The business cycle: Classical-Keynesian controversy
The purpose of this topic is show two alternative views of the business cycle and the major problems of unemployment and inflation. The classical theory is first presented. The Keynesian view is offered as a critique of the classical theory.
Contents
- 1 Classical theory
- 2 Say's law
- 3 Classical money market
- 4 Price and wage flexibility
- 5 Involuntary unemployment
- 6 Classical-Keynesian controversy
- 7 Keynesian saving-investment plans
- 8 Keynesian price-wage rigidity
- 9 Aggregate demand
- 10 Real balance effect
- 11 Aggregate supply
- 12 Classical range
- 13 Keynesian range
- 14 Intermediate range
- 15 Aggregate demand policies
- 16 Supply side policies
Classical theory
The classical theory is essentially the laissez faire belief of pure capitalism. In this view, business cycles are natural processes of adjustment which do not require any action on the part of government.
Say's law
Say's law proposes that supply creates its own demand. This means that the income derived from producing certain goods by some, allows them to purchase goods produced by others. Since all people have a need to purchase goods, they will seek to produce some goods to derive income and buy whatever they want. Thus the product markets will always necessarily be in equilibrium.
Classical money market
If some income happens not to be consumed immediately it will enter the money market as a saving. This saving will be put back into the economy as investment (i.e increase in capital) when it is borrowed. The interest paid by borrowers to savers assures that no saving will be idle. The money market equilibrates through an adjustment in the interest rate.
Price and wage flexibility
The classical theory proposes that all markets reequilibrate because of adjustments in prices and wages which are flexible. For instance, if an excess in the labor force or products exist, the wage or price of these will adjust to absorb the excess.
Involuntary unemployment
The classical theory proposes that no involuntary unemployment will exist because an adjustment in the wage rate will assure that the unemployed will be hired again. In addition, the need of workers to buy goods will encourage them to accept work at even the lower wage rates.
Classical-Keynesian controversy
Keynesian employment theory is built on a critique of the classical theory. In this critique, Keynes argued that savers and investors have incompatible plans which may not assure that an equilibrium exists in the money market, that prices and wages tend to be rigid and equilibrium may not exist in the product and labor markets, and that periods of severe unemployment have occurred (which the classical theory denied).
Keynesian saving-investment plans
Keynes showed that savers and investors are separate groups which do not necessarily interact: financial intermediaries (banks) are in between. When a recession is present, investment may not be equal to saving because, although the interest rate is very low, 1) borrowers have poor sales prospect, 2) banks are afraid of lending because of potential bankruptcy, and 3) savers want to wait for higher returns. This causes a liquidity trap: some saving is idle.
Keynesian price-wage rigidity
Keynes argued that prices and wages are not flexible as the classical theory asserts. Wages tend to be rigid on the down side because workers will not accept wages which do not permit them to live adequately; this is reinforced by the actions of unions. If wages are too low, unemployment will exist. In the case of prices, firms producing large tag items prefer to cut production and lay off workers than cut price. Their monopoly power often permits them to act that way.
Aggregate demand
Aggregate demand shown graphically represents the sum total of what household are willing and able to buy at different level of the price level.
Real balance effect
Aggregate demand curve is downsloping because of the real balance effect. If prices are higher than averages, then the purchasing power of monetary assets decreases and individuals tend to feel poorer and buy less. If prices are lower than historical price averages, the purchasing power of monetary assets increases, individuals tend to feel wealthier and buy more.
Aggregate supply
Aggregate supply is made of three sections: the classical range is vertical, the Keynesian range is horizontal and the intermediate range is upsloping.
Classical range
The classical range of aggregate supply is vertical because of the proposition of the classical theory that prices will adjust so that output is always at full employment. In this range, expanding aggregate demand will cause inflation, while contracting aggregate demand will reduce inflation.
Keynesian range
The Keynesian range of aggregate supply corresponds to the proposition that when price are very low, firms will prefer to cut production rather than sell at a loss. In this range, any change in aggregate demand will produce a change in output. Thus, in the case of a recession the correct government policy is to expand aggregate demand.
Intermediate range
This intermediate range of aggregate supply represents the case of preliminary inflation (or sectoral inflation): when demand and output expand, some sectors of the economy may experience bottlenecks and require that prices increase because output cannot.
Aggregate demand policies
When the intersection of aggregate demand and aggregate supply occurs in the Keynesian horizontal range a recession and excessive unemployment are present: the recommended policy would be to stimulate aggregate demand. When the intersection is in the classical vertical range, inflation is present: the recommended policy would be to contract aggregate demand.
Supply side policies
Supply side policies can be shown by attributing periods of stagflation (high prices and low level of output) to upward shifts of aggregate supply. The recommended policy would then not be an increased aggregate demand which adds to inflation, but instead a shift in aggregate supply downward by cutting costs of production.