Classical Economics vs. Keynesian Economics
Classical Economics vs. Keynesian Economics For the first time, the younger generations in America who have only studied about the Great Depression witnessed noticeable inflation, severe economic downturn and drastic measures taken by the U. S. government as the economic crisis unfolded. In order for us to make sense of what we have learned in the classrooms, we will examine the Classical and the Keynesian schools of the economic thought and the standpoint of Mr. Ben Bernanke and the current administration.
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Adam Smith’s Wealth of Nations of 1776 marked the beginning of the Classical school of economic thought. It focuses on long run solutions and it’s most notable for the idea of the free market that can self-regulate and self-adjust towards equilibrium without any intervention. Another fundamental idea is the “invisible hand” mechanism that could move a market to its natural equilibrium. This school of thought is constructed on several key assumptions. First, Classical economists assume that the prices of wages and commodities to be extremely flexible.
Under this assumption, there should be no unemployment and the commodity markets should always be in equilibrium. Second, the Classical economics is based on supply and the aggregate production in an economy must generate enough income to purchase all the economy’s output. Third, the household savings must equal to the capital investment expenditures. In case of inequality, the interest rates should be able to automatically restore equilibrium. As the Great Depression exposed several flaws with the Classical economics, John M. Keynes introduced the Keynesian school of thought.
The Keynesian theory bluntly points out that there is no “invisible hand” which could miraculously get us out of economic difficulties, and that government intervention is critical to growth and stability. Whereas the Classical theory focuses on long run, Keynesian theory focuses on short run. It also states that there will always be unemployment and government interventions should be employed to assist the economy through rough times. Keynesian economics is also based on several key assumptions. First, prices for wages and commodities are not very flexible due to constraints such as laws, nions, long-term wage agreements and supplier contracts. Second, Keynesian economics stresses on demand and actual household disposable income. It points out that in reality, only a fraction of the household income is used for consumption expenditures. Third, Keynesian theory dictates that household savings and investments are based on disposable income and that the incentive to save for future investments lies with the expected rate of return. Keynesian theory also states that most of the economic problems could be solved with fiscal policy and monetary policy.
At this point, one may ask what is our current administration’s standpoint. First, the government intervened and bailed out institutions that were “too big to fail. ” Second, the government has been pumping money into the economy to create artificial inflation. Third, the Fed has been employing monetary policy to keep interest rates at their all time low in an effort to stimulate lending, borrowing and consumer spending. In light of the government’s recent actions, it becomes clear that Mr. Bernanke and the current administration are utilizing Keynesian economics to revive the economy.