THE KEYNESIAN vs.

NEO-CLASSICAL SYSTEM
Capitalist economies experience periodic fluctuations in the levels of their employment and
income. These are known as Trade or Business Cycles, and were well known to the Classical
Economists such as Malthus, J.S. Mill, etc.
However the Neo-classical economists ignored these. They analysed market equilibrium by
assuming that market prices will always ensure full employment and full use of all resources.
If Supply exceeds Demand, prices will fall, and if D > S, then prices will rise, and
equilibrium will be achieved. So there is no need to have any govt control on the economy.
The Great Depression of 1929-36 proved there must be a flaw in the Neo-Classical Economic
Theory. Here prices and employment levels were falling, as also NY and rate of interest.
John Maynard Keynes pointed out that Micro solutions cannot be used to solve Macro
Economic problems. His theory, known as Keynesian Economics showed that Aggregate
Demand is the important factor that determines the level of income, and employment in a
fully developed, capitalist economy.
Keynes showed how various assumptions made by the neo-classical economists would not
work in a Macro situation.
1. Wage rate and Unemployment: Pigous Law:
According to the Neo-classical economists, unemployment was the result of high wage rates.
According to Pigou, if wage rates are reduced, employment will increase up to the level of
full employment.
In the diagram, wage rates and output are estimated on the Y axis, and employment on the X
axis. Given the MP of labour, a high wage

Wage rate

rate at W1 leads to employment of L1. But if

A

wage rate falls to W2 then employment can

W1

increase to L2.

W2

Thus the Neo-classical

economists recommended wage cuts during

unemployment situation to bring about full

L1
Employment

employment.

L2

But Keynes pointed out the error of this

MPL

argument. That is to confuse the Micro or Firm level analysis, with Macro or Aggregate
analysis. In Micro Economics, if a firm reduces its wage rate it can increase employment. But
at the Economy level, if all firms reduce their wage rates, then National Income falls.
Keynes argued that as the income of the people across the economy is reduced, it will lead to
fall in consumption expenditure. This will lead to fall in Aggregate Demand. As Demand
falls, firms will be unable to sell their goods, so they will reduce their production and
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investment, by removing some labour. As unemployment increases, national income falls,

consumption expenditure falls, and Aggregate Demand falls. This process will go on until the
economy reaches a Depression.
Therefore applying Micro Economics principles to Macro Economics does not solve Macro
problems, but only worsens the situation. Another difficulty is that in fully developed
capitalist economies, the trade unions will not allow the wage rate to fall. Thus wage rates are
sticky upwards.
2. Says Law of Markets:
According to the Neo-classical Economist, J.B. Say, Supply creates its own Demand. This
means that Aggregate Supply will always equal Aggregate Demand, and there can be no over
or under production in an economy.
For example: if Rs.1000 crores of output is produced, then Rs.1000 crores worth of income is
created. This creates demand for Rs.1000 crores of goods, which will be equal to the value of
output produced. So the system will always be in equilibrium. Even if some of this amount is
saved, as Savings equals Investment, the system will again reach equilibrium.
Output =
Rs.1000 crores

Figure 1. Says
Law of Markets
Expenditure (C + I) =
Rs.1000 crores

Income =
Rs.1000 crores

Keynes pointed out the error of this theory. In the first case all Savings need not be invested.
This is because the savers and the investors are two different sets of persons. Those who save
are not those who invest. So, Savings represents a Leakage from the Economy.
For example, if Rs.100 crores is saved, then demand will only be Rs.900 crores. The firms
will have to pile up inventories of Rs.100 crores (goods that are not sold). This will
discourage them from investing more next year, and they will invest only enough to produce
Rs.900 crores of goods. Since they reduce their investment, income and employment will also
fall. In the next round, the lower income will lead to again fall in expenditure, and aggregate
demand will fall short of aggregate supply, discouraging further investment, and so it goes on
till the economy falls into a depression.
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Secondly, ex ante Savings are not equal to ex ante Investment. Savings are a leakage out of
the economy. Investment is done independently by firms, regardless of the levels of savings,
which are done by households. This Investment leads to increase in NY, and when NY
increases then Savings also increase. So causation is from I S ex post. The causation is
from Investment to Savings, not Savings to Investment.
3. Instability of Capitalist Systems:
If Total Expenditure and Total Production in an economy are not equal, then such economies
are not in equilibrium as assumed by the Neo-classicals.
Secondly, there even if there is equilibrium, it is not stable, but can change with changes in
investment decisions by entrepreneurs. There is always the possibility of going into recession.
Thirdly, the equilibrium need not necessarily be with full employment, and
If economies are inherently unstable, then three outcomes are possible:
o The economy can come to equilibrium at a level of production lower than full
employment (Recessionary Gap)
o The economy can come to equilibrium at a level of production at full employment, or
o The economy can come to equilibrium at a level of employment above equilibrium
(Inflationary Gap)
4. Laissez Faire:
Since the Neo-classicals assumed that the economy can correct itself automatically through
adjustments of the Market Prices, they felt that there should be no Govt interference, i.e. there
should be a policy of laissez faire.
But Keynes showed that the Market cannot achieve full employment equilibrium. Therefore
Govt has to interfere and undertake investments to correct the disequilibrium situation.
Key Differences between Neo-Classicals & Keynes
In Neo-Classical Economics:
o Free market economies are always stable
o Tending toward full employment & full production equilibrium
o Freely fluctuating prices in the three major macro markets ensure this
o Government had no role in management of the economy Laissez-faire or
do nothing
In Keynesian Economics:
o Free market economies are unstable
o Equilibrium can be achieved but not always with full employment/full
production
o Demand becomes a much bigger driving force
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o Supply will always adjust to Demand

o Under Keynes, Government must step in to correct the inherent instability of
the economy
If the economy faces a recessionary gap (equilibrium at less than full
employment) Government must increase demand by spending more;
lowering taxes; lowering interest rates; increasing welfare
If the economy faces an inflationary gap (equilibrium at a level higher
than full employment), Government must reduce demand by spending
less; raise taxes; increase interest rates; reducing welfare.
1. Multiple Questions:
1. Periodic fluctuations in the level of income and employment in capitalist economies is
called:

a) Business Cycles b) Cob web cycles c) Periodic cycles d) Income cycles

2. In the Neo classical model, the economy would always achieve:
a) Recession

b) Full employment

c) Inflation

d) Unemployment

3. Keynes showed that wage cuts during recession will lead to:

a) Full employment b) Increase in demand c) Decrease in demand d) inflation

4) According to Keynes what is required to correct recession?
a) Free market b) Government intervention

c) taxation d) fall in rate of interest

5) In Keynesian theory, equilibrium of the economy can be achieved at:

a) Only full employment b) Never achieved c) Free markets d) Not always with
full employment
II. Fill in the Blanks:
1. According to Says Law, _______________ creates its own Demand.
2. Keynes showed that free enterprise economies were basically ______________.
3. In Keynesian theory causation is from Investment to _______________.
4. When equilibrium is achieved at greater than full employment it is known as
________________________ gap.
5. During deflation, the government should ____________________ taxes.
III. Short Answers: (5 lines)
1. Pigous law
2. Laissez faire
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3. Recessionary gap
4. Savings Investment relationship
5. Trade cycles