Question

1. Give a detailed critique of the Classical versus Keynesian view of the macro-economy.
   1. Keynesian versus classical analogies- Swiss watch versus old Idaho pickup.
   2. How does this debate apply to the financial markets?

Answer 1

KEYNESIAN VERSUS CLASSICAL ANALOGIES

The emergence and popularity of macro economics can be traced to the eminent economist John Maynard Keynes and his famous book "The General Theory of Employment, Interest and Money" .This book was published in 1936. Even though the macro approach of looking at and analysing the economy as a whole existed before Keynes, it was Keynes who revolutionised macro economics. His macro approach is referred to as the Keynesian Revolution.

Before Keyens, economic thinking was dominated by classical economics. Classical economists believed in and argued for laissez-faire, which means least intervention. Economic activities should be left to market forces. The 'Invisible hand' of market forces will ensure equilibrium and full employment. Therefore, the question of over production and deficiency of demand do not arise.

Classical ideas of full employment and automatic functioning of the economy was proved wrong by the Great depression of 1930s.It was the worst economic crisis in modern economic history. Unemployment shot up, widespread bank failures and US economy contracted. This disproved most economic ideas of classical economist. Keynes filled this gap with his great work 'The General Theory'. Keynesian Theory holds that unemployment is the normal state of the economy and significant government intervention is required if employment/output targets are to be reached.

So, we have two models of economic growth. The Classical Model says that the economy is at full employment all the time and that wages and prices are flexible. The Keynesian Model says that the economy can be above or below its full employment level and that wages and prices can get stuck.

Classical supporters want a market that is free to find its own levels of supply and demand. They believe that prices should fluctuate based on the wants of consumers. The market will adjust itself to any shortages and surpluses of products. Keynesians believe prices should be more rigid and that government should try to maintain price stability. They would like to see the government influence people and corporations to keep prices within specified ranges.