The Fundamental Points at Issue between the Keynesian and Classical Traditions in the UK - Essay Example

?The fundamental points at issue between the Keynesian and ical traditions in UK Table of Contents Introduction 2 2. Keynesians versus ical 3 2.1 Role of Aggregate Demand 4 2.2 Investment as a stimulus to growth 7 2.3 Government intervention 8 3. Conclusion 9 1. Introduction “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.” – John Maynard Keynes. (Keynes1953: 306) The Great Depression that started in September, 1929, following a stock market crash in the United States had given rise to a new economic school of thought. It is known as Keynesian school of economic principle. It challenged classical economic thought that government has no role to play in correcting any economic disequilibrium. The great Depression helped in shaping many economic institutions including the Fed. Modern macroeconomics was also formed by the Great Depression. (Dornbusch and Fischer, 1994) This major economic recession originated in the U.S., but it spread to the rest of the world including the UK very soon. The Great Depression did last approximately for a decade. It was the period between early 1931 and March 1933 when the depression became great and spread to other nations. The period of Great Depression is mainly recalled for significant unemployment, massive poverty and political turbulence that it caused. For the period of 1931-1940, the rate of unemployment was hovering around 18 percent. During the period of Great Depression net investment was negative and there was a massive fall in consumer price index as well. Between 1929 and 1933, the consumer price index dropped by 25 percent approximately. (Dornbusch and Fischer, 1994) Classical economists did not provide any elaborate explanations for such a huge economic downturn in developed nations like UK, USA and others. However, Keynes has recognized unchecked market movement as the prime reason behind such a great economic downfall. Classical economists mainly focused on the supply side of the economy to search for reason for this depression. However, Keynes held the aggregate demand side of the economy with great importance and recommended counter cyclical fiscal measures to improve aggregate demand. During 1933-1937, some recovery took place in the economy. Real GNP experienced a rapid growth at a rate of almost 9 percent annually. This rapid growth in GNP, however, fell to make a significant fall in the rate of unemployment. In 1938, another economic recession struck the economy and pushed unemployment rate up to 20 percent once again. The Great Depression caused a number of nations to change their political structure as many economists including Keynes considered this severe recession a result of unchecked capitalism. (Dornbusch and Fischer, 1994) This paper will focus on the major points of differences between Keynesians and Classical school of thoughts placing focus on UK economy. 2. Keynesian versus Classical There are two major schools of thought in the field of macroeconomics- Keynesian and Classical. Like other developed nations, UK used to follow Classical policy tools to deal with its economic situation. However, all the Classical measures that used to place major focus on supply side with no government interventions failed drastically at the time of Great Depression of 1930s. This failure of Classical policy tools had persuaded UK economic policy makers to take into account suggestions by Keynes. The UK economy had once again set itself on the path of economic growth by moving from the way of unchecked market capitalism towards government regulated market economy. This section will focus on three core areas of differences between Keynesian and Classical- the area of aggregate demand, the role of investment and government intervention.. 2.1 Role of Aggregate Demand Keynesian Economics contradict Classical Say’s Law which stresses supply side of the economy. Keynesian Economics has emphasized on demand side and considered effective demand to be the most important determinant of growth. (Dornbusch and Fischer, 1994). According to classical school of thought it is supply which creates its own demand. But, Keynes put major emphasis on aggregate demand side of the economy. Unlike classical economists who consider the economy to always be at full employment level of equilibrium, Keynesians economists hold the notion that the macroeconomic equilibrium is always achieved through the intersection of aggregate demand and aggregate supply of an economy. Keynesian economists also say that it is not possible for the economy to be at full employment level even at equilibrium. Keynesian economists emphasize on increasing aggregate demand to increase employment. According to Keynes, the Macroeconomic equilibrium can be shown with the ehlp of the following diagram. Price AS P* E* AD Quantity Y* Fig 1: Macroeconomic Equilibrium In Figure 1, the vertical axis shows the price level (P) whereas the horizontal axis represents the level of output/income (Y). Here, the output is considered in real term. Aggregate demand curve is represented in the figure by the negatively sloped straight line namely AD. The aggregate demand curve shows the amount of total demand for goods and services at different level of prices in the economy. This curve can be shifted towards left or right by different types of fiscal and monetary policies. The aggregate supply curve, on the other hand, is represented in the figure by the positively sloped straight line namely AS. It is actually short run aggregate supply curve. The equilibrium level of output and price level is determined through the interaction of the aggregate demand and aggregate supply curve of the economy. In the figure above, the point E* represents the point of macroeconomic equilibrium. At E*, the aggregate demand curve intersects the aggregate supply curve. P* and Y* represent equilibrium price and output, respectively. According to Keynes, if there is a shortfall of aggregate demand, then the economy can move into a recessionary phase. In the present time, the world recession is being widely used by almost every body to describe the ongoing global economic scenario, which has been experiencing a huge down turn since 2008. All the media across the world is talking about recession every day. Whether it is a news paper, on a news channel on television, or some news bulletin on radio, everywhere people are talking about recession, the methods to recover from the recessionary situation and so on. In short, the economic phenomenon ‘recession’ has been gathering huge attention of people across the world since quite a long time. Recession is actually a macroeconomic phenomenon. The recent recession has hit UK also. According to Keynesian school of thought, massive fall in aggregate demand causes this recessionary situation. Some important symptoms of economic recession that the UK has experienced due huge crunch in aggregate demand are as follows: 1. The extent of job cut becomes very alarming. 2. Many business houses across all the sectors of the economy experience a huge decline in their sales and their profits start to shrink in an alarming way. 3. Prices of essential commodities jump up. 4. Financial system breaks down, particularly the banking system as borrowers becomes incapable of repaying their loans. There are a number of causes, which push an economy into such a great shortfall in aggregate demand. The major causes of recession may be explained as follows: Among the simple causes, the most important one is inflation. As the rate of inflation rises, the purchasing power of people declines if income does not rise. Inflation can be caused by increase in costs of production, higher costs of energy, or increased national debt. When prices of goods rise, people tend to reduce their overall spending. Under inflationary situation, people have a tendency of reducing their spending on luxurious commodities and try to confine themselves only to the consumption of essential goods. As a result demand declines by a large extent and consequently G.D.P falls, which makes companies to suffer huge losses and therefore prompts them to cut production costs by cutting down jobs. Apart form this, not so well performance of financial sector, which ultimately results in reduced confidence of the people in the financial system, can also cause recession. (Ozaki 30-60; Siegel 50-70). To deal with this recessionary situtaion, effective fiscal policies coupled with efficinet monetary measures to boost aggregate demand of the UK economy will be the ideal one according to keynesian schools of economy. But following classical economic principle everything should be left at the hand of market as invisible hands are there to correct the situation. However, the country has adopted Keynesian policy tools to deal ith this situation. The country has started to take various counter cyclical fiscal measures along with some corrections in moneytary sectors to check capital movemnet. 2.2 Investment as a stimulus to growth According to Keynesian School of Economics, investment also plays a crucial role in economic growth as it is one of the most important factors that determine aggregate demand of an economy. Investment helps in a great way to increase total production of a nation. It influences economic growth by affecting aggregate demand of an economy. A change in investment increases total income of a country through the multiplier effect. The multiplier represents the amount by which the magnitude of change in investment should be multiplied to achieve the final effect on aggregate demand or income. (Dornbusch and Fischer, 1994; Encyclop?dia Britannica, 2011 ) When autonomous or planned investment increases by certain amount, it initially causes same amount of increase in production instantly. This initial increase in production causes consumption to rise as consumption is depended on income. This rise in consumption causes another round of increase in production. This process continues until the new equilibrium is reached and thus finally national income is increased by more than the increase in the planned investment. In contrast, classical economists hold the notion that investment is important only for accumulating capital and thus it affect an economy through th supply side. They totally ignore the role of investments in augmenting aggregate demand of the economy. 2.3 Government intervention John Maynard Keynes was the first economist who suggested intervention of government in order to modify economic fluctuations during business cycle. According to him, if a recessionary state of an economy is left unchecked, then depression is bound to occur. He advocated implementation of counter-cyclical fiscal policies to prevent depression. Where classical economists were of the opinion that the Great Depression was scheduled to happen and nothing could have prevented it, Keynes said that The Great Depression could have been prevented. In sharp contrast to classical economists who believe that demand has just a passive role in economy where supply creates its demand, Keynesian theory put major emphasis on aggregate demand side of the economy. According to him, aggregate demand plays the most crucial role in the process of economic growth. Keynes established a link between the real sector and the monetary sector. Contribution of Keynes to economic theory is huge and his theory has made it possible to look at the working of economic activities from a different angle. In the event of recession in any economy, the government can play a crucial role in helping the economy to come out of this bad phase. The government has the ability to influence the equilibrium level of income of the economy by purchasing goods and services. Purchase of goods and services by government which is generally known to be a government spending (G) forms an important component of aggregate demand of the economy. Whenever there is a government sector in an economy, the level of consumption spending will depend on disposable income of consumers. Disposable income is generally defined as the income net of tax payment to the government and transfer receivables from the government. Through fiscal policy, the government can increase or decrease the level of government spending. In the event of recession, the government can undertake an expansionary fiscal policy to increase the level of aggregate demand of the economy which will in turn increase equilibrium income level. Classical Economics, on the other hand, is based on the idea of a free market economy where invisible hands maintain balance between demand and supply. According to Keynesian Economics, government intervention is vital for ensuring growth and maintaining economic stability. 3. Conclusion On the basis of the discussion above it seems that the classical economists fail to provide any satisfactory explanation of current economic downturn of the UK along with the rest of the world. Keynesian school of thoughts, on the other hand, has identified demand side problems as major causes behind any economic disequilibrium. Keynesian policy tools for correcting aggregate demand would be ideal for UK to deal with any economic crisis by focusing on aggregate demand side and placing major role on government intervention. References: Keynes, J. M. (1953). The general theory of employment, interest, and money. New York: Harcourt Brace Jovanovich. Ozaki, R.. S. (1972). Inflation, Recession - and All That.New York: Holt, Rinehart and Winston. 1972. Siegel, J. J. (2002). Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies, 3rd, New York: McGraw-Hill. Dornbusch, R. and Fischer, S. (1994). Macro Economics. 6th Ed. McGrowHill.. Read More