Classical and Keynesian Models of Income Determination Compared

A comparison of the classical and the Keynesian models of income determination are given below:

The classical and the Keynesian models, given above in the notational form, refer to the working of the macro – level economic system in three markets, i.e. product, labour and money.

All the equations are functions of real values. Equations (1) to (5) deal with the product market; equations (6) to (8) with the labour market; and equations (9) and (10) with the money market.

1. Conditions for Equilibrium:

Equations (1), (4), (8) and (10) in both the systems express the conditions for equilibrium. Total income (or aggregate supply) = total expenditure (or aggregate demand) comprising total consumption expenditure and total investment expenditure (Y = C + I), and saving = investment (S = I) clear the product market; demand for labour = supply of labour (D_L = S_L) clears labour market; and money demand = money supply (M_d = M_s) clears the money market.

2. Say’s Law:

Say’s law which states that supply creates its own demand implies that a competitive capitalist system has a self- adjusting mechanism that assures full-employment of labour and other resources in the long run. In other words, full-employment output will be produced and purchased in a capitalist economy and the possibility of general overproduction does not exist.

Keynesian model has been developed as a reaction against the classical model. Keynes attacked not the logical consistency of the classical economic theory, but its empirical premises. According to him, the classical theory is perfectly logical, but it is incapable of solving the actual economic problems.

3. Assumptions:

Keynes attacked the fundamental assumptions of the classical model:

(a) The classical belief that full-employment equilibrium will be reached in the long run is not acceptable to Keynes, who wants to solve the short run problems. Keynes’ economics is short-run economics.

(b) The Great Depression of 1930s provides Keynes sufficient proof to believe that the economy is not self-adjusting; that full-employment equilibrium will not be automatically achieved in the short-run; and that government intervention is necessary to tackle the economic problems of the economy.

However, Keynes wanted to reform and not to destroy capitalism. In his analysis, he retained many of the traditional assumptions. (a) He based his analysis on the assumption of rationality. Producers seek profit- maximisation in Keynesian world as did in the classical world. (b) Keynes continued to deal with competitive market conditions, (c) He made extensive use of marginal analysis in his analysis, (d) Like the neoclassical economics the economics of Keynes was essentially static in nature. He took population, technology, organisation and equipment as given, (e) Despite his emphasis on the state intervention, Keynes accepted the existing institutions as given.

4. Labour Market:

According to the classical model- (a) wage rate flexibility (through its effect on demand for and supply of labour) assures full- employment and as a result general unemployment does not exist. (b) Demand for labour is a negative function of real wage f’ = F (W/P). (c) Supply of labour is a positive function of real wage [N = N (W/P)].

Keynes’ position regarding the labour market is:

(a) He accepts the classical demand for labour as a negative function of real wage [f’ = F (W/P)]. But he did not favour wage reduction as a proper method of increasing employment. Wages are a double-edged weapon.

A reduction in wages, if, on the one hand, produces favourable effect on employment through reduction in costs and prices, also, on the other hand, reduces income of the workers, which in turn decreases aggregate demand and hence employment.

(b) Keynes assumed that wages are rigid downward (W > W₀) because workers suffer from money illusion. This means that they are not willing to work at reduced money wages (meant for reducing real wages), but they are willing to work at lower real, wages brought about by a rise in prices. The supply of labour, thus, depends on nominal and not real wages. Powerful trade unions or minimum wage laws also lead to the downward rigidity of wages.

5. Product Market:

In the classical model (a) Aggregate production is a function of labour [Y = f(N)] and the law of diminishing marginal returns operates. (b) Interest rate flexibility, by equalising saving and investment plans, ensures that full-employment output is purchased in the product market, (c) Saving is a positive function of real interest rate. (d) Investment is a negative function of real interest rate.

Keynes’ views about the product market are:

(a) Like the classical economists, Keynes also believes that aggregate production is a function of labour, i.e., labour is the only variable factor of production and the law of diminishing returns operates.

(b) Real saving and real consumption are determined primarily by real income and by rate of interest [S = S (Y, i)). Net investment is also determined primarily by profit expectations which, in turn, depend upon income [I = I (Y, i)].

(c) If neither saving nor investment is determined only by interest rate, then changes in the interest rate cannot equalize them. Hence, there is no assurance that a full-employment output will be purchased in the product market.

6. Saving – Investment Equality:

In the classical model, rate of interest is the equilibrating force between saving and investment. If there is a tendency for saving to exceed investment, then the rate of interest will fall. This will encourage investment and discourage saving, thus, making the two equal. Similarly, if investment exceeds saving, the rate of interest rises. As a result, investment is discouraged and saving encouraged, and the two are once again equal.

According to Keynes, income and not the rate of interest is the equilibration force between saving and investment. When saving exceeds investment, aggregate demand decreases and income level declines. As a result, saving falls and becomes equal to investment. If investment exceeds saving, income level rises, saving increases and becomes equal to investment.

7. Money Market:

According to the classical model:

(a) Assuming output (Y) at full-employment level and the velocity of money (V) to be constant, Irving Fisher’s equation of exchange, i.e., MV = PY, indicates that there is a direct and proportionate relationship between the supply of money (M) and the price level (P).

(b) Money is neutral. Since money has been regarded only as a medium of exchange, change in money supply affects the absolute and not relative prices. Thus, real variables, like employment, output etc., are not affected.

Thus, the classical economists dichotomised the price process by maintaining that the relative prices are determined in the commodity market and the absolute prices are determined in the money market,

(c) According to the cash balance approach, the value of money is determined by the demand for holding money. People hold money for transaction motive (i.e., for day-to-day transactions) and precautionary motive (i.e., for meeting emergencies) and the demand for money for these motives is a function of income (L₁ = kY).

Keynes not only criticised the classical quantity theory of money but completely reformulated and generalised it.

(a) When there is unemployment of resources, an increase in the quantity of money increases Output and employment and affects prices very little and that too indirectly. An increase in the quantity of money reduces the rate of interest which increases investment and thus raises income, output and employment.

With the rise in output, cost of production increases which leads to a rise in prices. Thus, Keynes integrates the theory of money with the theory of value,

(b) Once, the full-employment level is reached, further increase in the quantity of money leads to a direct and proportionate increase in prices. It does not affect the real factors. Keynes argues that real inflation starts only after full employment,

(c) Keynes develops a monetary theory of interest according to which the rate of interest is determined by the money supply and the Keynesian demand to hold money in cash (liquidity preference), given the income level. Keynes gave three reasons for holding cash: transaction motive, precautionary motive and speculative motive.

The demand for money for transaction and precautionary motives depend upon the level of income and demand for speculative motive depends upon the rate of interest. An inverse relationship exists between the interest rate and the demand for money for speculative motive [L₂ = L₂ (i)]. Thus total demand for money becomes- L = L₁ + L₂ = kY + L₂ (i).

8. Policy Implications:

In the classical self-regulating economic system, there is no room for government intervention through monetary or fiscal policies. However, since, the classical economists recognise the existence of frictional unemployment representing a disequilibrium situation; they assigned a modest stabilising role to monetary policy to deal with the disequilibrium situation.

They prefer monetary policy to fiscal policy because the role of fiscal policy as a stabiliser of the economy is considered either negligible or redundant.

Keynes, who believed that a capitalist economy contains no self- regulating mechanism that assures full employment, assigned an important role to government in the stabilisation of the economy. He considers monetary policy to be less effective as compared to the fiscal policy.

Whereas government expenditure has a direct effect on investment, output and employment, money affects these variables only indirectly and unpredictably. Because of- (a) elastic liquidity preference function insensitive to changes in money supply and (b) inelastic investment function insensitive to changes in the interest rate, monetary policy is ineffective in recession.