Question

1. What are the differences between classical theory and what Keynes believed?
2. What are the different phases of the business cycle, and how are production and employment affected in each phase?

Answer 1

1.Emphasis on the Study of Allocation of Resources Only:

The existence of ‘full employment’ being a normal situation in the classical scheme, it followed that factors of production are always fully employed and there is no further scope for additional employment of resources in new industries. The choice, according to classsicals, was not between employment and unemployment but between employment here and employment there, i.e., increase in production in one direction could be achieved only at the cost of some decrease in another direction in the economy.

In other words, classicals fell there could not be any significant misallocation of resources as the price mechanism, acting as an ‘invisible hand’ would achieve the best, the most efficient allocation of resources. Since the optimum allocation of a given quantity of resources was the main subject-matter of classical economics, it was but natural that they did not discuss the problem of national output, income or employment.

With their assumption of full employment, there obviously could not be any change in the real national income of the community through additional employment of resources. What could possibly be done, given, the composition and volume of the real national income, was a more efficient allocation of the given resources.

As such, they remained concerned with the special case of full employment and not with the general factors that determine employment at any time. In brief, the well-known theory of value, distribution and production formed the ‘core’ of classical economics. That unemployment of resources could also persist to pose a problem did not occur to them at all.

2.Policy of ‘Laissez Faire’:

Classicals had great faith in the philosophy of laisez-faire capitalism, which meant ‘leave alone’ or ‘let alone’ in business matters. Laissez-faire capitalism would not tolerate any kind of intervention by the Government in business matters; they rather considered it a positive hindrance in the free working of the market economy.

Classicals believed in Laissez-faire capitalism as it was the traditional model of study from the very’ beginning. Classicals had great faith in price mechanism, profit-motive, free and perfect competition and the self-adjusting nature of the system. They felt that if the system is allowed to work freely without any encroachments on the part of the state, it has potentialities to overcome the maladjustments in the economic system, if there are any.

3.Assumption of Netural money:

Classicals did not give much importance to money treating it only as a medium of exchange its role as a store of value was not considered. To them, money facilitated the transactions of goods but had no effect on income, output and employment. They considered it as a ‘veil’ which hides real things goods and services. In other words, they assumed that people have one motive for holding money, i.e. the transaction motive.

Classicals completely ignored the precautionary and speculative motives for holding money. In short, they never recognised that money could also influence the level of income, output and employment. In contrast to this view, Keynes considered money on as on active force that in influences total output.

4.InterestRate as the Equilibrating Mechanism between Saving and Investment:

Classicals would give the pride of place to the rate of interest as the equalizer of saving and investment at full employment of resources. The implied assumption was that both saving and investment are highly sensitive to changes in the rate of interest.

The belief was firmly rooted that saving and investment can be equal only at full employment, and that ‘under employment equilibrium’ is a disequilibrium situation which would not last long in an atmosphere of wage price flexibility under the pressure of competition

The business cycle is a pattern that is recurring in an economy during the periods of expansion and contraction. During the period of expansion, there is an increase in economic activities and this increase continues until the economy reaches a peak season and cannot increase anymore. During the contraction period, economic activities are slowing down in the economy.

The business cycle plays a crucial role in the economy of any country. Just like how an individual experiences ups and downs in his health and may also impact other individuals, there are ups and downs in the level of economic activity (Gross Domestic Product) of every nation.

There are four different phases of the business cycle: Expansion, Boom, Recession, Depression and Recovery.

1.Expansion:

In the expansion phase, there is an increase in various economic factors, such as production, employment, output, wages, profits, demand and supply of products, and sales.

In addition, in the expansion phase, the prices of factor of production and output increases simultaneously. In this phase, debtors are generally in good financial condition to repay their debts; therefore, creditors lend money at higher interest rates. This leads to an increase in the flow of money.

2.Boom:

A Boom refers to a period of increased commercial activity within either a business, market, industry, or economy as a whole.

A boom is accompanied by a bull market in stocks and a bear market in bonds. Booms also run the risk of high inflation. That happens when demand outstrips supply, allowing companies to raise prices.

A boom starts when economic output, as measured by GDP, turns positive. Most leading economic indicators have already turned positive before that.

3.Recession:

In recession phase, all the economic factors, such as production, prices, saving and investment, starts decreasing. Generally, producers are unaware of decrease in the demand of products and they continue to produce goods and services. In such a case, the supply of products exceeds the demand.

Over the time, producers realize the surplus of supply when the cost of manufacturing of a product is more than profit generated. This condition firstly experienced by few industries and slowly spread to all industries.

This situation is firstly considered as a small fluctuation in the market, but as the problem exists for a longer duration, producers start noticing it. Consequently, producers avoid any type of further investment in factor of production, such as labor, machinery, and furniture. This leads to the reduction in the prices of factor, which results in the decline of demand of inputs as well as output.

4.Depression:

In the depression stage, the economy’s growth rate becomes negative. There is further decline until the prices of factors, as well as the demand and supply of goods and services, reach their lowest point. The economy eventually reaches the trough. It is the negative saturation point for an economy. There is extensive depletion of national income and expenditure.

5.Recovery:

After this stage, the economy comes to the stage of recovery. In this phase, there is a turnaround from the trough and the economy starts recovering from the negative growth rate. Demand starts to pick up due to the lowest prices and, consequently, supply starts reacting, too. The economy develops a positive attitude towards investment and employment and production starts increasing.

Employment begins to rise and, due to accumulated cash balances with the bankers, lending also shows positive signals. In this phase, depreciated capital is replaced by producers, leading to new investments in the production process.

Recovery continues until the economy returns to steady growth levels. It completes one full business cycle of boom and contraction. The extreme points are the peak and the trough.