Question

When it comes to the History of Economic Thought: A Critical Perspective by E.K Hunt

Explain the neoclassical theoretical argument that competitive capitalism should automatically self-adjust to achieve full employment equilibrium. During the Great Depression, real wage did not increase. Why was this economic fact in contradiction with the neoclassical (and Keynes’s) theory of employment? How was Keynes’s theory of interest rate and saving different from the neoclassical one? Why did Keynes believe that there were situations where monetary policy would be ineffective to bring the economy out of depression?    

Answer 1

Neoclassical economics completely dominated orthodox academic economics in the late nineteenth and rely on the twentieth centuries. Its basic assumption of pure competition (no buyers or sellers large enough to affect prices was patently ridiculous. The neoclassical argument that a purely and perfectly competitive economy led to an optimum allocation of resources, but they also showed that such an all-economy need not be a capitalist one. They demonstrated that a socialist economy, in which the means of production were collectively owned, (could also operate((though perfect planning or decentralized decision making) in a stage of optimal economic efficiency. Private ownership had absolutely no formal or theoretical importance in the neoclassical theory. Further Moore, under the socialist ownership, they argued, the inequalities of income distribution under a capitalist system would disappear.  

Full employment equilibrium refers to the equilibrium where all resources in the economy are fully utilized ( employed). Simply put, when the equilibrium between AD and As takes place at full employment of resources, it is called full-employment equilibrium. there are no unused resources anyway. Thus the equilibrium level of employment is the level at which aggregate supply is consistent with the current level of aggregate demand. The theory believes that demand creates its own supply rather than the classical claim of supply creates its own demand. When an economy is not in full employment, it cannot produce what it would have been in full employment. That output gap is caused in part by the employment shortfall. Output is at its equilibrium when the quantity of output produced is equal to quantity demanded. The economy is in equilibrium when aggregate demand represented is equal to total output.

In a free market/trade at the end will make each nation equally competitive in the world market. There is an argument that under competitive capitalism, aggregate demand must automatically adjust to aggregate supply if the government does not interfere. Of course, the US Economy did not automatically return to full employment, and millions of people suffered from lack of food, clothing, and shelter. The argument for this amazing doctrine - that demand would automatically come to equal supply, so nothing should be done about unemployment as based on the assumption that economic laws are universal and apply to all societies the same way. Thus orthodox neoclassical economists used examples and reasoning based on pre-capitalist society.

Keynes states that " we take as given the existing skill and quantity of available labour, the existing quality and quantity of available equipment, the existing technique, the degree of competition, the tastes and habits of the consumer, the disability of different intensities of labour and of the activities of supervision and organization, as well as the social structure including the forces, other than our variables set forth below, which determine the distribution of the national income. This does not mean that we assume these factors to be constant, but merely that in this place and context, we are not considering or taking into account the effects and consequences of changes in them. These restricting assumptions exclude from consideration, the consequences of a gradual increase in the stock of capital equipment consequent on successive investments made over a series of years. Thus the question about ultimate equilibrium, if there is one, to which the whole creation moves, cannot be treated directly by Keynes's apparatus; though, as will be seen presently, they can in some measure be treated by it indirectly.

Keynes theory of interest rate and saving different from the neoclassical one?

1) The classical theory of interest is a special theory because it presumes the full employment of resources. On the other hand, Keynes theory of interest is a general theory, as it is based on the assumption that income and employment fluctuate constantly

2) Neoclassicals regard the rate of interest to be equilibrating mechanism between saving and investment. Keynes regards changes in income to be the equilibrating mechanism between them. According to Keynes, savings depend on income. Classicals regarded savings as fixed corresponding to full employment income whereas for Keynes for every level of employment, there will be a different level of income and for different levels of income there will be corresponding savings.

3) According to classical, more savings will flow at a higher rate of interest but according to Keynes savings will fall because the level of income will fall, for the investment will be less when the rate of interest goes up, leading to a decline in income and hence savings.

4) The element t old hoarding occupies a central position in Keynes' liquidity preference theory of interest because he considers money as a store of value also; whereas the classical gave little importance to the element of hoarding and considered money only as a medium of exchange.

5) Classicals gave more attention to interest on bank loans, whereas Keynes was concerned with the entire loan and interest rate structure in the market and the complex rates of interest that exist. In his theory, the long-term rate of interest on loans, bonds and securities occupy greater significance as they include long-term investment.

Keynes believed that there were situations where monetary policy would be ineffective to bring the economy out of depression.

A liquidity trap is a contradictory economic situation in which interest rates are very low and savings rates are high, rendering monetary policy ineffective. First described by economist John Maynard Keynes, during a liquidity trap, consumers choose to avoid bonds and keep the4ior funds in cash savings because of the prevailing belief that interest rates could soon rise. Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline. At the same time, central bank efforts to spur economic activity are hampered as they are unable to lower interest rates further to incentivize investors and consumers.