Differences between Classical and Keynesian Economics
27 June 2017 | Pago Pago, American Samoa
Classical economics looks to the longer run only. Double the money supply and in time prices will double. Recessions and depressions will work themselves out in the long run. There is equilibrium in markets in the long run. Say's law applies so national income always equals consumption plus investment and investment always equals savings, again in the long run.
Keynes disagreed and wanted to know 1) what was the situation in the short run, and 2) do things actually equate out in the long run. In the short run, he concluded everything depends, and 2), no, in the long run matters did not always equate out.
In the classical view, according to Say’s law, supply creates its own demand. Excess income (savings) should be matched by an equal amount of investment by business. Interest rates, wages and prices would always perfectly adjust in the long run. The classical economists believe that markets always clear because prices would adjust through the interactions of supply and demand. Since the market is self-regulating, there is no need to intervene. This is the libertarian, Austrian view. The economy will reach full employment by itself. Just stay out and leave it alone.
Almost no one believes that line of thought anymore which is why the classical and Austrian views are discredited and out of the main stream.
Keynes also disagreed and said markets were not always self-correcting and did not always lead to full employment. Keynes explained why: 1) savings and investments are not always equal because some people hoard part of their savings, 2) producers often lower output and prices to reduce inventories and have quantities demanded get closer to quantities supplied; 3) Reduced aggregate demand from hoarding may increase the unemployment rate and decrease incomes even in the longer run; 4) monopoly power on the part of producers and labor unions would prevent prices and wages to adjust freely as needed. 4) some markets often never reach a stable equilibrium (e.g., currently, oil)
Keynes believed that what happened in the short run affected the anticipated results of classical economists in the long run. Now many economists no longer believe in equilibrium notions or the predictable longer term adjustment results of the classical and Austrian economists. Prediction only works in the very short run.
Keynes has clearly prevailed over the classical school and Austrians, His argument was twofold. The long run never becomes now, and in the long run we are all dead. The classical, Austrian school is only kept alive by those who politically hate government and think it should be shrunk and it should not intervene in the economy.