What are the Fundamental Points at Issue between the Keynesian and Classical Traditions in UK Macroeconomics
Policy Issues
Classical economic theory can be presented in variant formal models inclusive of the value and the monetary theories. The value theory affirms that although market and natural prices are related and subjective concepts, market prices fluctuate and are jostled by several transient influences that are abstract and difficult to theorize, (Ajuzie, Edoho, Wensheng, Uwakonye, and Keleta, 2008, p. 125). It further identifies cost of production and profits as the key determinants of natural prices with the neo classists noting that tastes, technology and endowments also determine value. In defining the money policy, monetarism and the theory of endogenous money forms the UK classical interpretation between banking and the currency school. Monetarists affirm that it is the responsibility of banks to control the supply of money noting that inflation is caused by excessive money supply. The theory of endogenous money however noted that money automatically adjusted to demands hence the key function of banks were to control its supply based on the terms of demand.
Fundamentally, the Keynesian economics focuses on the central issue of determining the levels of national income and employment in industrial economics and the primary causes of economic fluctuations, (Barber 1967, p. 227). Citing periodic errors in the decisions made by the private sector that often lead to inefficient macroeconomic outcome, the theory advocates for active policy response by the public sector. The theorys key recommendations include monetary policy and fiscal policy actions by both the Central bank and the public sector respectively hence the government plays a central role in stabilizing output over the business cycle, (Cukierman, 2005, p. 698). The theory also advocates for a mixed economy dominated by the private sector but controlled by the government and the public sector. The theory affirm that there exist certain micro-level economic actions of individuals and firms that may aggregately lead to macroeconomic results making the economy operate below its potential out and growth.
Theory Implications and the Says Law
Critical to the understanding of the way markets operate is the Says law attributed to French economist and businessman, Jean-Baptiste Say which affirms that in a free market economy, goods and services are produced for the primary purpose of exchanging them with other goods and services. The law therefore affirms that the total supply of goods and services in a purely free market economy should attract in equal terms the total demands of goods and services within specified time periods. It therefore implies that in cases where means of production applied to one product exceeds that of another, then a surplus can take place, (Pasinetti, and Schefold, 1999, P. 4).
Recession and unemployment are two critical factors that were explained by the Says law. On monetary policy, the law noted that in cases where people did not have enough money, business suffered making the economy to perform below its potential hence there was needed to print more money. However, although more money could be printed, individuals power to purchase could only be increased by more production. It is imperative to note that the Keynesian economic model refutes the classical economics claim that says law holds noting that for the cost of output to always be covered in aggregate by the returns from demand, an individuals savings must exactly equal the aggregate investment, (Ajuzie, Edoho, Wensheng, Uwakonye, and Keleta, 2008, p. 129). Furthermore, interpreted classically, Says law defines unemployment as arising from insufficient demand for labor. Additionally, it notes that recession is not caused by lack of money but rather an imbalance between supply and demand hence in agreement with the classical school of economic thought.
Quantity Theory of Money
Challenged by the Keynesian economics but updated by the monetarist school of economics, the Quantity theory of money affirms that money supply is directly and positively related with the price level. Barber (1967, p. 234) notes that the theory has evolved over the centuries and was revived by the monetary school of thoughts. Classical understanding was somewhat misleading with proponents such as John Law affirming that since trade was dependent upon money, more money in the economy would lead to full employment.
Law therefore suggested that in periods of less than full employment, the monetary authority could inject more money into circulation thereby inducing full employment, (Barber 1967, p. 232). Keynes however challenged the theory affirming that money supply lead to a decrease in the velocity of circulation and therefore on real income which dependent upon the flow of money to the factors of production. In modern terms however, the definitional relationship MVT PTQ where M refers to the total amount of money in circulation in an economy over a specified time period, and VT the transactions velocity of money i.e. the average frequency within all transactions involving the spending of a unit of money while PT and Q refers to the Vectors of the price and quantity of the i-th transaction, (Ajuzie, Edoho, Wensheng, Uwakonye, and Keleta, 2008, p. 127).
Keynes versus the classics
Classical economics states that prices of everything, whether labor, commodities or land must be both downwardly and upwardly mobile. In reality however, prices appear not to be as readily flexible downwards as they are upwards due to imperfections or rather external interferences. In contrast, Keynesian economists suppose that prices are rigid or inflexible, they affirm that while wage hike is easier to take, wage falls are often met by some resistance, (Barber 1967, p. 237). Similarly, a producer can easily allow upward price mobility while is resistant to any reductions hence prices are not as easily flexible as stated by the classical economic school of thought, (Ajuzie, Edoho, Wensheng, Uwakonye, and Keleta, 2008, p. 131).
Classical economists consider in the theory of invisible hand in which any imperfections in the economy automatically corrects itself, a claim strongly refuted by the Keynesian theories who affirm that Government intervention in the forms of monetary and fiscal policies must be absolute for any macro-economy to run smoothly, (Sloman and Wride 2009). Furthermore, the classical economists assertion that focus should be put in the long term hence provided long run solutions at the expense of short term loses, Keynes affirmed that it is the short run that should form the primary target, (Cukierman, 2005, p. 702).
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Courtesy of Goodacre, 2005, p. 25
Within the commodity market, classical economics is defined by Says law (supply creates its own demand) wile the Keynesian model affirms the importance of effective demand. It affirms that effective demand is derived from household disposable incomes rather than from the disposable income gained at full employment as stated by the classical theory. It further stresses that only a fraction of the disposable income will be used for consumption expenditure purposes, (Cukierman, 2005, p. 715). Actual observations in majority of economies today, supports the Keynesian rather than the Says law affirming that the latter may not hold since goods production is demand driven and is not based on production or supply.
Classical theory also strengthens the savings-investment equality, an assumption that requires the household savings to be equal to the capital investment expenditure. However with the observed flexible interest rates, savings do not always equal investment. In contrast, Keynesian economics believes that savings and investments are not triggered by the prevailing interest rates, but that household savings and investments are based on disposable incomes and the desire for both commercial capital investment and to save for the future.
Classical economics also states that unemployment in an economy is usually a temporary disequilibrium caused by excess labor available at the current wage rate. It therefore states that when wages are high, more people will be willing to work at the ongoing rate leading to unemployment while in an unregulated classical economy in which wages are flexible, the wage rates fall thereby eliminating excess labor available and reducing unemployment. Although employment can eventually be linked to changes in income, (Barber 1967, p. 247), affirms that the classical economists definition was rudimentary relative to the Keynesian wage units.
Keynesian Demand Management and the post-War boom
The Keynesian demand management that focused on demand noted was favored following the WWII. It affirmed that business cycle fluctuations could be reduced through fiscal and monetary policies. The policys goal was to attain stabilization over cycle with its stance being interventionist. The economic model was favored by both industrial and developing countries with the idea of promoting development, (Goodacre, 2005, p. 4).
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The classical monetarist counter-attack against Keynesianism
The Keynesianism which gained dominance following WWII was counter attacked by the monetarism with monetary policy as a stimulus to growth and employment becoming increasingly popular in the course of the past decade. ASDFA notes that critics of Keynesianism (which was particularly dominant in UK) claimed that the UK had performed poorly relative to other industrialized countries, (Pasinetti, and Schefold, 1999, P. 12). Exemplifying the Philips curve, they noted that there was instability in economic growth indicated by amplitude of fluctuations. They also argued that newly independent countries were losing force in the mid 80s hence classical proponents advocated for the minimization of the role of government on taxes and also to eliminate free flow of capital. They also advocated for the liberalization of trade and the privatization of state owned enterprises, (Goodacre, 2005, p. 6).
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Courtesy of Goodacre, 2005, p. 7
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Courtesy of Goodacre, 2005, p. 28
Summary
Comparative analyses indicate variations in how the two models describe and predict economic situations, although it is noteworthy to state that all theories are applicable under different economic assumptions or may be interpreted differently. The two schools of economic thought however believes that future economic expectations affect the economy hence although Keynes is supportive of corrective Government intervention, in classical theories corrective measures are determined by the motives of players within the system.