Question

After defining what is the "Keynesian revolution" and the contributions of "The general theory of employment, interest and money" by Keynes, you will explain how this revolution gave rise to "Keynesianism" and how the classic counterrevolution developed in response to Keynesianism, giving rise to the new classical macroeconomics. (ESSAY)

Answer 1

Answer:

The central argument of the General Theory is that the level of employment is determined by the level of aggregate demand. If the total demand for goods at full employment is less than the total output, then the economy has to contract until equality is achieved. Keynes thus denied that full employment was the natural result of competitive markets in equilibrium. Law depends on the operation of a market economy. If there is unemployment and there are no distortions preventing the employment market from adjusting to it, then there will be workers willing to offer their labour at less than the current wage levels, leading to downward pressure on wages and increased offers of jobs.

Keynes's economic theory is based on the interaction between demands for saving, investment, and money. Saving and investment are necessarily equal, but different factors influence decisions concerning them. The desire to save, in Keynes's analysis, is mostly a function of income: the wealthier people are, the more wealth they will seek to put aside. The profitability of investment, on the other hand, is determined by the relation between the return available to capital and the interest rate. The economy needs to find its way to an equilibrium in which no more money is being saved than will be invested, and this can be accomplished by contraction of income and a consequent reduction in the level of employment.

New classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations. it is in contrast to the rival new Keynesian school that uses price stickiness and imperfect competition to generate macroeconomics model.The Post-World War II period saw the widespread implementation of Keynesian economic policy in the United States and Western European countries.Problems arose during the 1973–75 recession triggered by the 1973 oil crisis. Keynesian policy responses did not reduce unemployment, instead leading to a period of high inflation and stagnant economic growth—stagflation.

The new classical perspective takes root in three diagnostic sources of fluctuations in growth: the productivity gap, the capital gap, and the labor gap. Through the neoclassical perspective and business cycle accounting one can look at the diagnostics and find the main ‘culprits’ for fluctuations in the real economy.

a) A productivity/efficiency gap is a simple measure of aggregate production efficiency. In relation to the Great Depression, a productivity gap means the economy is less productive given the capital and labor resources available in the economy.

b) A capital gap is a gap between the intertemporal marginal rate of substitution in consumption and the marginal product of capital. In this gap, there’s a “deadweight” loss that affects capital accumulation and savings decisions acting as a distortionary capital (savings) tax.

c) A labor gap is the ratio between the marginal rate of substitution of consumption for leisure and the marginal product of labor and acts as a distortionary labor tax, making hiring workers less profitable (i.e. labor market frictions).

If prices are completely flexible and if public expectations are completely rational and if real economic shocks are white noises, monetary policy cannot affect unemployment or production and any intention to control the real economy ends up only in a change in the rate of inflation. However, if any of these conditions does not hold, monetary policy can be effective again. So, if any of the conditions necessary for the equivalence does not hold, countercyclical fiscal policy can be effective. Controlling the real economy is possible perhaps in a Keynesian style if government regains its potential to exert this control. Therefore, actually, new classical macroeconomics highlights the conditions under which economic policy can be effective and not the predestined inefficiency of economic policy. Countercyclical aspirations need not to be abandoned, only the playing-field of economic policy got narrowed by new classicals. While Keynes urged active countercyclical efforts of fiscal policy, these efforts are not predestined to fail not even in the new classical theory, only the conditions necessary for the efficiency of countercyclical efforts were specified by new classicals.