Taylor Morris

ECON 2020-004
7AM

Classical vs. Keynesian Economics

Intro

Classical and Keynesian economic schools of thought, much like other

inventions, ideas, or philosophies, were created out of a time, place and socio-political

environment which according to the economists of each respective school of thought,

would have accurately perceived their economic environment. As they say, necessity is

the mother of invention; one could apply this thought toward the Classical theory of

economics in that the years from the 1770s to the 1930s did not bring about much

prolonged economic upheaval, which could have brought about a significant change in

economic thought. It would take a global economic collapse for a new economic way of

thinking to be born out of the chaos. With the onset of the Great Depression the

assumptions of Classical economics were tested and did not recover much like the

quality of life after the Second World War. The inability of Classical economics to explain

the dire straits the United States and the world came under brought on the Keynesian

school of economics. The following will address and then analyze the key components

of the Classical and Keynesian schools of thought.

Classical Overview

The Classical school of economics gained many of its principles from the book

The Wealth of Nations, published by the father of economics, Adam Smith. During the

time period the Wealth of Nations was written, trade laws were relegated to the king and

parliament of Great Britain, protectionism and mercantilism ensured that high tariffs

were placed on foreign goods, quotas were upheld and met and that the most efficient
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means of capital increase were through exchange of finalized good from the mother

country for raw materials in the colonies.

Classical economists believed that humans, as rational beings, will pursue their

own self interests, and in these self interests they will pursue actions that will increase

their capital wealth which will spread throughout the country. Additionally Classical

economic thinkers believed that a laissez-faire approach by the government should be

promoted. Laissez-faire allows two people, two companies, or two nations to trade

goods and services without the interference of import quotas, tariffs, and other

governmental regulation that was typical throughout the age of mercantilism. Smith

and other economists of the time perceived that wealth was not measured by how much

the treasury of the king contained, but how many goods the realm was producing.

According to Says law these produced goods, or supply, create its own demand.

The amount produced equals the expenditures paid, and thus there are no excesses,

unemployment or deficiencies. One could state that Says Law implies that economies

are closed and there is no over or under abundance, that every instance of capital is

used sufficiently. The classical model makes four assumptions: 1.) competition is pure,

2.) Wages and prices are flexible 3.) self-interest is what drives individuals, and 4.)

People cannot be fooled by the instance of an increase in wages in addition to an

additional increase in inflation, also known as money illusion.

Classical economists believed that because prices and wages are flexible any

shocks within the economy such as unemployment, or an increase in wages or prices

would eventually reach equilibrium. For example, if a recession were to occur resulting

in a reduction in demand, production price and wages would decrease and if

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unemployment were to occur, it would only last briefly as these workers would accept

wages at a lower price because of their desire to gain wealth and make purchases.

Classical Critique

The Classical economic school of thought dominated economics during a period

of time that saw great change on a social, technological and political scale. The

foundations of its principles were developed at a time when most labor capital was tied

to the land and not deeply concentrated within cities. The labor at the time was

uneducated, illiterate, and until recently were peasants tied to land held by the

descendants of feudal land owning nobles. The theory of Classical economics did not

foresee the development of massive industrialization and mass migration of labor from

the country into urban centers. Education and the press would inform and influence

labor to organize, unionize and demand fairer pay, work conditions and other benefits

we have today such as a 40-hour workweek. One could argue that the assumption that

wages are flexible is not correct and that a union would not allow wages to decrease to

maintain equilibrium within an economy.

The assumption that pure competition exists also can be found to be a fallacy.

The age after the Civil War was known as the Gilded Age because of the vast amount of

wealth industrialists compiled, this directly resulted in monopolies in different markets

such as oil, railroads, shipping, steel etc. Only the intervention of the federal

government under President Theodore Roosevelt would result in the regulation of

market monopolies.

The most blatant critique and downfall of the Classical school of economics came

about by the Great Depression starting in 1929. Classical economics argues that the
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economy is at its best when the government does not intervene and allows it to resolve

itself. However, the Great Depression brought about a deep decline in investment,

wages, and joblessness never before seen in the United States. The economic

downfall directly resulted in John Maynard Keynes solving the issues of the Great

Depression with the Keynesian economic school of thought.

Keynesian Overview

Keynesian policies did adjust for the changed times in that because

prices are somewhat sticky in that they do not generally change because of worker

contracts and unions. Keynes developed a horizontal short run aggregate supply line to

demonstrate that changes in demand would not change price or wages. John Maynard

Keynes saw that without investment from business, came about a loss of income and a

loss of consumption, which led to more lost profit. Keynes patronized the idea that the

government must invest in public works projects and other stimuli in order to get the

wheels of the economy and the nation to turn once more. One could argue that if it

were not for Keynes the United States would not have gotten out of the rut of the Great

Depression. However, it remains to be seen if Keynesian policies or the military

economy of World War II eliminated the Great Depression.

Keynesian Critique

One could argue that had World War II hostilities broken out earlier for the United

States, around the year 1931, instead of 1941, it would have rallied the nation to gear

up for a war economy to meet the needs of the soldiers sent to fight overseas. At that

time the government would not have fully adopted Keynesian stimulus packages but

would still closely follow the theories of Classical economics. Keynesian economics has
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opened the idea that more government spending means a healthier economy. The

Obama administration advocated Keynesian stimulus for banks that were on the brink of

closing, without it the entire world economy would have collapsed. However,

government stimulus usually brings about more bureaucracy and expenses to pay,

which ultimately requires more taxes and an increased federal deficit. Where would the

United States deficit be if World War II had broken out earlier?

Course of Action

Both schools of thoughts faults lie in their rigidity and dogmatic principles in that

they do not adapt to change quickly enough on the economic horizon. The Classical

economic theory would have allowed the country to further fall into economic distress

because of the principle that the government must not intervene in the economy. The

Keynesian school of thought when applied properly greases the wheels of the economy

but once implemented in the real world, politicians will not advocate to strip funding of

government programs. These same government programs equate to jobs and services

that the public consume. In a perfect world Keynesian economics would be applied as a

band aid for the economy and then removed once healed, however, Keynesian

economics as of now has ran us a deficit in the range of $20 trillion dollars. If the world

were perfect I would advocate a Keynesian style of economics in the case of economic

downturn with the knowledge that these programs would be temporary until the

economy were to recover to pre economic downturn conditions. However, as witnessed

by the Keynesian stimulus brought about by the Obama administration, the economy is

slowly growing and has not returned to the pre Great Recession conditions of the early

to mid 2000s.