - Investment Equality: This assumption requires the household savings to equal the capital investment expenditures. Now it takes no genius to know, that this is rarely the case. Yet, should the savings not equal the investment, the 'flexible' interest rates should be able to restore the equilibrium.

Keynesian Theory Assumption are

Rigid or Inflexible Prices: Mostly we see that while a wage hike is easier to take, wage falls hit some resistance. Likewise, while for a producer, commodity prices are easily upwardly mobile, he is extremely reluctant for any reductions. For all such prices, it is easily notable that they are not actually as flexible as we'd like, due to several reasons, like long-term wage agreements, long-term supplier contracts, etc. Effective Demand: Contrary to Say's law, which is based on supply, Keynesian economics stresses the importance of effective demand. Effective demand is derived from the actual household disposable incomes and not from the disposable income

that could be gained at full employment, as the classical theories state. Keynesian economics also recognizes that only a fraction of the household income will be used for consumption expenditure purposes. Savings and Investment Determinants: Keynesian economics directly contradicts the savings-investment proponent of Classical economics, because of what it believes to be the savings and investment determinants. While classical economists believe that savings and investment is triggered by the prevailing interest rates, Keynesian economists believe otherwise. They believe that household savings and investments are based on disposable incomes and the desire to save for the future and commercial capital investments are solely based on the expected profitability of the endeavour.

The main points of contrast between the Classical and Keynesian theories are mentioned below:1. Unemployment:Classical When the wage level of the workers is above the equilibrium wage level, the quantity of labour supplied is higher than quantity of labour demanded. The difference between the two (supply and demand) is unemployment. Unemployment results when there is an excess supply of labour at a particular higher wage level. By accepting lower wages, the unemployed workers will go back to their jobs and the equilibrium between demand for labour and supply of labour will be established in the labour market in the long period. This equilibrium in the economy is always associated with full employment level.

Keynesian J. M. Keynes and his followers, however, reject the fundamental classical theory of full employment equilibrium in the economy. They consider it as unrealistic. According to them full employment is a rare phenomenon in the capitalistic economy. The unemployment occurs, they say, when the aggregate demand function intersects the aggregate supply function at a point of less than full employment level. Keynes suggested that in the short period, the government can raise aggregate demand in the economy through public investment programs to reduce unemployment

2. Law of Market Classical Supply creates its own demand', is central to the classic vision of the economy. According to French classical economist, J. B. Say, the production of goods and services generates expenditure sufficient to ensure that they are sold in the market. There is no deficiency of demand for goods and hence no need to unemployed workers. According to him, full employment is a normal condition of market economy. Keynesian J. M. Keynes has strongly refuted Say's Law of Market with the help of effective demand. Effective demand is the level of aggregate demand which is equal to aggregate supply. Whenever there is deficiency in aggregate demand (C + I), a part of the goods produced remain unsold in the market which lead to general over production of goods and services in the market. When all the goods produced in the market are not sold, the firms lay off workers. The deficiency in demand for goods creates unemployment in the economy.

3. Equality Between Saving and Investment Classical The classical economists are of the view that saving and investment are equal at the full employment level. If at any time, the flow of savings is greater than the flow of investment, then the rate of interest declines in the money market. This leads to an increase in investment. The process continues till the flow of investment equals the flow of saving. Thus, according to the classical economists, the equality between saving and investment is brought about Keynesian J. M. Keynes is, however, of the view that equality between saving and investment is brought about through changes in income rather than the changes in interest rate.

through the mechanism of rate of interest.

4. Money and Prices: Classical The classical economists are of the opinion that price level varies in response to changes in the quantity of money. The quantity theory of money seeks to explain the value of money in terms of changes in its quantity.

Keynesian J. M. Keynes has rejected the simple quantity theory of money. According to him, if there is recession in the economy, and the resources are lying idle and unutilized, an increased spending of money may lead to substantial increase in real output and employment without affecting the price level.

5. Demand For Money: Classical According to classical economists, money is only demanded to make regular expenditure under the need transactions demand.

Keynesian The Keynesian economists are of the view that people hold money for transaction as well as speculative purposes. So far 'transaction demand' for money is concerned, it is a function of income. The higher the income, the higher is the transaction demand for money and vice versa. The speculative demand for money is a function of rate of interest. The higher the interest rate, the lower is the money balances which the nation holds for speculative purposes and vice versa.

6. Short and Long Run Analysis: Classical The classicists believed that a market economy, through flexible interest rates, wages, and prices, return to a state of full employment in the long run. Keynesian J. M. Keynes played a major role in suggesting as to how the government can reduce cyclical fluctuations through stabilization policies. Keynes analysis of economic problems is confined to short run. Keynes says, 'Let us forget the long run and focus on the short run. In the long run, we are all dead'.

7. Role of State in Achieving High Level of Income and Employment: Classical The classical economists are of the view that in commodity and labour market, the price mechanism works with reasonable promptness. The supply adjusts to demand through the flexible interest rates, wages and prices and the economic system returns to a state of full employment in the long run without government intervention. Keynesian J. M. Keynes puts less faith in market forces. He stressed and argued for more direct intervention by the state to increase/decrease aggregate demand to achieve certain national economic goals. J. M. Keynes considered fiscal policy as a steering wheel for moving the economy to a state of higher level of employment and price stability more quickly. If aggregate income is low and below the target national income, then appropriate expansionary fiscal policy should be adopted. Expansionary fiscal policy involves decreasing taxes and increasing government spending. In case the aggregate income is higher or above the potential level, then contractionary fiscal policy i.e. increasing taxes and decreasing government spending should by taken up by the state.

8. General Versus Special Theory: Classical The classical theory is based on four unrealistic assumptions (i) role of the government in the economy should be minimum (ii) all prices and wages and markets are flexible (iii) any problem in the macroeconomic is temporary (v) the

Keynesian J. M. Keynesian theory is a general theory. It has a wider application on all such situations of unemployment, partial employment and near full employment.

market force come to the rescue and correct itself. The market mechanism eliminates over production and unemployment and establishes full employment in the long run. The classical theory relates only to the special case of full employment.