The economists who generally oppose government intervention in the functioning of aggregate economy are named as classical economists. The main classical economists are Adam Smith, J. B, Say, David Ricardo, J. S. Mill. Thomas.
The economists who are in favor of general intervention by the state in the aggregate economy are named as Keynesian economists (Alvin Nansen, Paual Samuelson, Tinbergen, R. Frisch etc.,).
The main points of contrast (difference) between the classical and Keynesian theories of income and employment are discussed in brief as under:
The classical economists explained unemployment using traditional partial equilibrium supply and demand analysis. According to them:
“Unemployment results when there is an excess supply of labor at a particular higher wage level. By accepting lower wages, the unemployed workers will go back to their jobs and the equilibrium between demand for labor and supply of labor will be established in the labor market in the long period. This equilibrium in the economy is always associated with full employment level. According to the classical economists, unemployment results when the wage level of the workers is above the equilibrium wage level and as a result, thereof, the quantity of labor supplied is higher than quantity of labor demanded. The difference between the two (supply and demand) is unemployment.
J.M. Keynes and his followers, however, reject the fundamental classical theory of full employment equilibrium in the economy. They consider it as unrealistic. According them:
“Full employment is a rare phenomenon in the capitalistic economy. The unemployment occurs, they say, when the aggregate demand function intersects the aggregate supply function at a point of less than full employment level. Keynes suggested that in the short period, the government can raise aggregate demand in the economy through public investment programs to reduce unemployment”.
(2) Say’s Law of Market:
According to Say’s Law ‘Supply creates its own demand’, is central to the classic vision of the economy. According to French classical economist, J.B. Say, the production of goods and services generates expenditure sufficient to ensure that they are sold in the market. There is no deficiency of demand for goods and hence no need to unemployed workers. According to him, full employment is a normal condition of market economy.
J.M. Keynes has strongly refuted Say’s Law of Market with the help of effective demand. Effective demand is the level of aggregate demand which is equal to aggregate supply. Whenever there is deficiency in aggregate demand (C + I), a part of the goods produced remain unsold in the market which lead to general over production of goods and services in the market. When all the goods produced in the market are not sold, the firms lay off workers. The deficiency in demand for goods create unemployment in the economy.
(3) Equality between Saving and Investment:
The classical economists are of the view that saving and investment are equal at the full employment level. If at any time, the flow of savings is greater than the flow of investment, then the rate of interest declines in the money market. This leads to an increase in investment. The process continues till the flow of investment equals the flow of saving. Thus, according to the classical economists, the equality between saving and investment is brought about through the mechanism of rate of interest.
J.M. Keynes is, however, of the view that equality between saving and investment is brought about through changes in income rather than the changes in interest rate.
(4) Money and Prices:
The classical economists are of the opinion that price level varies in response to changes in the quantity of money. The quantity theory of money seeks to explain the value of money in terms of changes in its quantity.
J. M. Keynes has rejected the simple quantity theory of money. According to him, if there is recession in the economy, and the resources are lying idle and unutilized, an increased spending of money may lead to substantial increase in real output and employment without affecting the price level.
(5) Demand for Money:
According to classical economists, money is only demanded to make regular expenditure under the need transactions demand.
The Keynesian economists are of the view that people hold money for transaction as well as speculative purposes. So far ‘transaction demand’ for money is concerned, it is a function of income. The higher the income, the higher is the transaction demand for money and vice versa. The speculative demand for money is a function of rate of interest. The higher the interest rate, the lower is the money balances which the nation holds for speculative purposes and vice versa.
(6) Short and Long Run Analysis:
The classicists believed that a market economy, through flexible interest rates, wages, and prices, return to a state of full employment in the long run.
J. M. Keynes played a major role in suggesting as to how the government can reduce cyclical fluctuations through stabilization policies. Keynes analysis of economic problems is confined to short run. Keynes says, ‘Let us forget the long run and focus on the short run. In the long run, we are all dead’.
(7) Role of State in achieving High Level of Income and Employment:
The classical economists are of the view that in commodity and labor market, the price mechanism works with reasonable promptness. The supply adjusts to demand through the flexible interest rates, wages and prices and the economic system returns to a state of full employment in the long run without government intervention.
J.M. Keynes puts less faith in market forces. He stressed and argued for more direct intervention by the state to increase or decrease aggregate demand to achieve certain national economic goals. J. M. Keynes considered fiscal policy as a steering wheel for moving the economy to a state of higher level of employment and price stability more quickly. If aggregate income is low and below the target national income, then appropriate expansionary fiscal policy should be adopted. Expansionary fiscal policy involves decreasing taxes and increasing government spending. In case the aggregate income is higher or above the potential level, then contractionary fiscal policy i.e. increasing taxes and decreasing government spending should by taken up by the state.
(8) General vs Special Theory:
The classical theory is based on four unrealistic assumptions (i) role of the government in the economy should be minimum (ii) all prices and wages and markets are flexible (iii) any problem in the macro economic is temporary (v) the market force come to the rescue and correct itself. The market mechanism eliminates over production and unemployment and establishes full employment in the long run. The classical theory relates only to the special case of full employment.
J. M. Keynesian theory is a general theory. It has a wider application on all such situations of unemployment, partial employment and near full employment.