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The Comparison of Keynesian and Neoclassical Economics

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Introduction

The two modern schools that will be discussed in this paper are Keynesian and Neoclassical economics. In modern economics, capitalism is always referred back too. Capitalism involves the private ownership established upon two factors; means of production and distribution of goods. This occurs in a free competitive market motivated by profit. Capitalism could be defined as as an economic system that progresses on survival of the fittest. In order to compare and contrast the two schools of thoughts, I will identify their key ideas, underlying assumptions and theories of value and provide a short summary. This will include how the 1870 marginal revolution ingrained the ideological base of modern economics and the derivation of the Keynesian school of thought. John Maynard Keynes developed the Keynesian Economic theory. The basis of the theory was a circular flow of money. This is the idea of increased spending, in an economy, which leads to an increase in earnings with both factors forming a circular motion. During the Great Depression, Keynes’ ideas opened doors to various interventionist economic policies. Although the business cycle continuously regulates a normal and functional economy, it is believed that the government have the responsibility to smooth out any bumps. However, people hoarded their money on natural instinct when the Great Depression occurred. The economy was kept at a standstill as the circular flow of money stopped. Keynes came up with the solution of ‘prime pumping.’ He argued that the government should increase spending and increase the money supply. (King, 2012)

Comparative Advantage

To understand the differences between the two schools of thoughts, we must perceive the importance of history in the advancement of modern economics. A unanimous view of the macro economy from the thoughts of David Ricardo and Adam Smith came up around the 19th century. Adam Smith who is regarded as the founder of modern economics published his book ‘Wealth of Nations’ in 1776. This influential book discussed markets, production and economic theory. Smith was an advocate of free trade although at the time many countries had heavy tariffs in order to protect their manufactures at the cost of trade. From Smith ‘absolute advantage’ was pioneered. It is defined as the ability of an individual, firm or country to produce a service or good whilst maintaining a lower cost than its competitor. Industrial capitalism spread across Europe a generation later. The abolition of the 1846 Corn Law was viewed as a definitive movement towards an international regime of free trade as the political edge of the industrial bourgeoisie had been set. Smith’s ideas had been expanded upon by David Ricardo in the form of theory of ‘comparative advantage.’ This is the idea that two countries, firms or people can equally benefit in trade regardless of one of them producing more of everything. As both parties specialise in what they do best, trade becomes a gain for everyone. This theory, in favour of free trade, prevailed in the 19th century. (Smith, 1793)

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Marginal Revolution

Sustaining economic and political commotion, the 1870’s raised questions in regards to the capitalist system. When three economists (Leon Walrus, William Stanley Jevons and Karl Menger) with no prior relation to each other published similar ideas, Hermann Heinrich Gossen developed these further, which established the ‘marginal revolution’, which took place between 1871-1874. The idea of ‘marginal utility’ was a product of the marginal revolution, with equilibrium and an individual’s wellbeing and needs being prioritized. Marginal utility aimed to explore how much of a service or marketable good the consumer wanted to purchase, with this resulting in additional satisfaction for consumers with the opportunity arising to consume extra units of a good or service. The heavily apparent changes in the methodology of neoclassical economics was resultant of the revolution of social economic, intellectual history and political context. (Betz et al, 1973)

Crisis

John Maynard Keynes was the founder of modern mixed economics, with his philosophies contributing and constituting the Keynesian school of thought. While Keynesian economists do credit Adam Smith’s work in neoclassical theory, they only agree with it to a certain extent. By which, in a multitude of ways Keynesian school can be seen as an attachment to the neoclassical theory. Progressive expansion caused the US economy’s real GDP in 1929 to have reached $103 billion peak, all from mass consumer spending. With the economy experiencing inflation and personal debt, the limited income of individuals began to reduce consumption levels, along with massive losses of savings as a result of bank failures and disposable income evaporation in the stock market crash. Consumerism in America dropped significantly and unemployment rate continued to increase, with it raising from 3.2% in 1929 to 8.9% in 1930. (Ruggeiro, 2005) In 1930, the country fell into a recessionary gap with the United States Real GDP shrinking by 10%. Individuals were assured by economists and the president that the economy would fix itself, as they used the neoclassical theory of flexible prices and wages as an attempt to recover the economy. As unemployment worsened, national income levels were decreasing rapidly even with flexible prices and wages, thus causing the realization that consumers were unable to afford to spend enough money to stabilize the economy. Firms shut down and Real GDP contracted by 50% as aggregate demand continuously decreased. (Aasend, 2001) As the economy in the US was in free fall as a result of their economy being contracted by $47 billion and unemployment rate reaching a high of 25%, this period was termed the ‘Great Depression’ and took place between 1929-1933. Adam Smith could not understand how such an economical disaster could happen and did not have the answers to reconstruct the US economy. Creating the field of macroeconomics, John Maynard Keynes proposed a way forward in his book ‘A General Theory of Money, Interest and Employment’, suggesting that the government must invest money into the economy to fix this recession. By doing this, the public will not suppress themselves from spending, allowing the demand for goods and services to improve, thus increasing economic activity. Since publishing his theory as to how to improve the economic state of the US after the ‘Great Depression’, Keynes’ ideas have been used widely across economics. (Aasend, 2001)

Laissez Faire

‘Laissez-faire’ was a concept that was coined from a French term meaning “let do”, which essentially means ‘leave alone’. This is a capitalist concept that expresses an opposition to government involvement in the economy. Dr Francois Quesnay originally devised this theory, expressing the believe that capitalists believe that little to no involvement from the government will allow the economy to flourish. Adam Smith coined the term ‘invisible hand’, introducing the concept that natural and inconspicuous forces of supply and demand allows markets to self-regulate. Smith suggested that the economy would function better if regulations and restrictions were not imposed by the government, allowing consumers to engage freely in economic activity. By allowing people to act within their own interest, he believed it could result in common good within society and the economy. By having price levels and quantities of goods and service at an equilibrium in a free market economy, voluntary exchange can allow participants to satisfy their goals and needs. Fluctuations cause the natural market forces, or the ‘invisible hand’, to fix themselves without government interference. ‘Laissez-faire’ and the ‘invisible hand’ are both concepts that are part of an economic system that plays a significant role in free market capitalism and is at the centre of neoclassical economics. (King, 2012)

Keynesian on Government Intervention

On the contrary, Keynesian economists believe that when the economy fluctuates, it is dependent on the ‘invisible hand’ to correct market forces, omitting the influence of government intervention. However, this is not always the case; the Keynesian school of thought postulate that while the market is self-correcting to some extent, government intervention can be mandatory in amending market failures. With a lack of government intervention, flawed economic conditions will continue, resulting in a destabilized economy. The Keynesian school of thought is believed to focus on short run variations within the economy, placing importance on the ‘demand-side’ theory. Therefore, they believe optical economic performance is key to achieving such demand, with significance being placed on the stimulus that resultantly manipulates government policies. An upsurge in government spending and reduction in taxes (expansionary fiscal policy) would demonstrate this. Therefore, to protect social wellbeing of individuals within society, the government must take responsibility and intervene when deemed necessary to amend the ‘invisible hand’, according to Keynesian economists. (Sangkuhl, 2015)

Theory of Value

Value of commodity is determined by the quantity of labour expended for its production, as stated by the Ricardian labour theory of value – with this value possibly being reflected at any time and place in the market. Contrary to this, the subjective utility theory of value conveys the idea that the value of a commodity is established by “the varying wealth and inclinations of those who are desirous to possess them”. Therefore, there is an argument that the “subjective” utility theory of value places significance on the consumption and demand aspect, whereas the “objective” labour theory of value focuses on the production and supply aspect. With labour being the standard by which the value of commodities can be measured and compared to, Smith states that “money is their nominal price only”. Nevertheless, Keynesian school does not have its own theory of value as such, with different economists arguing whether there is a distinct theory of value within this school of thought. Whilst accrediting the work of Adam Smith on the ‘labour commanded’ theory of value, the ‘subjective preference’ theory of value construes neoclassical economics as a school of thought shaped by social conditions and intellectual apprehensions of the 1870s. (Mill, Riley and Mill, 1994)

Keynes on Why Markets Don’t Self-Correct

Both John Hicks and Keynes agreed that market economies do not self-correct due to wages and prices taking time to adjust. They argued that in times of recession, governments should be active using fiscal and monetary policy in order to increase output and decrease unemployment. Although Keynes wasn’t agreeing with communism, his views absolutely challenged classical economists as they saw government intervention as causing harm to the economy. Keynesian economics has become a part of mainstream economics and his ideas have allowed an increasing amount of government intervention.

Says Law

The production of goods creates its own demand. This is known as ‘Says Law’. The theory was established by Jon Baptiste Say. There is a crucial argument against this rule which is the income received by the producer of the goods will be spent. Baptiste mentions in his book A Treatise on Political Economy that “It is worthwhile to remark that a product is no sooner created than it, from the instant, affords a market for other products to the full extent of its own value.” Increasing production not aggregate demand was the key to achieving sustainable economic growth. David Ricardo and James Mill have agreed upon this. Keynes expanded on this theory. He emphasised that demand creates it own supply and that differences in aggregate demand creates differences in real GDP and employment. Keynes’ perspective is taken largely by mainstream economists in the shorter run due to the belief of demand being more important than in comparison to the long run where they stress on the significance of supply. Overall, this leads to a Neoclassical approach. (King, 2012)

Rational Behaviour

From a neoclassical perspective, rational behaviour means that when faced with a set of options an individual will choose the best one. However, Keynesians believe humans behave irrationally. This is relevant to today’s society. This theory is supported by Steve Keens in Debunking Economics where he mentions humans prioritise maximising utility. Along with questioning assumptions Keen also argues for herd behaviour. This is the behaviour of individuals in a herd acting together without common direction.

Conclusion

The significant difference between the two schools is that neoclassical economists perceive markets as self-regulating whereas Keynes believes government intervention is required especially using fiscal policy for demand management. This results in an ideological separation. Neoclassicals are opposing intervention, regulation and active industrial policy on the basis that the market performs at optimum efficiency whilst being left alone and that government interventions cause distortion in the market. Keynesians favour to correct failings and to achieve higher equitable outcomes. They centre on aggregate supply and demand to identify the economic market structure where it is controlled by the government to ensure fair business. During the great depression Keynes strongly supported government expenditure to push trigger economic growth. Neoclassicals agreed on the opposite.

References

  1. Aaseng, N. (2001). The Crash of 1929. San Diego, CA: Lucent Books.
  2. Betz, H., Black, R., Coats, A. and Goodwin, C. (1973). The Marginal Revolution in Economics. The Canadian Journal of Economics, 6(4), p.630.
  3. King, D. (2012). Economics. Oxford: Oxford University Press.
  4. Mill, J., Riley, J. and Mill, J. (1994). Principles of political economy. Oxford: Oxford University Press.
  5. Ruggiero, A. (2005). The Great Depression. New York: Benchmark Books.
  6. Sangkuhl, E. (2015). How the Macroeconomic Theories of Keynes influenced the Development of Government Economic Finance Policy after the Great Depression of the 1930’s: Using Australia as the Εxample. Athens Journal of Law, 1(1), pp.33-52.
  7. Smith, A. (1793). An inquiry into the nature and causes of the wealth of nations. London: Printed for A. Strahan and T. Cadell.

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