Features Of The Main Theories Of Economics - Research Paper Example

Features Of The Main Theories Of Economics Introduction The Classical and the Keynesian schools are the 2 main schools of economy. The 2 schools have many contradictions between each other. This essay will make a comparison between the classical theory and the Keynesian theory of economics. The comparison points will be: 1. The main principles. 2. The money market. 3. Prices and wages. 4. Inflation. The Classical Economics The Main Principles The fundamental principle of the classical theory is that the economy is self-regulating. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed. (Wiley Publishing, 2009a) Classical economists don't agree on the idea of government intervention in the economy ("Keynesian", n.d.). Sometimes the level of the national economy could become above or below "the natural level of real GDP". But somehow with "self-adjustment mechanisms" the economy fixes itself and returns to the natural level of real GDP. The theory of the stability of the level of national income depends on 2 basic ideas: 1. "Say's Law".2. Interest rates, wages, and prices are flexible variables in the national economy (Wiley Publishing, 2009a). The Say's Law was the idea of "J. B. Say". The concept of Say's Law is that the national economy can generate a total income that equals the value of the real GDP (Wiley Publishing, 2009a). And that means that the economy has the ability to buy all of its own production (Wiley Publishing, 2009a). J. B. Say himself says that "Supply creates its own demand" ("Debate", n,d,). The Money Market It is not a certain fact that the economy will spend all of the generated income. That's because a part of the income will be saved, and that means that the "aggregate demand" will decrease. "Aggregate supply" must be reduced in order to become equal to aggregate demand. "Suppliers will cut back on their production and reduce the number of resources that they employ" (Wiley Publishing, 2009a). The equilibrium level of the real GDP will drop because the production resources are not in a status of full employment. The existence of "aggregate saving" prevents GDP from reaching its natural level. According to classical economists, the savings will return to the economy as "investment expenditures". Investment expenditures are considered a part of the real GDP. But the savings can become more than the required investment in the economy. "In this situation, the level of real GDP will fall below its natural level because investment expenditures will be less than the level of aggregate saving" (Wiley Publishing, 2009a). The following diagram explains this theory: (Wiley Publishing, 2009a). In the previous diagram, the curve of Aggregate savings (S) goes up. And that means that with the rise in interest rates, people prefer to save more money. That's because it means more interests on their savings, and that will lead to more profits. The curve of Aggregate investment (I) goes down. And that means that with the rise in interest rates, people are less likely to take loans for investments. That's because it means more costs, and it will not be a profitable decision for investment (Wiley Publishing, 2009a). In the case of having an unchanged interest rate, if the Aggregate savings increases, the curve (S) will move to the right and become (S1). In this case, it is noticed that there is a "gap" between aggregate savings and aggregate investment. The new equilibrium level of real GDP will become at a lower level. In classical economics, wages, prices and interest rates are flexible variables. Thus, with the increase in savings and the decrease in investments the interest rate will drop until the aggregate savings become equal to the aggregate investments. The previous figure shows how that happened when the interest rate fell from (i) to (i1). The drop in interest rates will encourage investors to borrow for investments because the costs of loans will rise. As a result, the real GDP will return to its natural level again (Wiley Publishing, 2009a). Prices and Wages There are two main factors in the labor market, the supply of labor (workers) and the demand for labor (firms). If the supply of labor is more than the demand for labor the levels of offered wages will drop. Employers will cut the wages so they can hire more workers, and that's supposed to help in making the production resources in the economy fully employed. The low levels of wages will discourage the labor to accept the jobs and that will result in unemployment. In classical economics, every type of unemployment is "voluntary". But if the labor is ready to get hired with the lower levels of wages, the firms will be ready to hire them and pay them (Wiley Publishing, 2009a). The following diagram shows how prices and wages act in a time of recession: (Wiley Publishing, 2009a). In this diagram, the SAS curves represent 2 different levels of short-run aggregate supply. And the AD curves represent 2 different levels of aggregate demand. If the aggregate demand falls from AD1 to AD2 the price level will drop from P1 to P2. The equilibrium real GDP will shift down from its natural level at Y1 to its new level at Y2. When the real GDP is in a lower level than its natural level, this means that the production resources aren't fully employed. In this case, firms will offer lower wages for production resources. The drop in the levels of wages will help firms to supply more products with more cuts in prices. The SAS1 curve will move to the right to become SAS2 after the increase in supplies (Wiley Publishing, 2009a). Inflation In order to explain inflation, Classical economists followed a theory called the "Quantity Theory of Money" and it can be expressed by the "Fisher Equation of Exchange" ("Keynesian", n.d.). The equation follows the following formula. MV=PT M: "The amount of money in circulation". V: "The velocity of circulation of that money" P: "The average price level". T: "The number of transactions taking place". According to classical economists, the increase in money supply causes inflation. With the increase in the amount of money in circulation (M), the average price level (P) will rise ("Keynesian", n.d.). The Keynesian Economics The Main Principles According to this theory, the government should use its power to control the markets in order to maintain the balance in the economy ("Keynesian", n.d.). Thus, the government must always keep the "aggregate income" equal to the current "aggregate expenditure". "If the current level of aggregate expenditure is not sufficient to purchase all of the real GDP supplied, output will be cut back until the level of real GDP is equal to the level of aggregate expenditure" (Wiley Publishing, 2009b). The government has 2 ways to control the markets: 1. Fiscal Policy: The government makes changes on government spending and taxes according to the situation of the economy. If the employment rates are high, the government must increase the amount of spent money on goods and services, but in the same time taxing policies must remain unchanged. Another solution is to reduce that tax rates on individuals' incomes, but in the same time the government spending must remain unchanged ("Debate", n.d.). 2. Monetary Policy: The goal of this policy is to make changes on money supply "in order to influence the level of economic activity". In the case of having high rates of employment, the government must increase the money supply to open the door for easy borrowing. When there is money in hands, spending will increase and the aggregate demand will increase as a result. Firms will need to increase their production levels in order to meet the increasing demand. In this case, the firms will have to employ more workers and that means that the employment rates will drop. The increase in the amounts of money supply will cause inflation. In order to fix this problem, the government can make the borrowing procedures stricter than before. Another solution is reducing government spending ("Debate", n.d.). Another main principle in the Keynesian theory of economics is that wages and prices are not flexible variables (Wiley Publishing, 2009b). The Money Market Keynes claims that saving money is not beneficial. Saving money can be considered an opportunity for supporting investments according to classical economists. But Keynes doesn't trust the market. He criticizes saving because it means less spending. The result will be a decrease in aggregate demand. After that, the national income will decrease and the national economy will face a crisis. The private sector itself will stop investing because it doesn't find enough demand. Keynes claims that the investments depend "much more on business expectations" ("Keynesian", n.d.). Prices and Wages In the case of recession, the aggregate demand decreases to become below its natural level. This will drive suppliers to cut the prices of their products. The level of real GDP will drop. The prices will continue dropping until the workers decide to "resist" it because it affects their wages. As a result, suppliers will become unable to increase their supplies and the prices will rise to a new equilibrium level. There will be a rise in the level of real GDP in this case (Wiley Publishing, 2009b). The following diagram explains how this happens: (Wiley Publishing, 2009b). In the previous diagram, the aggregate demand decreases from its natural level (AD1) to a new level at (AD2). At the beginning, the levels of prices will remain unchanged at (P1) and the real GDP will drop from its natural level at (Y1) to (Y3). After that, the prices will drop from (P1) to (P2). The prices drop here to meet the intersection of the curves AD2 and SAS. In this case, the level of real GDP will rise from (Y3) to (Y2) (Wiley Publishing, 2009b). In the times of recession the demand for labor falls. Keynes claims that wages are "sticky downward". And that means that the levels of wages will drop and cause many workers to refuse jobs but labor will "resist". This will prevent wages from continuing to fall to much lower levels ("Debate", n.d.). The following diagram shows how this theory works: ("Keynesian", n.d.). In the previous diagram, the demand decreased from (Demand 1) to (Demand 2). As a result, the number of labor fell from Q2 to Q1 because of the drop in wage rates. The gap (ab) represents the unemployment ("Keynesian", n.d.). Inflation The Quantity Theory of Money is essential for understanding inflation in the Keynesian theory of economics. It can be expressed by the Fisher Equation of Exchange: MV=PT M: "The amount of money in circulation". V: "The velocity of circulation of that money" P: "The average price level". T: "The number of transactions taking place" ("Keynesian", n.d.). According to the Keynesian theory, the increase in money supply in the national economy doesn't always result in inflation. Keynes says that if the amount of money in circulation (M) increases the velocity of its circulation (V) will decrease. Another possible scenario, if the amount of money in circulation (M) increases the number of transactions (T) will increase too. Keynes puts the second scenario because he doesn't trust the economy's ability to reach "its own equilibrium ". It is possible that the demand is not enough to meet the required "full-employment equilibrium". In this case, it's important to increase money supply so that the demand will increase. Thus, the demand will increase and the economy will reach full employment ("Keynesian", n.d.). Conclusion There are a lot of contradictions between the classical economics and the Keynesian economics. The main difference between the 2 schools is that the classical economists trusted the market but the Keynesians trusted the power of the government. In classical theory, the real GDP will return to its natural level (full employment) even if the economy faces a recession. But in the Keynesian theory, any equilibrium is suitable for the economy whether the production resources are in the status of full employment or not. Wages, interest rates and prices are very flexible according to the classical theory, but the Keynesian theory disagrees on that. References Keynes and the Classical Economists: The Early Debate on Policy Activism. (n.d.). Retrieved April 26, 2009 from: http://www.wps.aw.com/wps/media/objects/11/11640 Keynesian Theory of Economics. (n.d.). Retrieved April 24, 2009, from http://interzone.com/~cheung/SUM.dir/econthyk1.html Wiley Publishing, Inc. (2009a). The Classical Theory. Retrieved April 25, 2009, from http://www.cliffsnotes.com/WileyCDA/CliffsReviewTopic/ The-Classical-Theory.topicArticleId-9789,articleId-9741.html Wiley Publishing, Inc. (2009b). The Keynesian Theory. Retrieved April 24, 2009 http://www.cliffsnotes.com/WileyCDA/CliffsReviewTopic/ The-Keynesian-Theory.topicArticleId-9789,articleId-9742.html Read More