Essay on "Keynesian and Classical Economic Schools of Thought Compare and Contrast"

Essay 3 pages (1043 words) Sources: 2

[EXCERPT] . . . .

Classical vs. Keynesian economic theory

Classical economic theory was the generally accepted economic paradigm until the Great Depression. Classical economics is said to have begun with the publication of Adam Smith's influential 18th century treatise the Wealth of Nations. In this text, Smith states that the 'invisible hand' of the market should be allowed to govern human economic decision-making. Producers supply their product to meet consumer demand, and the market arrives at a fair equilibrium price naturally. When consumers are willing to pay more, suppliers make more goods. As price goes up, demand goes down. As price goes down, demand goes up, but producer's willingness to produce more goods goes down as well. These assumptions were challenged by the spiraling downward of the economy after the 1929 stock market crash.

While classical economists did recognize that there were boom and bust cycles within the free market economy, they believed that these cycles would be naturally corrected if the business cycle was left to run its course. Eventually, prices would become so low during a recession consumers would begin to buy goods and services again. However, the great economist John Maynard Keynes stated this was not always the case. Consumers during a severe economic contraction would wisely fear for their jobs and 'hide their money' under the mattress, according to Keynes. This policy, while wise for the individual, was unwise for the economy, and would cause consumption to plummet still further. More individuals would be laid off, only intensifying the cycle. Even investors would 'hide their money' under the mattress -- i.e., not invest in commerce and infrastructure -- given the turbulent economic climate.

Ironically, wages that were too high may have intensified the Great Depression. Wages were supposed to plummet during a recession, according to conventional classical wisdom. However, wage rates were constant until 1931, which effectively meant in an environment of rapidly decreasing prices, wages had gone up. Wages proved to be 'sticky' to changes in the economy, yet consumers did not spend their additional money, and layoffs continued to increase. Adding to the problem was that the United States was still on the gold standard, which meant that the amount of money it could print was limited by its amount of gold reserves. The Federal Reserve was forced to adopt a deflationary economic policy to remain on the gold standard: to be fiscally responsible it increased its discount rate, the rate at which member banks could borrow from the central bank, effectively raising the interest rate the banks were forced to charge to consumers (Smiley 2008). The economy thus continued in its downward spiral of allowing less money for investment, decreased production, increased unemployment, and decreased consumer demand.

The solution to this spiral was government spending, according to the Cambridge-educated British economist John Maynard Keynes: "Keynes believed that consumption was the key to recovery and savings were the chains holding the economy down. In his models, private savings are subtracted from the private investment part of the national output equation, making government investment appear to be the better solution. Only a big government that was spending on behalf of… READ MORE

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