Keynesian Vs. Classical Economics Notes
John Maynard Keynes published “The General Theory of Employment, Interest, and
Money” in 1936 during the Great Depression. He advocated government intervention in
an attempt to smooth out the business cycles since they did not seem to be correcting
themselves.
Keynesian: John Maynard Keynes
1. Economy will not self-correct.
 Savings will lead to the “Paradox of Thrift” people as individuals will save more
and so no spending will happen resulting in everyone having less money and so
total savings goes down.
 Keynes claimed that prices and wages were sticky and could not change that
quickly, so there will be no natural correction.
 People are motivated by “animal spirits”
2. Given that the economy will not self-correct we need to stimulate it:
 Monetary policy is not enough because once enough money has been injected into
the economy then injecting more won’t influence people (liquidity trap)
 So you need expansionary fiscal policy: More government spending, lower taxes
which will lead to a budget deficit: We should run budget deficits during
recessions and budget surpluses during expansions (raising taxes and reducing
government spending) to even out the business cycle (Up until Keynes the
government had tried to run a balanced budget, including during the Great
Depression where they raised taxes to pay for all their spending).
 This expansionary policy will have a multiplier effect
Classical: Friedrich August Hayek (F.A. Hayek)
Economy will self-correct:
1. when recession hits:
 people save more which lowers interest rates and that stimulates investment and
spending
 Wages go down and that causes people to hire more and expand output and the
economy will correct itself fairly quickly (prices going down also stimulates
people to buy).
 People are motivated by economic calculation
2. Given that the economy will self-correct, no expansionary policy is needed.
 Further more expansionary policy is dangerous in that, politically, it is tough to
impose than take away. Politicians have the incentive to run budget deficits all of
the time leading to large amounts of debt.
 Changing taxes and government spending takes a lot of time and is subject to
timing lags:
1. Recognition lag: have to recognize where the economy us headed (our ability
to forecast the economy is pretty bad – in the last 50 years the index has
correctly predicted each of the last 8 recessions. It also predicted 5 recessions
that did not happen).
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2. Administration lag: Once recognized the government has to legislate this stuff
into action.
3. Impact lag: once enacted these things have to work through the economy
which takes time.
Multiplier will only happen if it uses unemployed resources, using employed
resources does not create jobs, but rather shifts them around (broken window
fallacy).
Mistiming this policy will make the economy less stable and lead to a large
number of unintended consequences