Abstract

This paper explains the Classical and Keynesian Theory of Economics. The understanding of
difference between these two perspectives for the economic analysis and decision making for the
financial inclusion of the country stands at its utmost importance. The 2008 crisis was one of the
largest financial disaster for the world and these two theories played an important role in
understanding and slowing the disaster.

Introduction

Economics plays an important role in the financial decision making for not only on micro level

but also at macro level. In economics two theories pertaining different perspectives contains two

different set of thoughts, providing steps for a sound decision for the country’s financial

decisions on two different levels are Classical and Keynesian theory. The 2008 crisis in the

financial markets of the world contained with itself a huge disaster for employment, income,

standard of living, manufacturing industries, service industries etc.

Classical and Keynesian theories are two theories based different set of minds with different

principles. On monetary policy both of the theories have their own understanding and provide

unique thinking in tackling the management of financial products.

In order to understand these two different perspectives, their history and founders to be explained

fully.

Classical Theory

Classical Economic Theory came into reality in the 18th Century when the industrialization was

at its peak. The main point of Classical economic theory, to much extent define its understanding

as “supply makes its own demand”. This theory is totally based on the supply side perspective

and Laissez – Faire market. It means that the market according to Classical theory should be set
free because the market has the ability to adjust to equilibrium by itself. The rational consumers

in the market will eventually be at the equilibrium point because of the self-governing nature of

the markets. Classical theory believed that there should be no involvement of any other party i.e.

Government in the process/execution of the market. This theory believed that the

noninvolvement of any third party i.e. Government for the financial decisions will free hand the

market and the market will govern itself due to the consumer’s nature of always acting in their

self-interests. Classical theory does less focus on government spending however, it focuses more

on the financial investments and the consumer spending nature (Woodruff, 20199).

Classical theory basically explains the perspective of limiting the government intervention in the

market because of the belief that market govern themselves due to the rational consumer

spending and consumers always spending in their self-interest. This theory possess an Inelastic

supply curve because it contains of the view that in the long run market will always adjust itself

and will cause equilibrium.

Keynesian Theory

During the tenure of Great Depression in the 1930’s, Classical theory was challenged due to its

excellence in providing the long term effects but discarding the short term effects of the

decisions on the operations of the market (Davies, 2011). An Economist named John Maynard

Keynes challenged the theory and explained the facts that after the Great Depression markets are

not stabilizing as stated by the Classical theory. The short run effect on the labor market was

being neglected and the equilibrium stage as stated by the classical theory was not being

achieved. Keynes basically pointed out the fact that the unemployment is calculated by the

output of economy and this output is determined by the total spending of the customers. The total
output is what explains about the employment and unemployment in the labor market

(Woodruff, 20199).

In case of the intervention of Government in the economic decision for the market is supported

by this theory. This theory explains that the Role of Government in the decisions of market is

very important because the markets does not settle itself due to the change in nature of

consumers. The invisible hand cannot govern the market due to its inefficiency in analyzing the

other factor effecting the equilibrium of the market. This theory is of the view that the

Government intervention can improve the financial standing of the market and can prove to be n

authority over the market in order to save it from exploitation (Christiano, 2017).

2008 Crisis and Economic Theories

The 2008 Recession brought with itself a huge financial disasters not only for the US market but

also effecting different parts of the world. The unemployment increased, consumer spending

decreased, a huge real estate crisis and the monetary effects of shadow banking were just the

initial stages of this crisis. Economists and Policy Makers were unable to detect the financial

problems and were also unable to predict a crisis as large as it was (Christiano, 2017).

However, the economists around the world were fonder of the Keynesian theory due to its

efficiency in countering the negative effects of recession in the shorter run. The employment rate

was decreased at a much higher rate and there was a solution highly demanded by the

economies. Keynesian theory provided a much reasonable solution due to its principle of

involving the Government in controlling the markets (Stiglitz, 2013).

The other effect of this recession in the market was the activity of consumers involving in more

savings and less investing. This caused the interest rates to fluctuate to a negative level, however
the interest rates cannot be negative so the effect was mainly on the output and income of the

parties involved in the markets. This put the markets an usher need for the involvement of

government in regularizing the markets. The people were more prone to save due to lower

employment and lower investment returns causing a hue disturbance to the banking market.

The shadow banking was one of the major cause of causing recession the world’s economic

market. This means the banking activities were carried out through the steps outside the

regulatory framework. To Control this shadow banking there was a strict need for the

government to intervene and control the financial transactions (Stiglitz, 2013).

Conclusion

Classical theory and Keynesian theory differs in many ways due to difference in their approaches

to solve the financial markets distress. The classical theory deals in the long term effects and

defines the fact of markets stabilizing itself due to the invisible hand / self-sustaining nature.

However the approach of Keynesian theory mainly deals with the short term effects of the

market fluctuations. The 2008 crises was a major setback to the financial market, however

classical theory after being failed in self-sustaining the markets, demanded an intervention of

government in regularizing the market’s operation proved the wrathfulness of Keynesian theory.

References
Christiano, L. J. (2017). Why it happened, endured and wasn’t foreseen. And how it’s changing theory.
The Great Recession: A Macroeconomic Earthquake. Retrieved from
https://www.minneapolisfed.org/research/economic-policy-papers/the-great-recession-a-
macroeconomic-earthquake#_ftn7
Davies, G. (2011, May). The classical view of the global recession.
Stiglitz, J. (2013). After the financial crisis we were all Keynesians – but not for long enough.
Woodruff, J. (20199). Differences Between Classical & Keynesian Economics.