The Difference Between Keynesian And Neoclassical

Introduction

According to Olivier Blanchard (2009) modern macroeconomics starts in 1936 with John Maynard Keynes and his General Theory of Employment, Interest, and Money, in which the author attacked what he named ‘Classicals’ and the Business Cycle Theory (Macroeconomics), challenging their view that “aggregate output is determined, in normal times, by the supply of factors of production” (Arnold, 2002, p. 2).

Keynes’ theory was regarded not only by himself but by many economists as a revolution in economics. However, his theory was later questioned giving place to the Neoclassical Synthesis, a number of theories that reunited Keynes’ and previous economists’ views and created a more formulated prospect of macroeconomics.

This essay has the purpose of explaining and contrasting Keynes’ General Theory and the Neoclassical Synthesis, giving an overview of this major revolution in economics in the 20th century.

Keynes: “The General Theory”

The General Theory written by Keynes in the 1930’s lays its importance in a period of financial downturns, with the Great Depression and the prior crash of the Wall Street in 1929. According to the literature, at this point in time and until the General Theory, economists had little advice to provide on economic policies.

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Keynes argues that inefficient macroeconomic outcomes are a consequence from the private sector decisions. Thus in order to stabilize output over business cycle, the public sector has to respond through monetary and fiscal policies. Therefore, a mixed economy is supported by Keynes, where private sector is predominant but the government and public sector with a large role.

Keynes not only questioned Classical and Neoclassical assumptions of full employment, but also affirmed that investment depend on rate of interest and saving income in terms of wage units (Keynes, 2008)

Keynes’ work had a few fundamental elements such as the liquidity preference, changes in money wages, the marginal efficiency of capital and the consumption function, which are explained as follows:

Effective demand

The General Theory gives emphasis for what we call nowadays as aggregate demand, addressed by Keynes as effective demand.

First of all, “The principle of effective demand asserted that the level of employment was determined by the volume of aggregate demand, independently of the supply decisions of individual workers. If demand was inadequate, workers would be unemployed even if they valued the prevailing real wage more highly than the marginal disutility of working” (King, 2002, p. 12)

In fact, Keynes assured that the most important reason of involuntary unemployment is nothing but a malfunction of effective demand, and added that “…the volume of effective demand at any point in time would determine the level of employment and output in an economy” (Keynes, 2008, p. xxv)

In reality, two elements combined are the key for effective demand: expenditure and investment.

Thus, we can say that “The General Theory introduced the notion of aggregate demand as the sum of consumption, private investment and government spending and the impact of imports and exports in open economies” (Keynes, 2008, p. xxi).

According to Keynes (2008) point of view, for an economy to reach a full employment, under a situation of underemployment, it needs help of government spending.

Animal Spirits

Keynes affirms that consumption and investment can be affected by expectations, and adds that part of the expectations of prospective yields are based upon existing facts, assumed as certain, and partly future events, which cannot be forecasted with full confidence (Keynes, 2008).

The state of psychological expectation which covers the latter (future events) is called by Keynes as ‘the state of long-term expectations’ and involves among others: “…type and quantity of the stock of capital assets and in the tastes of the consumer” (Hansson, 1986, p. 312)

He makes his point on the fact that expectations shouldn’t be made according to matters of uncertainty, however, they should depend on the confidence we deposit in forecasting, which is the same thing as the investment demand-schedule.

Keynes also points out the fact of expectations playing a significant role in demand and output, which means that, when changes in expectations occur, changes in demand and output can also occur.

In other words: “Keynes argued that instability arises ‘due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic’. Thus investment decisions depend upon the ‘animal spirits’ of entrepreneurs.” (King, 2002, p. 13)

Liquidity Preference

According to the Liquidity Preference Hypothesis, consumers are compelled to hold money for different purposes preventing themselves of uncertain future events as a way of store their wealth, in money or goods.

“In the General Theory, the rate of interest is a monetary variable, not the outcome of the real classical factors of capital productivity and thrift. It depends instead of liquidity preference, and this is a speculative phenomenon reflecting the uncertainty of future bond prices in a world in which interest rates vary and capital gains and losses are unpredictable” (King, 2002, p. 13)

Thus an increase in interest rate and current income can affect the money demand.

Changes in Money Wages

Classical theory during the Great Depression defended the idea that mass unemployment and disincentive to produce came as a consequence of high real wages. To Keynes, people would firmly oppose nominal wage cuts. Even though, Keynes argued that the wage bargain is made in monetary terms, but changes in the money wage do not necessarily correspond to changes in the real wage (Clarke, 1988, p.151).

And, to boost employment, Keynes argues that real wages had to go down and nominal wages even more than prices. Consequently, consumer demand and aggregate demand would fall, bringing down profits and sales revenue. This shows that wage cuts could enhance a worse scenario.

The Neoclassical Synthesis

The post war period was marked with a movement in academic economics and the emergence of the Neoclassical Synthesis. As its name suggests, the theory was a combination of Keynes’ and previous economists’ ideas, formalized mathematically, fact avoided by Keynes in the General Theory.

The main differences from Neoclassical to Keynesian theories are that Neoclassical argue the individual`s rationality, and their ability to maximize utility and firms to maximize profit. And, as mentioned above, the wide use of mathematical equations in multifarious aspects of the economy.

Disseminated by Paul Samuelson in his textbook ‘Economics’, the Neoclassical Synthesis’ initial version was the IS-LM model, developed just after the General Theory by John Hicks.

IS-LM Model

The Model, as pointed out by Olivier Blanchard (2009) had important characteristics which weakened Keynes’ insights: “Expectations played no role, and the adjustment of prices and wages was altogether absent” (Blanchard, 2009, p. 603). Keynes believed that there is no flexibility in prices and wages in a short period in time, which also means that industries do not change their prices continually.

In contrast, as asserted by John Hicks (1980-1981, p. 141) his model “was a flexible price model, a perfect competition model, in which all prices were flexible, while in Keynes’ the level of money wages (at least) was exogenously determined. … A full employment model”.

Moreover, while Keynes took in consideration a short period, IS-LM model was an “ultra short period” model, where Hicks wanted to take in consideration reflections of the exact moment rather than a period with too much happenings (Hicks, 1980-1981).

Theory of Consumption, Investment and Money Demand

The consumption theory was created by Franco Modigliani (life cycle theory of consumption), who emphasizes that “consumers’ natural planning horizon is their entire lifetime” and Milton Friedman (permanent income theory of consumption), who states that “consumers look beyond current income” (Blanchard, 2009, p. 358)

In fact, the theory known also as the permanent income hypothesis, states that “…the average propensity to consume is a constant at all income levels once adjustments for transitory’ income has been made. What Friedman argued was that individual saved more from their ‘transitory’ income than from ‘permanent’ income” (Keynes, 2008, p. xxiii)

In other words, the higher the disposable income, the higher will be the consumption. Furthermore, expectations play a major role in determining consumers’ spending in two different ways: firstly consumers must calculate their wealth and make their own expectations regarding interest rates, labour income and so on. Secondly, through stocks, bonds, housing etc, where they just take their value as a given. (Blanchard, 2009, p. 362)

On the other hand, the investment theory developed by James Tobin states that investment decisions are affected by expectations. The relation here lays on the value of profits and the investment. In other words, “As Tobin has explained, aggregate investment can be expected to depend in a stable way on the ratio of the stock market valuation of existing capital to its replacement cost” (Summers et al, 1981,p. 68)

Milton Friedman, on his Money Demand theory, emphasized that “a necessary condition for money to exert a predictable influence on the economy is a stable demand function for money” (Barnett et al, 1992, p. 2086).

Friedman’s point of view comes across the liquidity preference theory drawn by Keynes where capital gains and losses are unpredictable and therefore the demand for money can be affected either by the current income or an increase in the rate of interest.

Growth Theory

The Growth Theory was developed by Robert Solow and Swan in the 1950’s and provide a framework where the determinant driving force for growth is technical advances. According to Aghion and Howitt (1998, p. 11) : “The most basic proposition of growth theory is that in order to sustain a positive growth rate of output per capita in the long run, there must be continual advances in technological knowledge in the form of new goods, new markets or new processes”.

Therefore, in contrast to the Keynesian theory where the increase in saving rate generates a decline in consumption, in the growth theory, the result of high saving rates is an increase in output.

Keynesian versus Monetarists

One of the main leaders of the Monetarists is Milton Friedman who argued the role played by policy and the importance of monetary policy rather than the Keynesian fiscal policy, which argued that monetary measures are not able to lower the rate of interests.

Simon Clarke affirms that “The monetarist counter-revolution has not only abandoned the Keynesian commitment to full employment, but more fundamentally has challenged the Keynesian conception of the role of the state in the regulation of capitalism, returning to the pre-Keynesian emphasis on the primary role of money and the market” (Clarke, 1988, p. 5).

In contrast to the Keynesians, monetarists have the belief that in scenario of restrictive fiscal policy, a reduction in the rate of inflation is not possible without a declining in monetary expansion rate (Stein, 1981)

Moreover, the monetarist theory focused on the debate on the Phillips Curve, which although was not part of the Keynesian theory, could bring about a good explanation of wages and price movements over time (Blanchard, 2009).

Phillips diagram analysed the inverse relation of inflation and unemployment, however the evolution of the curve was disagreed by Friedman and Edmund Phelps, where they argued the inexistence on the relation of unemployment and high inflation.

The third monetarist’s argument was regarding the function of fiscal policy and the use of simple regulations, as argued by Friedman, such as stable and fixed money growth.

Conclusion

In the last few decades Neoclassical economics are being the dominant microeconomics school, alongside with their rational choice theory. And there have been many efforts to mix Keynesian macroeconomics and neoclassical microeconomics, emerging from that the neoclassical synthesis.

However, Neoclassical is often under attacks for not considering human behaviour and forgetting that real people are different from the “economic man” created by this theory. More critics appear about their postulations that do not reflect the truth situations, since humans are susceptible to other extra events. Moreover, their highly mathematical assumptions are considered, for many writers, as condemned to fail once they are unrealistic. . Nevertheless, Neoclassical and Keynesian economics are still competing nowadays, especially after the downturn of 2008/09. When a resurging curiosity amongst the economic class turned to Keynes theory, trying to implement and discuss its ideas of a larger role from the public sector. Even some notorious economists such as Paul Krugman, advocated to employ Keynesian analysis again.

On the other hand many do not embrace this idea of Keynesian policy.

Clearly to see then, that Neoclassical and Keynesian theories are still debated at universities across the world, and the awkward recent downturn restarted that. But, only within a few years and the results from this meltdown has passed then other considerations will be made about those theories.

References

Aghion, P, and Howitt, P, 1998. Endogenous Growth Theory. USA: Library Congress Cataloging-in-Publication Data.

Arnold L, G, 2002. Business Cycle Theory. New York: Oxford University Press.

Barnett, W, A, Fisher, D, and Serletis, A, 1992. Consumer Theory and the Demand for Money. Journal of Economic Literature, Vol. 30, No. 4, pp. 2086-2119.

Blanchard, O, 2009. Macroeconomics. New Jersey: Pearson Education Inc.

Clarke, S, 1988. Keynesianism, Monetarism and the Crisis of the State. UK: Edward Elgar Publishing Ltd.

Hansson, I, 1986. Classical, Keynes’ and Neoclassical Investment Theory – A Synthesis. Oxford Economic Papers, New Series, Vol. 38, No. 2, pp. 305-316.

Hicks, J, 1980-1981. “IS-LM”: An Explanation. Journal of Post Keynesian Economics, Vol. 3, No. 2, pp. 139-154.

Keynes, J, M, 2008. The General Theory of Employment, Interest and Money. New Delhi: Atlantic Publishers and Distributors Ltd.

King, J, E, 2002. A History of Post Keynesian Economics since 1936. Cheltenham, UK: Edward Elgar Publishing Limited.

Snowdon, B,Vane, H, 1997. A Macroeconomics Reader. New York: Routledge.

Summers, L, H, Bosworth, B, P, Tobin, J, and White, P, M, 1981. Taxation and Corporate Investment: A q-Theory Approach. Brookings Papers on Economic Activity, Vol. 1981, No. 1, pp. 67-140.