The Economy: Keynesian vs. Classical Economists (Essay Sample)

THE ECONOMY: KEYNESIAN VS CLASSICAL ECONOMISTS
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The Economy: Keynesian vs. Classical Economists
Overview
This essay examines the debate between Keynesian and classical economists on whether or not the economy is self-regulating. While classical economists believe in economies being self-regulating, Keynesian economists have spent much time considering the role of government regulation and oversight in economic growth. Classical economists are so-called because their arguments were the first to be formally set out. The underlying policy arguments trace their roots to the eighteenth century and are primarily based on the European model (Eltis, 2000). Keynesian economists, on the other hand, had their arguments take hold in the 1930s after the publication of Maynard J. Keynes research (Padua, 2014). Altogether, these economists’ teachings have a more worldwide view and take the stance that a free market does not always result in a stable economy. An analysis of the 2008 global economic crisis will determine which theorists are more practical.
Classical Economists
According to Arnold (2007), classical economy is primarily the laissez-faire belief in pure capitalism. He argues that classical economists believe that business cycles and natural process of adjustment do not require government intervention. As Adam Smith stated in the invisible hand, firms tend to produce what consumers want without government intervention and as such the economy works outs its problems (Arnold, 2007). Classical economists base their argument on Says Law which states that supply generates its own demand (Eltis, 2000). This inherently implies that the income derived from the production of goods and services by some firms allows them to buy goods produced by other firms. Since all firms have a desire to purchase goods, they will seek to produce certain goods to derive income and purchase whatever they desire, implying that the product markets will always tend to be in a state of balance, with governments interference (Eltis, 2000).
The same case applies to individuals who work for income in order to be able to purchase a variety of goods and services of their choice (Schultz, 2004). Therefore, by toiling and producing goods, these individuals earn their income with which to purchase products of their choosing. Where the income is not immediately spent on the purchase of goods, it enters into the money market as saving. The savings are put back into the economy in the form of investment when it is loaned. The interest paid by borrowers to lenders assures that there are no idle savings. As noted by Arnold (2007), the money market gets into an equilibrium state through an adjustment in the rate of interest. Interest payments motivate those who would want to lend money, and where the interest is higher lenders will tend to lend more. However, borrowers shy away from loans when interest rates are unreasonably high. This essentially results in a liquidity trap where consumers opt to save rather than using loan capital to purchase bonds and other investment options for fear of a decline in asset prices (Cochrane, 2017). Any monetary policy aimed at stimulating demand would fail as consumers do not need to be encouraged to hold additional cash (Cochrane, 2017).
According to Eltis (2000), the argument in classical economics is that all markets attempt to re-equilibrate due to adjustments in wages and prices which are readily flexible. For example, in cases of an excess products or workforce, prices or wages of these will adjust downwards to absorb the extras. Where, for instance, many people are unemployed, companies will hire their employees at lower wage rates, given the law of demand which argues that a reduction in labor costs will result in more employees being hired into the labor market (Eltis, 2000). Though this may help reduce unemployment, hiring qualified workers at lower wages may weaken their morale and self-esteem which may consequently result in the production of low-quality products.
Keynesian Economists
Keynesian economists were inspired by the great depression of the 1930s. The depression was as a result of the 1929 stock market crash which resulted in a contraction of the economy (Temin, 2016). Noting that monetary policy measures such sharp reductions in expenditure, taxes, and regulation helped resolve the crisis, Keynes sought to overturn the then existing ideology that free markets are self-regulatory (Keynes, 2016). Keynes believed that aggregate demand, as measured as the total expenditure of the government, businesses, and households, is the primary force for driving economic growth. He asserted that free markets have no self-regulating mechanism that can result in full employment. The economists justify the intervening power of governments through policies that have an objective of achieving price stability and full employment.
Keynesian economists argue that inadequate overall demand can result in prolonged periods of high unemployment. According to Keynes (2016), economic output is the sum of four main components, namely: investment, consumption, government purchases, and net exports. Keynesian economists will argue that any hike in demand has to come from one or more of these components, and especially consumption which is the largest component of all. However, during a recession, stronger forces do dampen demand as expenditure goes down (Padua, 2014). For instance, during an economic crisis uncertainty usually erode consumer confidence which in turn causes them to reduce expenditure, particularly on discretionary purchases such as cars or houses (Padua, 2014). This decrease in the expenditure by consumers can lead to less investment expenditure by firms, as businesses react to weakened demand for their products. According to Keynes (2016), government intervention is essential in moderating the busts and booms in an economic activity, often referred to as business cycles.
The Keynesian economics is based on three fundamental assumptions. First, Keynes (2016) assumes that aggregate demand is affected by several economic decisions, both private and public. Private sector decisions can occasion adverse macroeconomic outcomes such as reduced consumer expenditure during periods of economic downturns. These market failures call for active policies by the government such as stimulus packages. The underlying implication is that Keynesian economists support a mixed economy which is guided by the private sector but partly operated by the government. Second, wages and prices are assumed to respond slowly to variations in demand and supply, occasioning periodic surpluses and shortages, especially in labor. Lastly, variations in aggregate demand, whether expected or otherwise, have a tremendous short-run influence on employment and real output, and not on prices. Agarwal (2010) note that Keynesian economists believe that since prices are somehow rigid, variations in any constituent of expenditure alter economic outputs. Where government expenditure for instance increases, all other components remaining constant, then the output will go up (Agarwal, 2010).
In the presence of unemployment, falling wages will not necessarily restore full employment. The reason behind this is that the wage cuts will only help in reducing income which reduced people’s ability to consume which in turn reduces aggregate demand. In just the same way, interest rates will not necessarily lead to equating saving and investment. Income, and also the investment by the prospect of profits is what will largely influence the level of savings.
According to Keynes (2016), unhampered market mechanisms should never be supposed to coordinate the many individual decisions such that the level of aggregate demand is made sufficient for the full-employment level of income to thrive. The aggregate demand is usually boosted by governments spending as it is a component of aggregate demand while taxation, on the other hand, has a direct influence on disposable income. All these factors positively affect consumer spending which in turn result in economic growth and therefore government plays an important role in economic growth (Keynes, 2016).
Analysis
The 2008 economic crisis started as a financial crisis in developed economies due to deregulation of their financial markets and wild speculations that such deregulations made possible (Ivashina and Scharfstein, 2010). Another explanation for the crisis is that the US federal government kept interest rates too low between 2001 and 2002, which increased the supply of credit required for the production of the high leverage levels associated with the 2008 economic crisis (Ivashina and Scharfstein, 2010). According to Crotty, (2009) the US government failed or deliberately chose not to interfere in its financial sector, a move which follows after the classical economics principles. This non-government interference resulted in insufficient aggregate demand which has been stated to be the leading cause of the 2008 global economic crisis. Insufficient aggregate demand meant that firms had to reduce their production owing to reduced consumer appetite which in turn lowered economic growth. This begs the question “could the crisis might have been resolved or prevented by additional aggregate demand?” Though this question may not be adequately answered, the 2008 world economic crisis can be seen to be evidence enough that markets are not self-regulating (Stojanov, 2009). The government had to play a critical role in tackling the crisis according to Keynesian economists.
The crisis resulted in large-scale falls in UK retail sales owing to reduced consumer spending. Businesses experienced low sales and profitability. Banks could also not sup...