Question

2. Describe Pre-1930s conventional wisdom. How does this theory differ from Keynesian economics? Provide a detailed discussion.

Answer 1

The Great Depression of 1930's caused a widespread change in the conventional wisom of economic theory that dominated the economic scenario till then. The conventional economic theory was mainly centered around the classical economic theory that was put forward by Ricardo in the early 18th century. Ricardo had the focus on the long run and on the factors that causes the potential economic output in the long run. The conventional wisdom theory had focus on the flexibility of the wages and prices that tends to keep the economy near its natural level of employment. The classical theory, hence suggested that although some fluctuations may be seen in the short-run employment scenario, the same is expected to correct itself in the long run and the employment problems would be settled in the long run

The Keynesian economic theory sprouted as a reaction to the Great Depression of 1930's and according to this theory, all the effects that were considered as temporary effects by the classical theory were considered as causing permanent effects in the economy. The keynesian theory hence suggested that all the effects that were caused during the Great Depression like increased unemployment, inflation rates and decreased priductivity were expected to have long term effects on the economy.

Thus, on camparison of the conventional wisdom or the classical theory of economics and the new Keynesian economics that came during that period, it can be seen that it caused a shift from the aggregate supply to the aggregate demand. The theory put forward by Ricardo put a great stress on the supply side as it had a focus on the economy producing optimal output. But Keynesian theory shifted the focus to the aggregate demand suggesting the recessionary and inflationary gaps in the economy. The argument is that the prices in the short run are sticky and this stickiness caused the barrier to adjusting the full employment. Thus, the above differences clearly states the differences between the conventional theory and the new Keynesian theory.