Question

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

Competitive capitalism refers to the idea of pure Western capitalism and follows the free market competitive economic phenomenon. In this concept, the competitive free market relations predominate. A full employment equilibrium in an economy refers to the equilibrium where all the resources of the economy are fully utilised. Here the aggregate demand is equal to the supply at full employment levels. While the Keynesian theory states that there is no self regulating mechanism that can generate full employment in an economy, the neoclassical theory states that the competitive capitalism should automatically adjust itself to achieve the full employment equilibrium. Neoclassical economics believes in a theory that focus on the supply and demand as the major factors that drives the pricing, production and consumption of goods and services. It argues that it is the consumers perception of a product value that decides its prices. In a competitive capitalistic market, as the theory suggest, the supply and demand forms the basis of trade and the consumer satisfaction plays a role in buying and selling in the market mechanism. Thus we can see that the market will self adjust so as to use its resources according to the demand requirements and hence full employment equilibrium may be attained.

                                    Neoclassical theory suggest that unemployment is voluntary and states that it is a temporary problems whose solution should be sough on the market forces. Between 1929 and 1933, employment fell by about 25% and output fell by 30%. According to the theory, the levels would have been back to normal levels by 1930, but the level of depression was so huge that it was not achieved. The theory suggests that the real wage in an economy is decided based on the demand for labour. But, when we analyse the era of great depression, we can see that although there was a huge demand for labour, the real wage did not see an increase which is a contradiction to the neoclassical theory.

                                    According to the neoclassical theory, interest refers to a reward for the use of loanable funds and the interest rate is determined by the demand for and supply of loanable funds. They suggests that it is the savings that determines the investment. In contrast, the Keynesian theory suggests that it is the investment that decided the savings and the interest rate performs the function of equating the demand and supply in an economy.

                                   

                                    Keynesian theory suggests an indirect link between the money supply and real GDP. It suggests that expansionary monetary policy would result in increasing the supply of loanable funds through the banking system which causes the interest rates to fall further. Thus during recession, when an expansionary policy is followed, the above may happen causing the interest rates to fall further thereby resulting in further dip in the economy which reveals the ineffectiveness of a monetary policy according to Keynesian theory.