Classical and Keynesian models of macroeconomic equilibrium

In the world economic literature, two main directions of the mechanism for regulating national production in market conditions can be distinguished. The first is the classical direction of automatic self-regulation of the market system. Its representatives are D. Ricardo, D. St. Mill, F. Edgeworth, A. Marshall, A. Pigou. The second is Keynesian, proceeding from the need for mandatory state intervention in the market system, especially in conditions of depression. Accordingly, two models of macroeconomic equilibrium have developed in these areas.

The classical model of macroeconomic equilibrium prevailed in economics for about 100 years, until the 30s of the XX century. It is based on the law of J. Say: the production of goods creates its own demand. For example, a tailor produces and offers a suit, and a shoemaker offers shoes. The supply of a suit to tailors and the income that he receives is his demand for shoes. Similarly, the supply of shoes is the demand of a shoemaker for a suit. And so in the whole economy. Every manufacturer at the same time is a buyer – sooner or later he acquires goods produced by another person for the amount earned from the sale of his own goods. Thus, macroeconomic equilibrium is ensured automatically: everything that is produced is realized. This similar model assumes the fulfillment of three conditions:

each person is both a consumer and a producer; all producers spend only their own income; income is spent in full.

But in the real economy, part of the income is saved by households. Therefore, aggregate demand decreases by the amount of savings. Consumption expenditures are insufficient to purchase all manufactured products. As a result, unsold surpluses are formed, which causes a decline in production, an increase in unemployment and a decrease in incomes.

In the classical model, the lack of funds for consumption caused by savings is compensated by investment. If entrepreneurs invest as much as households save, then the law of J. Say applies, i.e. the level of production and employment remains constant. The main task is to encourage entrepreneurs to invest as much as it takes to save. It is solved in the money market, where supply is represented by savings, demand by investments, price by the interest rate. The money market self-regulates savings and investments through an equilibrium interest rate (Figure 8.13).

The higher the interest rate, the more money is saved (because the owner of the capital receives more dividends). Therefore, the savings curve (S) will be upward. The investment curve (I), by contrast, is top-down, as the interest rate affects costs and entrepreneurs will borrow more and invest more cash at a lower interest rate. The equilibrium rate of interest (R0) occurs at point A. Here, the amount of money saved is equal to the amount of money invested, or, in other words, the amount of money offered equals the demand for money.

If savings increase, the S curve will shift to the right and take the position of S1. Although savings will be greater than investment and cause unemployment, a surplus of savings implies a reduction in the interest rate to a new, lower equilibrium level (point B). A lower rate of interest (R1) will reduce the cost of investment until it equals savings, reducing full employment.

The second factor that ensures equilibrium is the elasticity of prices and wages. If for some reason the interest rate does not change with a constant ratio of savings and investments, then the increase in savings is compensated by lower prices, as producers seek to get rid of surplus products. Lower prices allow for fewer purchases, while maintaining the same level of production and employment.

In addition, a decrease in demand for goods will lead to a decrease in demand for labor. Unemployment will cause competition and workers will accept lower wages. Its rates will decrease so much that entrepreneurs will be able to hire all the unemployed. In such a situation, there is no need for state intervention in the economy.

Thus, classical economists proceeded from the flexibility of prices, wages, interest rates, that is, from the fact that wages and prices can move freely up and down, reflecting the balance between supply and demand. In their opinion, the aggregate supply curve of AS has the form of a vertical straight line, reflecting the potential volume of GNP production. A decrease in price entails a decrease in wages, and therefore full employment is maintained. There is no reduction in the value of real GNP. Here, all products will be sold at other prices. In other words, a decline in aggregate demand does not lead to a decrease in GNP and employment, but only to a decrease in prices. Thus, the classical theory holds that the economic policy of the state can only affect the price level, and not the volume of production and employment. Therefore, its interference in the regulation of output and employment is undesirable (Figure 8.14).

In the early 30s of the XX century, economic processes ceased to fit into the framework of the classical model of macroeconomic equilibrium. Thus, the decline in the level of wages led not to a decrease in unemployment, but to its growth. Prices did not decrease even when supply exceeded demand. No wonder many economists criticized the positions of the classics. The most famous of them is the English economist J. S. Miller. Keynes, who in 1936  published the work “The General Theory of Employment, Interest and Money”, in which he criticized the main provisions of the classical model and developed his provisions of macroeconomic regulation:

saving and investing, according to Keynes, is carried out by different groups of people (households and firms) with different motives, and therefore they may not coincide in time and size; the source of investment is not only household savings, but also the funds of credit institutions. And not all current savings will end up in the money market, as households leave part of the money on their hands, for example, to pay off bank debt. Therefore, the amount of current savings will exceed the amount of investment. So, Say’s law does not work and macroeconomic instability occurs: an excess of savings will lead to a reduction in aggregate demand. As a result, output and employment are declining; the interest rate is not the only factor influencing savings and investment decisions; lower prices and wages do not eliminate unemployment. The fact is that the elasticity of the ratio of prices and wages does not exist, since the market under capitalism is not completely competitive. The decline in prices is hindered by monopolistic producers, and wages are hindered by trade unions. The classics’ claim that lowering wages in one firm would allow it to hire more workers proved to be inapplicable to the economy as a whole. According to Keynes, a decrease in the level of wages causes a decline in incomes among the population and entrepreneurs, which leads to a decrease in demand for both products and labor. Therefore, entrepreneurs will either not hire workers at all, or will hire a small number.

Thus, the Keynesian theory of macroeconomic equilibrium is based on the following provisions. The growth of national income cannot cause an adequate increase in demand, since an increasing share of it will go to savings. Therefore, production is deprived of additional demand and is reduced, causing an increase in unemployment. Consequently, economic policies that stimulate aggregate demand are needed. In addition, in conditions of stagnation, depression of the economy, the price level is relatively stationary and cannot be an indicator of its dynamics. Therefore, instead of the price of J. S. Keynes proposed to introduce an indicator “sales volume”, which changes even at constant prices, because it depends on the quantity of goods sold.

In constructing the aggregate supply curve, Keynes proceeded from the assumption of the invariability of the level of wages. Since its value is unchanged, entrepreneurs cannot reduce production costs. So, in this situation, a price reduction is unlikely to happen. As a result, the AS sentence curve has an L-shaped appearance (Figure 8.15).

This model reflects the inflexible nature of prices and wages in the short term and the availability of unoccupied resources, in particular unemployment. The aggregate demand line crosses the aggregate supply line at point K, where GNP is equal to OC. If demand increases and the demand schedule moves to the A1D1 position, then prices will not change much, as the volume of production will increase, i.e. GNP will increase by the amount of BB1.

The Caseians believed that the government could contribute to the growth of GNP and employment by increasing government spending, which would raise demand to the position of A1D1, and prices would not change much, as the volume of production would increase. The increase in GNP will be BB1. With an increase in the volume of GNP, there will be an increase in employment. Consequently, in the model of J. S. Keynes’ macroeconomic equilibrium does not coincide with the potential use of factors of production and is compatible with a drop in production, the presence of inflation and unemployment. If the situation of full utilization of factors of production is achieved, the aggregate supply curve will take a vertical form, i.e. in fact coincides with the long-term AS curve.

Thus, the volume of aggregate supply in the short term depends mainly on the value of aggregate demand. In conditions of underemployment of factors of production and price rigidity, fluctuations in aggregate demand cause primarily changes in the volume of output (supply) and can only subsequently affect the price level. Empirical evidence supports this point.

If the government wants to increase output in the economy, then, according to the Keynesian approach, it should stimulate aggregate demand through fiscal and monetary policy, for example, increase government spending, reduce taxes, expand the supply of money, etc.

The question arises: which of the two considered concepts of achieving macroeconomic equilibrium – classical or Keynesian – is the most acceptable for making managerial decisions in the field of economic development? It seems that none of them can be considered in a literal sense, since each of them simplifies real processes. It is hardly acceptable to assume that the market itself will regulate everything without any state intervention. The merit of Keynes is that he showed that the state can exert influence on the market economy and has the tools for such influence. However, the entire economy cannot be entrusted to the state. It must be remembered that the state has never created and will not create a product. In this sense, you need to trust the market economy. As a result, the most acute problem is the issue of the optimal ratio of the market and the state.