classical vs Keynesian theory.pptx

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, which is the level of real GDP that is obtained when the economy's resources are fully employed.
National output or income was determined by real factors such as capital stock, state of technology, labour supply and in no way was affected by the general price level which was determined by the quantity of money. This classical doctrine is generally referred to as classical dichotomy.
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 doctrine—that the economy is always at or near the natural level of real GDP (full employment)—is based on two firmly held beliefs:
The assumption of the full employment of labour and other productive resources
Belief that prices, wages, and interest rates are flexible.
The general over production, and hence general unemployment, is impossible.
The normal situation is stable equilibrium at full employment.
The classical economist believe that the policy of laissez-faire guaranteed normal full employment. They had great faith in free and perfect competition, efficacy of the profit motive and price mechanism to remedy the temporary ills of the economic system and ensure full employment.
Prof. Pigou says, “With perfectly free competition, there will always be at work a strong tendency for wage rates to be so related to demand that everybody is employed.”
They treated money as a mere medium of exchange. (Transaction motive)

1. Central Agricultural University 1 College of Post Graduate Studies in Agriculyural Sciences, Umiam Ri-Bhoi District- 793101 Meghalaya. AG.ECON-502 Classical theory vs Keynesian theory Presented By Athawale Snehal Shivlal School of Social Sciences Ph.D (Agri. Economics) 1 st Year

2. Points to be discussed…. 2 Classical Theory of Employment Postulate of classical theory of Employment Modern View Three ranges of Short-run aggregate supply curve Keynesian Economics Keynesian theory of employment Wage rate Flexibility Aggregate Demand-Aggregate Supply Model (with Price Flexibility) Aggregate Demand Aggregate Supply Interest rate flexibility Keynesian Versus Classical Theories of Aggregate Demand Keynes’s Monetary Theory : Money affects real variables Saving-Investment Relation Are Savings automatically Invested ? Classical Dichotomy and Neutrality of Money Unemployment and Full Employment

3. Classical Theory of Employment Central Principle: ‘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, which is the level of real GDP that is obtained when the economy's resources are fully employed. National output or income was determined by real factors such as capital stock, state of technology, labour supply and in no way was affected by the general price level which was determined by the quantity of money. This classical doctrine is generally referred to as classical dichotomy . 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 doctrine—that the economy is always at or near the natural level of real GDP (full employment)—is based on two firmly held beliefs: The assumption of the full employment of labour and other productive resources Belief that prices, wages, and interest rates are flexible. The general over production, and hence general unemployment, is impossible. The normal situation is stable equilibrium at full employment. The classical economist believe that the policy of laissez-faire guaranteed normal full employment. They had great faith in free and perfect competition, efficacy of the profit motive and price mechanism to remedy the temporary ills of the economic system and ensure full employment. Prof. Pigou says, “With perfectly free competition, there will always be at work a strong tendency for wage rates to be so related to demand that everybody is employed.” They treated money as a mere medium of exchange. (Transaction motive) 3

4. Postulate of classical theory of Employment 4 Interest rate flexibility Through the free market interaction, Demand for investment and supply for saving will be same Balance Budget Government must maintain its revenue and expenditures in equilibrium. Wage rate Flexibility Unemployment is of a temporary nature and this could be corrected by wage cut policy.

5. Interest rate flexibility The classical economist believed that through the free market interaction. ‘II’(demand for investment)and ‘SS’ (supply of savings) will be equal. ‘II’ (Investment) demand is an inverse function to the rate of interest ‘ i ’ whereas saving ‘SS’ is a direct function to the rate of interest ‘ i ’ this is the belief of the classical economist that, there is always fluctuations and through these, the economy achieve equilibrium automatically. The classical economist believe that all savings are invested ‘II’ is the investment demand as the rate of interest is high investment is low, and as rate of interest is low investment is high i ∝ 1/II and where as the savings is directly related to interest rate. In other words i ∝ SS. In the diagram ‘II’ and ‘SS’ interact at point ‘E’ which determines the rate of interest ‘ i ’. If there is shift o the right hand side of II (increase in investment)then the interest will increase to O 1 savings and investment will be shifted to a new equilibrium ‘E 1 ’ and there will be increase in ‘SS’ and I 1 I 1 to OQ 2. 5

6. Wage rate Flexibility The classical economist believed that “Unemployment is of a temporary nature and this could be corrected by wage cut policy.” Voluntary employment may exist but involuntary employment could be corrected by wage cut policy , which through self adjusting process in which economy will lead to full employment. In free enterprise economy: if wages are allowed to find there own level, then through perfect competition involuntary unemployment will disappear. In the diagram ‘MRP’ Marginal revenue productivity is given. At ‘OW’ wages the total employment is ‘ON’, if the wages will reduce to ‘OW1’ then employment will increase upto ‘ON1’. 6

7. Keynesian Economics 7 “ Raising Keynes: An old economist finds new rock-star status” Central Principle: The economy often operates at less than full employment ; market system does not self adjust. Markets clear slowly, if at all. In a depression and recession, much unemployment is involuntary. Economy often operates at less than full employment since markets don’t clear. Government intervention may be desirable to stabilize the business cycle. (Fiscal and Monetary Policies) Equilibrium is there but no reason for full employment. Money wage rates are sticky (i.e. remain constant) The term “Keynesian economics” was used to refer to the concept that optimal economic performance could be achieved and economic slumps prevented by influencing aggregate demand through activist stabilization and intervention policies by the government.

8. Keynesian theory of employment 8 “ Raising Keynes: An old economist finds new rock-star status” Principle of effective demand Greater the aggregate effective demand, greater will be the volume of employment, and vice versa. Unemployment is the result of a deficiency of total demand. Effective demand represents the total money spent on consumption and investment. The total national expenditure is equal to the total national income which is equal to the national output. Deficiency of effective demand is due to the gap between income and consumption. The gap must be filled up by increasing investment and hence effective demand, in order to maintain employment at a high level.

9. Aggregate Demand-Aggregate Supply Model (with Price Flexibility) 9 “ Raising Keynes: An old economist finds new rock-star status” Aggregate Demand Aggregate demand is the total desired quantity of goods and services that are bought by consumer households, private investors, government and foreigners at each possible price level, other things being held constant. Thus aggregate demand is not any quantity demanded at a particular price level but is a whole schedule of total output demanded at various price levels and is represented by a curve. The aggregate demand has four components: 1)Consumption demand 2)private investment demand 3)Government purchases of goods and services 4) net exports. Thus, aggregate demand curve depicts the total output of goods and services which households, firms, and Government are willing to buy at each possible price level. Aggregate Demand Curve with Varying Price Level Factors responsible for AD curve slope downward are- Real Balance Effect Rate of interest effect Foreign Trade effect

10. 10 “ Raising Keynes: An old economist finds new rock-star status” Fig. Aggregate Supply Curve : Classical View Fig. Keynes’s Aggregate Supply Curve In the classical theory, the aggregate supply curve of output is perfectly inelastic (i.e. a vertical straight line). They assumed that full employment of resources in the economy. According to them, if at any time there is deviation from this full-employment level, the wages, interest and prices quickly and automatically adjust or change to restore equilibrium at the full employment level. Aggregate Supply Aggregate supply curve shows the various amounts of aggregate output which the producers in the economy are willing to produce and sell in the market at various price levels. Shows the relationship between price level and the aggregate production (supply) during the period of depression and involuntary unemployment where it will be seen that aggregate supply is a horizontal straight line (i.e. perfectly elastic) up to the level of full employment. Since output of goods and services cannot be increased beyond the full-employment level, Keynes’s aggregate supply curve becomes vertical at aggregate output level YF which represents full-employment level of output.

11. Modern View Three ranges of Short-run aggregate supply curve 11 “ Raising Keynes: An old economist finds new rock-star status” At times of depression or severe recession, the more can be produced without much rise in marginal cost of production and therefore the aggregate supply curve is nearly flat rather than perfectly horizontal. This first range is therefore called nearly flat range . With the given stock of capital (i.e. plant and equipment) when output is expanded beyond this range the diminishing returns and rising marginal costs occur which ultimately cause the aggregate supply curve to slope upward gently. Thus there is a part of gently rising short-run aggregate supply curve which represents intermediate range of short run aggregate supply curve.. As the firms in the economy approach near their capacity output their marginal costs rise sharply which cause sharply rising aggregate supply curve. Beyond the level of capacity-output, that is, when the given resources of the economy are fully employed, short-run aggregate supply curve (SAS) becomes a highly steep curve. Thus, aggregate demand curve depicts the total output of goods and services which households, firms, and Government are willing to buy at each possible price level. Fig. Short-run Aggregate Supply Curve with Three Ranges

12. 12 Fig. Classical Aggregate Supply Curve and Price Output Determination National output does not change in response to changes in aggregate demand or the price level. Since classical aggregate supply curve is vertical, output and employment in this theory is completely supply-determined and the level of aggregate demand does not play any role in determining national output and employment. Keynesian Versus Classical Theories of Aggregate Demand Fig. Keynes’s View of Aggregate Demand Keynesian view the level of aggregate demand is an important factor determining the level of output and employment, if the economy is working at less than full employment level. He lays stress on the stickiness of money wages. At the full-employment, increase in aggregate demand will cause rise in price level with national output remaining unchanged.

13. Saving-Investment Relation Are Savings automatically Invested ? 13 “ Raising Keynes: An old economist finds new rock-star status” Classical view : Always a full-employment equilibrium Based on Say’s law according to which every supply creates its own demand. Self-employed individual producers. Financial markets had not yet developed. Every act of saving also constituted the act of investment. Changes in interest rate provided a mechanism which ensured equality of saving and investment. Keynesian view: Classical economist failed to take account of the changes in income that come about from any change in saving or investment. And the classics failed to realise that what people intend to save . From fig 1 fall in investment would lead to the decline in level of income. From fig 2 increase in saving implies decline in consumption demand. Decline in consumption expenditure would also lead to the decrease in income. Fig.1 Fig.2

14. Classical Dichotomy and Neutrality of Money Economic variables are classified into- Real variable: A real variable measured in terms of goods or services. These real variables, according to the classical theory, depend on such factors as labour supply, capital stock, technology etc. and further that money plays no role in determining output, employment and real wages Nominal variable : whereas a nominal variable is measured in monetary units such as rupees or US dollars. classical economists thought national output or income was determined by real factors such as capital stock, state of technology, labour supply and in no way was affected by the general price level which was determined by the quantity of money. This classical doctrine is generally referred to as classical dichotomy. In Keynes’s theory, money supply determines rate of interest which influences investment which, in turn, plays an important role in determining output and employment in the economy. 14

15. Classical Dichotomy and Neutrality of Money 15 Graphically illustrate classical dichotomy Panel (a) determination of price level through classical vertical aggregate supply curve AS and downward-sloping aggregate demand curve AD is shown. With money supply equal to M0, aggregate demand curve is AD0 which intersects aggregate supply curve AS at point E0 and determine price level P0. Panel (b) shows labour market equilibrium which determines real wage rate equal to W/ P0and labour employment equal to ONF. From panel (c) it will be observed that with ONF amount of labour employed, full-employment level of output YF is determined. Suppose that money supply is reduced to M1 (M1 < M0) resulting in the fall in aggregate demand curve to AD1 which causes price level to fall to P1 while real national output remains unchanged at YF. Now, with the money wage equal to W, the fall in price level (P1 < P0) will bring about rise in real wage rate to W/P1 . But, with this higher real wage rate labour market will be thrown into disequilibrium with emergence of excess supply of labour (see panel (b)). According to classical theory, to restore labour -market equilibrium money wage rate will quickly fall to W1 so that real wage returns to the original level W/P0. In labour market equilibrium, labour employment remains at full-employment level ONF. In panel (c), with ONF amount of labour employed, national output remains at YF though the quantity of money has been reduced from M0 to M1 As determination of real variables is concerned, money is said to be neutral. Supply of money determines only nominal variables

16. Keynes’s Monetary Theory : Money affects real variables 16 money is non-neutral Keynes brought about integration of money market and real goods market. He showed that rate of interest was determined by demand for money and supply of money.(increase in the supply of money will lower the rate of interest) in panel (a) money market equilibrium is shown. Given money supply equal to M1, money supply curve MS1 intersects money demand curve Md at rate of interest r1. It will be seen from panel (b) that at rate of interest r1, investment is I1. Then, in panel (c) with the consumption function curve C and investment equal to I1, aggregate demand curve is C + I1 which intersects the income line OZ at point E and determines level of real national income equal to Y1. Suppose that there is increase in money supply from M1 to M2 which causes shifts in money supply curve from MS1 to MS2. As a result in panel (a), rate of interest falls from r1 to r2, and as a result of fall in interest rates in panel (b) investment increases from I1 to I2. With this increase in investment (DI), aggregate demand curve shifts above to the position C + I2 in panel (c). With this increase in aggregate demand, level of real national income increases from Y1 to Y2. Corresponding to this increase in real national income the level of labour employment will also rise. Keynes succeeded in integrating money market with goods market and with this he showed that money supply plays an important role in determining real variables such as real investment.

17. Unemployment and Full Employment Meaning of Unemployment: Unemployment is defined as a state of affairs when in a country there are a large number of able-bodied persons of working age who are willing to work but cannot find work at the current wage levels. People who are either unfit for work for physical or mental reasons, or don’t want to work, e.g., sadhus , idle rich etc. are excluded from the category of the unemployed. Everyman’s Dictionary of Economics defines unemployment as “involuntary idleness of a person willing to work at the prevailing rate of pay but unable to find it.” Mere engagement in some productive occupation does not necessarily mean absence of unemployment. People, who are only partially employed or are engaged in inferior jobs, though they can do better jobs, are not adequately employed. It is called a state of underemployment which is equally bad for the prosperity of a country. 17

18. 18 There are three main types of unemployment: 01 02 03 Frictional Unemployment Lack of adjustment between demand for and supply of labour . Lack of necessary skills Labour immobility Breakdowns of machinery Shortages of raw materials, Period between losing one job and finding another Structural Unemployment Economic changes are massive, extensive, deep-seated, amounting to transformation of an economic structure. Result of mismatch between demand for and supply of labour . Unemployed workers lack skills. Also known as long term or Marxian unemployment Cyclical Unemployment Deficiency of effective demand. Also called cyclical ‘Keynesian unemployment’ Income and output fall Reduction in extent of utilization of factors of production. Increases during periods of recession or depression.

19. 19 Other types of unemployment: 04 02 03 Seasonal Unemployment Seasonal fluctuations in demand. Season bound production activities. Unemployment during Slack season Eg . Ice-cream sellers remain unemployed during winter. Technological Unemployment Technological change tends to increase output per man-hour which has the effect of raising the potential total output in the economy. Modern production process displacing existing workers. Eg . Mechanization displaces labour , resulting unemployment. Disguised Unemployment People are prepared to work but they are unable to find work throughout the year due to the lack of complementary factors. A person is considered to be underemployed if he is forced by unemployment to take a job that he thinks is not adequate for his purpose.

20.       MEASURES TO ACHIEVE AND MAINTAIN FULL EMPLOYMENT Fiscal Policy Public finance, expenditure, taxation and debt Monetary Policy Credit control, investment. Income Policy Limiting wages and prices. Encourage self-employment By providing raw materials and technical training. Price Policy Determining the prices of goods and services International measures Loans from IMF and World Bank

21. Full Employment Meaning of full employment: Full employment may be defined as the situation wherein all those who are willing and able to work at prevailing wage rates are in fact employed for the work in which they are trained. Full employment does not mean that every one is employed. Some people like children, old men and physically or mentally handicapped people are not able to work, these people are not included in the labour force of the country. Full employment will exist in spite of their not working. Some people called ‘idle rich’ though able to work are not willing to work because they get enough unearned incomes to live. These people are also not included in the labour force of the country. Full employment is said to exist in the economy even if there is prevailing some amount of frictional and structural unemployment in the economy. If the number of unemployed is greater than frictional and structural unemployment, only then we shall say that full employment does not prevail. (Lord Beveridge estimated frictional unemployment of 3% in a full employment situation for England). Keynesian full employment is, by definition, the maximum level of employment that private enterprise countries can attain without experiencing strong inflationary pressure. . 21

22. Thank you! You can find me at- [email protected]