Sample Paper on The Keynesian vs. Neoclassical Theories

The Keynesian vs. Neoclassical Theories

Introduction

This paper contrasts two clashing and convergent kinds of economic theories namely, Keynesian theory and neoclassical theory.  Each of the two theories employs a unique way of comprehending not only how economies work, but also the manner in which they interact with society.  Put simply, both the Keynesian and Neoclassical theories differ in the way they approach the economic elements of society (North 39).  Specifically, the paper shall endeavor to evaluate the differences between the Keynesian and Neo-classical theories in the theories of unemployment, money, and assumption on human behavior.

Keynesian vs. Noe-classical Theories

Both Keynesian and Neo-classical economics mainly differ on their view on money on fronts: price stickiness, and income distribution. Neo-classical economists largely presuppose that prices and wages are, by and large, flexible. They also believe that the quick adjustment of “clear” market prices helps to balance demand and supply. Keynesian theorists affirm that the reason why we have involuntary unemployment is due to the stickiness of prices and wages (Wolff and Resnick 18).  For this reason, Keynesian theorists believe that economic activities are strongly influenced by monetary policies.

 

Both the Keynesian and Neo-classical economies clash in their view of income distribution. Economists from the two camps cannot seem to agree on the constituents of an “acceptable” theory of income distribution. Keynesian economists are of the view that income distribution can be explained best using the differences in power between capitalists and workers. Neo-classical economists rely on factor prices of a market theory to explain the distribution of income.  The Keynesian theory brought a new dimension of economic understanding where the public had a role to play in influencing demand and supply in the market. However, the idea was criticized by neoclassical economists who saw it as a quick fix that could not sustain the economy in the long-run (Evan 2).

The monetary policies of neoclassical theory are based on an assumption of exaggerated demand for goods by the theory (OECD 115). Neoclassical theorists believe that as long as supply is maintained at a limited level, it would result in a laissez-faire (free market) situation. Here, government intervention is limited or nonexistent.

The two theories also differ greatly on their ideas of solving unemployment or creating employment opportunities for that matter. The ideas of neoclassical theories do not appear to provide immediate solutions to a problem that need an immediate response. This is because the major differences between these two theories is their approach in solving economic issues where the Keynesian theory provides short time solutions while the neoclassical theory focuses on long term solutions.

To further explore the issue of employment, neoclassic theorists rely on the law of markets, popularly known as Say’s law. According to this law, demand is reliant on the existing supply. In other words, the output produced generates income to remove it (the output) from the market. In other words, economies should eventually expand to full employment since all that has been produced gets to be sold. Interest rates fall because loanable funds are readily available. Consequently, businesses have access to investment funds. Failed interest rates would not cause deficiencies in spending because of the resultant price and wage adjustments (Wolff and Resnick 66). The only time when there would be prolonged unemployment is in case of unreasonable wage demands by workers.

Neoclassical theory argues that as prices go down so does the wage demands. According to this economic view, it is the duty of the business people to manage the issue of unemployment by reducing the prices of goods and services. Low price of goods and services implies low employees’ expenses thus leading to reduced wage demands (Froyen 56). However, the prices would need to remain low for this principle to work without which companies would have to lay off some of their employees leading to unemployment. The Keynesian economists saw the public involvement in economic affairs and market regulation as the solution to such predicaments of unemployment.

However, the Great Depression brought with it prolonged and massive unemployment and this only acted to cast more doubts of the predictions made by classical economists.  One of the chief critics of the neo-classical theory during this time was John Maynard Keynes.  According to Keynes, there are no sufficient internal mechanisms in a market economy to ensure full employment. Keynes was of the view that the total demand for services and goods (or total spending) was the key determinant of the health of an economy (Wolff and Resnick 119). Therefore, unemployment would ensue in case of inadequate spending. On the other hand, excessive spending would lead to economic inflation.

Keynesian theory argues that demand does not always result in equal product capacity. As such, too low or unmet demands can lead to adverse effects on inflation, employment, and organizational productivity. Proponents of Keynesian theory argue that demand is influenced by the private and public sector rather than the private sector alone as neoclassical economists argue. Additionally, deficiency of demand can arise from unemployment and increased prices something that can cripple an economy. Therefore, the Keynesian theory sees the public sector as having the potential to deal with unemployment issues through the government (Wolff and Resnick 121). The government can offer public related jobs to the public to help jump start a dying economy rather than waiting on the economic and consumer forces.

Both theories admit that a nation’s economy is made up of business investment, consumer spending and government spending. However, they differ in the levels at which the government should be involved in regulating and managing the economy (Froyen 127). The neoclassical see government involvement as an economy-crippling agent while the Keynesian theorists see the government as the viable solution in times of economic recession.

Keynesian economists believe that the government should assume the responsibility of fighting inflation and unemployment. To do so, use should be made of either a monetary policy or fiscal policy. The former entails manipulation of government taxation and spending with a view to guiding economic performance, while the latter involves a change in money supply in order to influence the performance of the economy and total spending.

Keynesian economists discredit the assumption by neoclassical theorists that flexible prices and wages are consistent with the economic situation in the real world. In this regard, Keynesian economists argue that various forces hinder wages and prices from adjusting quickly and more so in a downward trajectory. To start with, unlike neoclassical theorists who viewed markets as being highly competitive, Keynesian theorists view them as being less competitive. They view many product markets as being either oligopolistic or monopolistic. Accordingly, a decline in demand in these markets will compel sellers to minimize output, as opposed to reducing prices. In regards to labor markets, especially the ones characterized by strong labor unions, there is a tendency among such workers to resist wage cuts (North 46). Therefore, there was no quick adjustment in prices and wages, as they remained “sticky” or rigid.

Keynesian economists are opposed to the idea that prices and quantity of money are proportionally and directly related. Rather, they argue on a non-proportional and indirect effect of change in prices and quantity of money. In contrast, neo-classical theorists believe in the static equilibrium or neutral state of money whereby it is believed to have no effect on real equilibrium of the economy.

On the issue of human behavior, neo-classical theorists assume that human beings act rationally, in total disregard of the vital elements of human behavior. The theory draws a distinction between real people and the “economic man”, a view that has been criticized by Keynesian economists who argue that human behavior in terms of the choices that they make is intended to accord them the best possible benefit on account of the circumstances facing them, such as limited income and taxes.

Conclusion

For over five decades, neo-classical economists and Keynesian economists have clashed on several fronts. Neo-classical economists are of the opinion that a market economy devoid of artificial restrictions would afford the society services and goods and at the same time, ensure full employment. The idea supply begets its own demand is a key foundation of the neo-classical theory in as far as employment is concerned. Neo-classical theory holds that the only time when prolonged unemployment was likely to be experienced is in the event of unreasonable wage demands from workers. However, the Great Depression brought with it prolonged and massive unemployment, prompting heavy criticism by Keynesian economists. Keynesian economists are of the view that a market economy is not sufficient to guarantee full employment. Therefore, it is important for the government to step in and combat inflation and unemployment through the use of fiscal and monetary policies.  Other areas where the two theories differ is with respect to their views on price stickiness and income distribution. Differences between the two theories are also apparent in their assumption of human behavior and money.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Works Cited

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Froyen, Richard. Macroeconomics: theories and policies. Upper Saddle River, N.J: Pearson           Prentice Hall, 2009. Print.

North, Douglass C. Understanding the Process of Economic Change. Princeton: Princeton

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OECD. The effectiveness and scope of fiscal stimulus. 2009. Web. 21 November 2014.             <http://www.oecd.org/eco/outlook/42421337.pdf>.

Wolff, Richard and Stephen Resnick. Contending Economic Theories: Neoclassical, Keynesian

            and Marxian. Stamford, Mass.: The MIT Press, 2012. Print.