Question

What is the key difference between the Keynesian and Neoclassical approaches to the usefulness of government policy in addressing the short-run fluctuations in the economy?

Answer 1

The two main school of thoughts that addresses the usefulness of government intervention to reduce fluctuations in the economy are Keyensian scholl of thought and Neo Classical school of thought. Neo Classical School of thought emphasizes on self adjustment mechanism in the economy wherein economy self corrects itself to reach the full employment level of output in case of fluctuations from potential level of output in the economy. This is based on the fact that prices and wages are flexible in the economy. Thus , wages change due to changes in unemployment level and this causes shift of the aggregate supply curve and economy adjusts automatically to the full employment level of output.

On the other hand, Keynesian economics is based on demand side which emphasizes that wages and prices are rigid in the short run and thus economy cannot correct itself automatically in case of fluctuation from the potential level of output. In this case, government intervention becomes necessary to move the economy towards its potential level. Expansionary fiscal policy is needed when economy is in recession and contractionary fiscal policy is needed when the economy is in boom.

Thus, Neo Classical Economics emphasizes on self adjustment mechanism of the economy and no government intervention in the economy and Keynesian economics emphasizes on the need of government intervention to correct fluctuations in the economy.