Question

Briefly contrast the classical economists view and the modern economists view about Economic Stabilization?

Answer 1

The use of fiscal and monetary policy as a means of stabilizing the economy is fairly recent, largely a post-World War II development of the time. The only stabilization policy during the 19th century was that associated with the international gold standard. Under the gold standard, when there was a shortfall in a nation's balance of payments, gold continued to spill beyond the region.

To reverse this process, monetary authorities would increase interest rates and stiffen credit conditions, triggering a decrease in prices, wages, and employment; this in effect resulted in a decline in imports and an expansion in exports, thereby improving the balance in payments. When a nation had a balance of payments surplus, gold continued to flood in; this meant the interest rate fell and the supply of money and credit was increased.

When interest rates fell in surplus countries and rose in deficit countries, mobile international financial capital tended to flow from the former to the latter, contributing to the elimination of deficits and surpluses in the balance of payments. The working of this mechanism was partly automatic and partly the result of deliberate actions by the monetary authorities in each country.

Keynes 's opinion was that recessions arise when aggregate demand falls – primarily as a consequence of a downturn in private spending – forcing businesses to perform below their capacity. Companies require less workers to produce less, and therefore jobs falls. For reasons that Keynesian economists tend to discuss, businesses struggle to slash wages to the extent expected by job seekers, and hence involuntary unemployment rises.

The new classicals reject this step as irrational. Involuntary unemployment would present firms with an opportunity to raise profits by paying workers a lower wage.

If companies failed to seize the opportunity, then they would not optimize. Employed workers should not be able to effectively resist such wage cuts since the unemployed are ready to take their places at the lower wage. Keynesian economics would then appear to rest either on imperfections in the market or on irrationality, both of which Keynes denied.

These Keynesian economic critiques illustrate the two basic tenets of the new classical macroeconomics. First, individuals are seen as optimizers: they select the best choices available, considering the costs, including wage levels, they face and the assets they possess, including their education and training (or "human capital"). Companies maximize profits; individuals maximize utility. When prices adjust, incentives to the people change, and thereby their choices, to align quantities supplied and demanded.

Keynesians’ belief in aggressive government action to stabilize the economy is based on value judgments and on the beliefs that (a) macroeconomic fluctuations significantly reduce economic well-being and (b) the government is knowledgeable and capable enough to improve on the free market.