Classical and Keynesian Economics

The Classical Tradition The Keynesian Revolution The Monetarist Approach New-Classical Macro Economics Supply-side Economics

Many opinions and suggestions can be heard during discussions or debates on macroeconomic issues. If the focus of the discussion is the budget, some economists would propose an increase in taxes to cut deficit, while others would propose a cut in taxes to give a boost to economic growth. Opinions would also differ as to whether the government should play an active role in managing the economy or its role is limited to simple monitoring. These differing opinions are inspired by different schools of economics. One school deals with the different views relating to how aggregate demand is determined, another school is concerned with the role of price flexibility, still another is concerned about rationality in decision making and there are several others too. In this chapter, we will study the essence of different schools of economic thought. We shall examine the classical approach, the Keynesian approach, the Monetarist approach, Neoclassical approach and the supply-side economics approach. THE CLASSICAL TRADITION The debate regarding the government's role in the market economy's movement towards long run, full-employment equilibrium has been going on for more than two centuries. Some economists like Adam Smith, J.B.Say etc, stressed the role of self correcting forces in the economy. These economists are called classical economists. According to the classical approach, prices and wages are flexible and the economy is stable. Thus the economy moves automatically and quickly to full employment equilibrium without any government intervention. We shall discuss the scientific foundations and policy implications of the classical approach, with the help of aggregate supply and demand analysis. Say's Law of Markets The classical economists were highly inspired by the impact of the industrial revolution on the economy, i.e., division of labor, capital accumulation, and growth of international trade. They viewed business cycles as temporary and self correcting movements in the economy. J.B.Say, a prominent classical economist argued that over production is impossible. This forms the basis of what is known today as "supply creates its own demand". Says Law is based on the premise that no difference exists between a monetary economy and a barter economy. Say's Law assumes that workers can afford to consume whatever the factories produce. Prominent economists like Ricardo, J.S. Mill, and Alfred Marshall agreed with the classical view that overproduction is impossible. This view was expressed forcefully by eminent economist A.C. Pigou. During the Great Depression, when 25% of the American labor force was jobless, Pigou wrote that when there is perfect free competition, the tendency will be towards full employment. If there is any unemployment, it would be because of frictional resistances that would prevent any adjustments being made in wages and prices. From Pigou's words we can infer that wages and prices are flexible and the market would soon return to equilibrium. The adjustment in prices and wages in the short run will be so short that it can be ignored. Thus, according to the classical economists economy operates at full employment or at its potential output. The classical approach and Say's law in particular is depicted in Figure 14.1. The figure shows prices and real wages in competitive markets, and their movements to eliminate any excess

Classical and Keynesian Economics

demand and supply in the economy. The figure depicts a downward sloping aggregate demand (AD) curve and vertical aggregate supply (AS) curve.

If the aggregate demand falls as a result of tight money, falling exports, or other forces then the AD curve shifts leftward to AD1. At the original price level P, the total spending falls to point B, and a small fall in the output is seen at this point. The shift in demand is followed by changes in wages and prices and the price level falls from P to P1. As a result of the fall in prices, the total output returns to its full capacity and at point C there is full employment. The classical view of macroeconomics is based on the belief that though changes in aggregate demand affect the price level, it has no long-term impact on output and employment. There exists a flexibility in the prices and wages, and this flexibility ensures that full employment is maintained and output yield is at its full capacity. From the classical approach two conclusions can be drawn which are important for economic policy. Unemployment and underutilization of capacity in the economy are temporary and for a brief period. The economy will not experience any sustained depression or recession and qualified workers will find job at the prevailing market wage. The classical approach does not rule out frictional unemployment, underutilized resources, distortions and inefficiencies. What it says is that there cannot be pervasive and persistent unemployment, and underutilization of resources, because of insufficient aggregate demand. The classical approach has been used in some of the writings of neo classical school, which shall be discussed subsequently in the chapter. THE KEYNESIAN REVOLUTION As classical economists continued with the argument of impossibility of persistent unemployment, the large group of unemployed workers during the Great Depression of the 1930s were a matter of concern for both economists and the government. Against this backdrop, Keynes came up with an alternative to the classical approach. 1[1] He suggested a new approach to study the impact of economic policies and external shocks on the macro economy. Keynes presented the concept of aggregate supply and aggregate demand. While the classical theory was based on the premise that prices and wages are flexible and the Aggregate Supply (AS) curve was vertical, Keynes, insisted that prices and wages are inflexible and the AS curve is flat or upward-sloping. In Keynes approach, supply

1 2

Classical and Keynesian Economics

cannot create its own demand, and there can be a deviation in output from its potential for long indefinite periods. Keynes approach is explained in Figure 14.2 where the aggregate demand curve is combined with the upward-sloping, aggregate supply curve. Figure 14.2: Concept of Aggregate Demand and Output

Keynes first observation was that a modern market economy could get trapped in underemployment equilibrium i.e., a balance of aggregate supply and demand where the output is far below potential and a significant fraction of the workforce is involuntarily unemployed. If the intersection of the AD and AS curves take place far to the left, shown as point A in Figure 14.2, it can be inferred that the equilibrium output is much below the potential output. According to Keynes, due to the inflexibility in the wages and prices there is a lack of an economic mechanism to ensure quick restoration of full employment and production at full capacity. A nation's low output may continue for a long time because of the non-existence of a self-correcting mechanism or an invisible hand that can pull the economy back to its full-employment. Keynes second observation is based on the first. According to him the government can help in the maintaining optimum output and employment through the efficient implementation of monetary and fiscal policies. In Figure 14.2, if the government increases its purchases, then the aggregate demand would increase from AD to AD1. The increase in aggregate demand would result in an increase in output from Q to Q1 and the gap between the actual GDP and the potential GDP would narrow down. Thus, it can be said that with the help of economic policies the government can help generate high output and provide maximum employment. Keynes called this newly created aggregate demand Effective Demand. i.e., effective demand tends to create a full-employment equilibrium. Keynesian Approach Vs Classical Economics In economics, the perception and analysis of a particular situation depends heavily on the inclination towards a particular school of thought. Economists, who are more influenced by the classical school of thought are always skeptical about the need for government intervention to stabilize the business cycle. According to them, government intervention to increase aggregate demand would lead to increased inflation. They also feel that Keynes remedies would slow down the economic growth. Classical economists give more importance to the long-term consequences of government intervention on potential output and aggregate supply. On the contrary, Keynesian economists have a completely different view of business cycles.

Classical and Keynesian Economics

According to Keynesian economists, business cycles are a common phenomenon in an economy with alternate periods of high unemployment followed by speculation and inflation. They argue that the government can alter the aggregate demand with the help of monetary and fiscal policies. While emphasizing on the monetary policy, Keynesians also give importance to fiscal automatic stabilizers. These according to them, help reduce the multiplier effect of unforeseen shocks. The fundamental point of difference between Keynesian and classical schools of thought is whether there exists in the economy strong self correcting forces such as flexible wages and prices that help maintain full employment. Classical economists give importance to long-run economic growth and do not pay much attention to stabilization policies for business cycles. Keynesian economists on the other hand feel that growth policies need to be supplemented with monetary and fiscal policies, in order to maintain stability in the business cycle. THE MONETARIST APPROACH It is the central bank's responsibility to decide the money supply and credit. There are different views as to what is the best way to manage monetary affairs. Some believe in an active policy which emphasizes slowing down money growth during inflation and vice versa. However, others doubt the ability of policymakers to correct inflation and unemployment using the monetary policy. They feel that monetary policy can be at best used to contain inflation. Monetarists are those who believe that monetary policy can bring about best results when it is implemented as a rule. The monetarist approach can be understood better by looking at its linkages with both classical as well as Keynesian approaches. The History of Monetarism According to Monetarists, money supply determines the short-run movements in nominal GDP and long-run movements in prices. Keynesian macroeconomics also emphasizes the role of money in determining aggregate demand. The major difference between Monetarists and Keynesians is in their approaches to the determination of aggregate demand. While Keynesians argue that there exists more than one force (money) that affect aggregate demand, Monetarists, believe that money supply is the most important factor that determines output and price movements. To better understand Monetarism, we need to understand a recent concept velocity of money and a new relationship the quantity theory of money. The Velocity of Money When money is locked in banks for long periods, it slows down the money turnover. Sometimes particularly during inflation, money transaction takes place faster and money circulates rapidly from one hand to another. Velocity of money measures the speed at which money changes hand or circulates in the economy. Velocity of money is high when money turns over rapidly and velocity of circulation is low when the quantity of money is large in relation to the flow of expenditures. Income velocity of money refers to the ratio of nominal GDP to the stock of money. Velocity measures the rate of stock of money turnover in relation to the total income or output of a nation. Mathematically it can be expressed as:

Where P stands for average price level, Q stands for real GDP, p stands for price of goods, q stands for quantity of goods, V can be defined as nominal GDP per annum divided by money stock.

Classical and Keynesian Economics

Let us assume that the economy produces only rice and the GDP consists of 120 million bags of rice, per bag being sold at Rs 1. So GDP = PQ =Rs 120 million per year. If the money supply is Rs 10 million, then according to the definition, V=Rs 120 million/Rs 10 million=12 per year. This means that money turns over once a month as income is used to buy rice. The Quantity Theory of Prices The quantity theory of prices helps us understand movements in the overall price level. The assumption here is that the velocity of money is relatively stable and predictable. According to Monetarists, the velocity of money is stable because velocity shows the underlying patterns in the timing of income and spending. Classical economists used the velocity of money to explain changes in the price level. This approach is known as the quantity theory of money and prices. Mathematically, it can be expressed as:

This equation is derived from the velocity of money equation, and k is substituted with V/Q for obtaining P. Many classical economists believe that if transaction patterns are stable, k would remain constant or relatively stable. It is also assumed that there is full employment in the economy and real output will grow smoothly and will equal potential GDP. Thus, putting both these assumptions together, k = (V/Q) would be almost constant in the short run and will grow in the long run. As we have seen from the equation, if k is constant, the price level would move proportionately with money supply. If the supply of money is stable, prices would be stable and if the money supply grows rapidly prices would also grow rapidly. With the rapid growth in price, the economy will experience hyperinflation. To sum up the concept of quantity theory of money and prices, it can be said that prices move proportionately with money supply. Though this theory is a rough approximation, it explains the reason for moderate inflation in countries with low money growth and high inflation in countries with rapid money growth. Modern Monetarism Milton Friedman developed modern monetary economics. He challenged Keynesian economists, and stressed on the importance of monetary policy in bringing macroeconomic stability. Later on, the monetarist approach split into two schools of thought. One school continued with the Monetarist approach while the other became the New-classical school. According to Monetarists, nominal GDP in the short run and prices in the long run are determined by growth of money. This analysis is based on the quantity theory of money and prices and depends on the analysis of trends in velocity. According to Monetarists, the velocity of money is stable. If this is correct, it is very important, because the quantity equation shows that if V is constant, PQ (or nominal GDP) will be affected proportionally by movements in M. The assumption of wage and price flexibility by the Monetarists also points to the fact that changes in money supply do not affect the real output greatly, instead they have a significant impact on P, the general price level.

Comparison of Monetarist and Keynesian Approaches The major differences between Monetarists and Keynesians can be seen in Figure14.3. The figure shows the behavior of aggregate supply and demand curves under both approaches.

Classical and Keynesian Economics

Figure: 14.3: Comparison of Monetarist and Keynesian Views

Both schools disagree over the forces that operate on aggregate demand. According to Monetarists, only money supply affects aggregate demand and the impact of money on aggregate demand is stable. They also believe that fiscal policy should be backed by monetary changes to have an impact on output and prices. Keynesians however argue that it is not only money that has an effect on aggregate demand, output and prices. There are other factors as well. Keynesians believe that money helps in output determination along with spending variables like fiscal policy and net exports. Also, as V changes with interest rates, M alone cannot keep the nominal or real GDP constant. The second point of contention between Monetarists and Keynesian schools is the behavior of aggregate supply. Keynesians emphasize the stickiness of prices and wages. Monetarists think that Keynesians exaggerate stickiness in wages and price in the short run. They are of the opinion that the AS curve is much steeper (though not vertical) than what the Keynesians would allow. As a result of this difference, there are different views on the short run impact of changes in aggregate demand. According to the Keynesian economists, output will significantly change if there is a change in nominal demand. However, the change in output will have a very small effect on prices in the short run. Monetarists on the other hand feel that a change in (nominal) demand will have an effect on prices alone, not quantities. NEW-CLASSICAL MACRO ECONOMICS Many economists agree that monetary policy affects unemployment and output, at least in the short run. A new group of economists however challenged this school of macroeconomic thought. A new approach called New-classical macroeconomics which emphasizes the role of flexible wages and prices came into existence. The approach also has a new feature called rational expectations. New-classical macroeconomics is based on two assumptions: prices and wages are flexible and people use all available information. The first assumption which is based on the classical approach means that prices and wages adjust quickly to balance supply and demand. The second assumption implies that peoples expectation are formed on the basis of all available information. It says government cannot mislead people as they are well informed and have access to the same information that government has about monetary and fiscal policies. Rational Expectations Expectations are an important aspect of economics. Expectations regarding investment, consumerspending and savings play a significant role in macroeconomic analysis. According to the rational expectations hypothesis, people make unbiased forecasts regarding the future of economy based on all available information. Thus, the basic assumption is that the government cannot "fool" the people

Classical and Keynesian Economics

with planned economic policies (whether it is fiscal or monetary). So it was a critique of the monetarist assumption of the New-classical school of thought. In other words, the theory of rational expectations was a self critique of the New-classical economics. SUPPLY SIDE ECONOMICS The Keynesians and monetarists, as discussed earlier, emphasized the role of aggregate demand in economic growth. They opposed the classical view that supply creates its own demand. Keynesians proposed that by controlling aggregate demand (through government intervention, in the form of fiscal policies) a nation can attain a high level of output and employment. However, during the 1970s, monetarists came to the fore again and advocated the control of aggregate demand by controlling the money supply and interest rates which would help stimulate economic activity. The early 1980s saw the emergence of a new school of thought that emphasized the impact of aggregate supply on the economic growth of nations. This new school of thought was called supply-side economics. Supply-side economists argued that creating an economic environment that provided incentives for people to work and save money, and also an environment that is conducive for firms to invest and create employment would cause an increase in aggregate supply. The supply-side economists assumed that the aggregate demand of the nation was always adequate and that it would absorb the aggregate supply, thus indicating their acceptance of Says law. Supply-side economics, thus, laid emphasis on reduction in tax-rates and social spending, promotion of free labor markets and liberalization of economy. The supply-side economists believed that incentives and tax-rates influence the economys aggregate supply to a great extent. According to them, the tax-rates induce people either to produce or to utilize their resources in a productive manner i.e. tax-rates have an impact on peoples consumption and saving activities. This is because tax rates determine the level of disposable income. Disposable income is the income available with people for personal consumption, saving, investment, etc. The main objective of the supply-side policies is to improve employment and reduce inflation in the economy and thereby achieve economic growth. Factors Determining Economic Growth in Supply-side Economics Role of incentives Supply-side economists believe that fiscal policy plays a major role in determining the aggregate supply and economic growth in an economy. They propose that tax cuts influence post-tax factor rewards. Enforcing tax cuts would imply increase in the after-tax rewards that individuals earn for working, saving or investing. When people gain having higher rewards or incentives, it encourages them to work more or invest more in order to gain higher incentives. Therefore, workers increase their productivity and entrepreneurs infuse more capital into the economy. Thus, it impacts the aggregate supply in the economy. Supply-side economists believe that a reduction in taxes on income received from interest rates, or dividends, would lead to an increase in savings, investment, and economic growth. Some of the incentives that would encourage growth activities like savings and investments include: A reduction in corporation tax that would encourage entrepreneurs to invest more as they would be exposed to lower entrepreneurial risks. A reduction in the marginal rate of income tax, as this would encourage individuals to save more as they would have higher post-tax incomes. However, this reduction in tax-rate might reduce the total tax revenue for the government. Tax cuts

Classical and Keynesian Economics

Another important feature of supply-side economics is its emphasis on large tax-cuts. The advocates of supply-side economics criticized Keynesian economics on the grounds that Keynesian economics laid too much emphasis on the impact of tax-rates on aggregate demand (the multiplier effect of tax-rates on aggregate demand and output). One of the main proponents of supply-side economics, Arthur Laffer argued that high tax rates led to a reduction in tax revenues (Refer Exhibit 14.1). According to him, higher tax-rates led to shrinking tax bases. This was because higher tax-rates caused reduction in economic activity. There would be a reduction in economic activity because huge taxes discouraged individuals from working (as they got less disposable income in the higher income slabs) and entrepreneurs to invest (as they would have to pay higher interest rates). As the government keeps increasing the tax rates, it is less worthwhile for the individual to work more as he gets less disposable income in hand. So he withdraws his work effort and increases his leisure. This means that the higher tax rate results in less economic effort and output, and at a very high tax rate, the higher rate no longer gives the government a higher total tax revenue. So the government will stand to gain more tax revenue by reducing the tax rate, thus pushing up the incentive to work and increasing the base on which taxes are levied. Economic activity as a whole (including consumption) is also encouraged by lower tax rates, once again increasing the base on which taxes are levied and contributing to higher total tax revenues. Therefore, Laffer advocated tax cuts for economic growth. According to Jean-Baptiste Say, a classical economist, supply creates its own demand. In other words, overproduction can never occur because there will always be sufficient demand to consume the products being produced. The Laffer Curve Arthur Laffer, an American economist, proposed that there is an optimal tax-rate that provides the Government with maximum revenues. This concept is explained by him with the help of a curve, which is popularly known as the Laffer curve. In the Figure 14.4, x-axis represents the tax revenues of the Government and y-axis represents the tax rate imposed by the Government. In the figure, at zero tax-rate, the Government cannot generate any taxrevenues. Hence, there is no tax-revenue for zero tax-rate. As can be seen in the diagram, the curve originates at this point. Similarly, at 100 percent tax-rate, people will have no incentive to work because the entire income is paid to the Government in the form of taxes. Therefore, at 100 percent tax-rate too, the Government cannot earn any revenues. Thus, the curve ends at the horizontal axis at the point where the tax-rate is equal to 100. In between these two tax-rates, the Laffer curve takes an inverted U-shape. This indicates that taxrevenues rise along with the increase in tax-rate until it reaches the point T1. After this point, the tax-revenues begin to fall with the increase in tax-rates i.e. increase in tax-rate is counterproductive to tax revenues. This is because higher tax rates discourage people from working and there will be less people working. This reduces the revenue generated on taxes. Thus, Laffer proposed that at T1 rate of tax, the Government can maximize its revenues.

Classical and Keynesian Economics

However, a number of Keynesians, and even some supply-side economists vehemently opposed Laffers theory that reducing tax rates would increase tax revenues. Laffers critics pointed out that a cut in tax rates could provide a disincentive to work. The reduction in taxrate would reduce the amount of work required to earn a given after-tax income. So, people might opt for more leisure rather than working more because they can now earn the earlier income by putting in less effort. Therefore, people might decide to work less and enjoy more leisure. Thus it has an unfavorable impact on government revenues as the base on which the tax is levied shrinks. Supply-side economists proposed a complete restructuring of the tax system through supplyside tax cuts. This approach was based on the following premises: The reforms to restructure the tax system must be made with a view to encourage workers and entrepreneurs by lowering tax rates. The restructured tax system should reduce the tax burden on individuals with high incomes. The restructured tax system must be designed to encourage productivity and supply of factors of production instead of controlling or influencing aggregate demand. Supply-side economists propose numerous tax cuts that would encourage incentives. Some of the tax cuts they suggest are: Lowering the tax rates on personal incomes. Reduction in the corporation tax. Reduction in the tax rates of income earned from savings.

Tax exemptions to firms making investments in new businesses, new plants and buildings, etc. Supply-side Reforms in the U.K. - Thatcherism During the 1980s, the UK government deregulated its economy with a view to encourage investment from businesses and improving productivity in the economy. The Thatcher government in the UK at the time believed that fostering competition would lead to increased production efficiency and lowered prices of goods and services. As a result, there were a string of reforms taken up by the UK government to encourage competition. Following are some of the highlights of the supply-side reforms undertaken by the Thatcher government:

Classical and Keynesian Economics

It opened up the telecommunication equipment sector to private firms.

It opened up the local bus transport and encouraged private firms to compete with the government. It enacted the Local Government Act 1988, which compelled local authorities to contract services such as cleaning, ground maintenance, repairs, catering, etc. to private business houses. Criticism Although many critics did agree that tax cuts enhance the incentive to work hard, they criticized supply-side economics on several other aspects. Following are some of the criticisms leveled against supply-side economics: Supply-side economists laid excess emphasis on large tax-cuts. Past statistical data revealed that reduction in tax rates led to only a moderate increase in individual savings or supply of workers. Supply-side economists proclaimed that reduction in tax rates would lead to economic growth because it stimulates economic activity. However, this was proved wrong when taxcuts in the US during the 1980s led to a steep fall in tax revenues, which ultimately led to a high budget deficit in the US. Supply-side economists proposed a lower tax burden on high income individuals. Critics argued that this would increase inequality among people in the economy. Supply-side economics gained prominence in the 1980s during Ronald Reagan's (Reagan) presidency in the US. Reagan introduced substantial changes in the US tax laws, which were based on the supply-side considerations of providing a conducive climate for workers and entrepreneurs. It was observed by economists that supply-side policies were introduced and there was a considerable decrease in the unemployment rate and inflation rate in the US. However, critics opined that the supply-side policies did not have much impact on the growth of potential output of the US (Refer Exhibit 14.3). Hence, whether Reagans supply-side policies helped in the economic growth in the US is still debatable. Economists opined that supply-side economics did not live up to the expectations of it and it gradually lost its appeal in the 1990s

Reaganomics Ronald Reagan (Reagan) popularized supply-side economics during his tenure as the President of the US, so much so that supply-side economics was even given the name Reaganomics. Reagans economic program for his nation was based upon four objectives: To reduce government spending To reduce tax-rates Encouragement of money restraint To relax the regulatory burden on businesses

Reagan announced that his economic program when put into practice, would increase the level of productivity and employment and decrease the inflation rate in the country. The Economic Recovery Act of 1981, meant to bring supply-side reforms in the US, was also passed as an extension of this program. As a result of this act, the American economy saw substantial changes in its tax laws. Some of the highlights of the changes in tax laws were as follows: There were huge cut in personal income tax rates. The rate of (maximum) personal income tax on investment income recorded a steep fall from 70% to 50% (as on January 1, 1982).

10

Classical and Keynesian Economics

The Reagan government drew up a pension plan called Individual Retirement Account (IRA), according to which, any wage earner could contribute an amount up to $2,000 in a year. Further, the individual was not required to pay taxes on the contribution or the interest received (till he/she withdrew funds from the plan) Measures were taken to provide incentives to businessmen to invest in new businesses. Firms were given a 6% investment tax credit for purchasing new cars, small trucks, and research equipment and a 10% investment tax credit for purchasing other equipment. The Reagan government reduced the corporate taxes for corporations whose earned profit was less than $50,000. Reagans economic program which was based on supply-side approach to factors of production was criticized on the following grounds: Analysts said that the impact of incentives, if any, on labor supply, saving and investment spending was negligible. Analysts opined that the aggregate expenditure or demand could increase more rapidly when compared to aggregate supply, which in turn would aggravate inflationary tendencies. Analysts also pointed out that the reduction in personal income tax rates favored individuals who earned high incomes. However, the supporters of supply-side economics maintained that large tax-cuts in marginal tax rates were vital to providing incentives to work, save and invest. They believed that this led to increase in output and employment and decrease in inflation, which in turn caused economic growth.

SUMMARY

In this chapter we examined the different schools of thought in macro economics and the assumptions on which the economic theories are based. According to the classical approach, prices and wages are flexible and the economy is stable. The economy moves automatically and quickly to full employment equilibrium without any government intervention. The Keynesian approach on the other hand is based on the assumption that prices and wages are inflexible and government needs to intervene to maintain stability of business cycle. Monetarists believe that it is only money supply that affects aggregate demand, output and prices whereas Keynesians argue that money helps in output determination along with spending variables like fiscal policy and net exports. Keynesian economists, feel that output will significantly change if there is a change in nominal demand but the change in output will have very small effect on prices in the short run. But Monetarists feel that a change in demand will change the prices not the real output. The Neo-classical approach is based on two assumptions: prices and wages are flexible and adjust quickly to balance supply and demand; peoples expectation are formed on the basis of all available information and government cannot mislead them as they are well informed and have access to all the information about governments monetary and fiscal policies. The early 1980s saw the emergence of a new school of thought that emphasized the impact of aggregate supply on the economic growth of nations. This new school of thought was called supply-side economics. The supply-side economists believed that incentives and taxrates influence the economys aggregate supply to a great extent.

11