Theory And Policy For Macroeconomics - Essay Example

Running head: Macroeconomics Macroeconomics: Theory & Policy (The debate between Keynesian and ical economists on the efficiency of the market mechanism and the efficacy of government policy intervention on the basis of current financial crisis) Abstract The current financial and economics crisis all over the world has again started debate among the economists about which economic theory is more useful in explaining market mechanisms. Some economists advocate the Keynesian economic theory whereas the others argue that Classical economic theory is more useful in studying the market mechanisms effectively. In any case, it is a fact that none of the economists were able to predict the current economic crisis before it actually occurred. Even the big corporate world failed to anticipate such a catastrophic event and the business world has suffered lot of setbacks because of the unexpected arrival of the current financial crisis since they failed to take any precautionary measures. This paper briefly explains both Keynesian economic theory and Classical economic theory and compares the merits of both in the basis of the current market failure and economic crisis. Introduction Keynesian economics and classical economics are the two major streams of economics. Classical economic theory was the first economic school of thought founded by the great economist Adam Smith in the 18 the century. The Classical economics theory assumes that free markets can regulate themselves if left alone, free of any human intervention (Patil, 2010). This theory has immense belief in the market’s ability to stabilise after fluctuations. Classical economists believe that it is difficult for the market to function without fluctuations because of the dependence of the market with so many other internal and external parameters. Any changes that happened in these parameters can affect the market mechanisms or the performances. Classical economists believe that the government need not intervene in the market to save it in case of big fluctuations as the market itself has the stabilising capacity. On the other hand, Keynesian economics the brain child of the great economist, John Maynard Keynes, believe that there is no divine entity, nor some invisible hand, that can tide us over economic difficulties, and we must all do so ourselves. It stresses on the fact that Government intervention is absolutely necessary to ensure growth and economic stability (Patil, 2010). Thus we can see that both classical economists and the Keynesian Economists have different views about the market mechanisms and the market functioning. The current economic crisis came at an unexpected time and neither the classical economists nor the Keynesian economists succeeded in predicting the current crisis. A deep understanding of the basic principles of these two models of economics will help us to understand the current crisis more deeply. Keynesian economics, classical economics and the current crisis As mentioned earlier classical economists believe that the involvement of government is not necessary even if the market goes out of control whereas the Keynesian economists believe that the government should have the control over the market. When we analyse the current financial crisis, we can conclude that the Keynesian economists were right as we cannot imagine, what was going to happen in case the government was stayed away from the market when the current crisis has started. In almost the entire countries, the governments entered the market and made lot of changes in their policies and the functioning of the market. For example, in America, the government has declared a stimulus package worth billions of dollars to save the economy from total destruction. The declared American stimulus package was worth around $ 825 billion in total; Tax Cuts - $275 Billion: Aid to States - $119 Billion: Education - $117 Billion: Infrastructure - $90 Billion: Aid to Those Hit Hardest - $106 Billion: Energy - $54 Billion: Science - $16 Billion: and Other - $48 Billion (Zacks Investment Research, 2009). The above statistics clearly shows that the government forced to aid the key areas of American economy to come out from the current crisis. Even then many people in America lost their jobs and many others had their salaries cut down. Unemployment has reached all time high now in America. If the Americans rely on the views of classical economists, the current financial crisis could have created even more negative results. Classical economists believe in flexible prices whereas the Keynesian economists argue for rigid or inflexible prices (Patil, 2010). Classical economists are of the opinion that the prices of the commodities like labor, land etc must be flexible for the market to function healthily. In other words, the prices should swing from one direction to other direction. But in reality, these prices normally swing in one direction only; to the upward direction only. The living standards and the family expenses are going high and it is rubbish to believe that the prices may come down at certain period of time. Keynesian Economists believe that the instead of the swings in market prices, the prices should stay stable. It is difficult for the business people and the consumers to actively participate in a market in which the prices go in one direction only; the upward direction. On the other hand, stable price is beneficial to both the consumers and the business people. The consumers can plan their expenses more meaningfully if the prices remain constant. The business people also can think of future investments and other business strategies more eagerly if the market does not undergo much fluctuation. For example, the current financial crisis destroyed the construction or the real estate sector. No real estate business group will currently think in terms of investing in the real estate sector because of the less demand. Classical economists believe that Supply creates its own demand (Say’s law). They believe that if a good is produced, it has to be bought. On the other hand, Keynesian economists argue that effective demand controls the supply (Patil, 2010). In this case also the argument of Keynesian Economics seems to be logical. Most of the production activities are currently demand driven only rather than supply driven. For example, take the earlier case of real estate sector itself. It is difficult to anticipate that more production/supply of buildings or apartments in the current economic crisis climate may boost the demand/sales. On the other hand it is logical to think that since many people were affected by the financial crisis the demand for new apartments or buildings will remain feeble today even if more of them were produced. The third argument of the classical economist is with respect to the savings. This assumption requires the household savings to equal the capital investment expenditures. The classical economists believe that the people will save more money if the interest rates are high whereas the Keynesian Economics believe that the desire to save for the future and commercial capital investments are solely based on the expected profitability of the endeavour (Patil, 2010). In this case also the argument of the Keynesian Economics seems to be more relevant. For example, for fixed deposits in financial institutions, people are getting a fixed amount as interest income whereas if they deposit their money in share markets or mutual funds, they may get huge benefits if the markets are growing at a substantial level. In other words, people will opt for the share market if the market condition is good. The bank interest rates will be higher only when the market condition would become good. In short, the people will be left with two choices when the market is growing; either to go for the bank deposits which yield fixed income or to go for share markets which have the potential of making their investment double or triple in a fixed time period. Classical economists believe that the wages will increases as the prices of the commodity increases and hence the price hikes might not affect the people’s life much. On the other hand, Keynesian economist argues that real wage decreases when the prices increase (Classical economics, n. d). Suppose an employee is drawing a salary of $ 2000 per month. The employer may increase the salary of the employee at the most by $ 500 when the prices go high in the market. But this $ 500 salary increase might be negligible when the market prices became skyrocketing. The essential commodity prices like, house rent, food, water, electricity, telephone bills, clothing etc all will have comparative hike in the price and the $ 500 increase would serve as nothing for an ordinary person at a period of price hikes. Classical economics have no clue about what is going to happen if the market is hit by a financial crisis. Depression and classical economics may not function together because of the contradictions in their principles. On the other hand, Keynesian economics and depression can function together as Keynesian economics have answers to the questions raised by depression. In fact, Keynesian economics deals mainly with avoiding a market crisis situation or market failure. Adam Smith described the market mechanism as an "invisible hand" that leads all individuals, in pursuit of their own self-interests, to produce the greatest benefit for society as a whole whereas Keynes arguments proved the modern rationale for the use of government spending and taxing to stabilize the economy (Major Schools of Economic Theory, n. d). Government should interfere in the market periodically when the market goes beyond the control of the government by varying the tax rates, interest rates etc. India is one of the fewest countries in the world which escaped from the current recession without many damages. Indian government has entered the market when the recession started to appear on the screen and made lot of policy changes tackle the recession. The tight measures taken by the Indian government during the recession period has recently liberalised again when the government felt that the threats from recession is over. Conclusions Classical economics and Keynesian economics have different views about the market mechanisms. Classical economist believes that the market has the self stabilizing ability without seeking help from the government whereas the Keynesians believe that the government should interfere in the market whenever it goes beyond the control. Classical economics believe that the market is supply driven whereas the Keynesians believe that the market is demand driven. Both Keynesians and the classical economist differ in their opinions about savings, wages, unemployment, prices etc also. In the current world, Keynesian economics seems to be the best economic theory compared to classical economic theory in handling recession like economic problems. References 1. Major Schools of Economic Theory (n. d) Retrieved on 21 March 2010 from http://www.frbsf.org/publications/education/greateconomists/grtschls.html 2. Patil Sayali Bedekar , (2010)Classical Economics vs Keynesian Economics, Retrieved on 21 March 2010 from http://www.buzzle.com/articles/classical-economics-vs-keynesian-economics.html 3. Zacks Investment Research, (2009), Americas New Stimulus Package, Retrieved on 21 March 2010 from http://www.istockanalyst.com/article/viewarticle/articleid/2964166 4. Classical economics, (n. d), Retrieved on 21 March 2010 from http://www.theshortrun.com/classroom/doctrines/classicals.html Read More