The Debate between Keynesian and Neoclassical Economics

The concept of Keynesian demand management introduced in the previous film is a controversial subject within economics today. In this article, Dr John Gathergood explores how Keynesian demand management relates to some of the common schools of thinking in macroeconomics.

The tension between Keynesian and Neoclassical Economics takes us to the heart of debate, disagreement and argument in modern macro-economics. Macroeconomics is a deeply divided subject. In some areas of economics there is widespread agreement on how the economy functions and the effects of policies – such as in the field of international trade, where there is a common view on the causes and consequences of trade across borders and the likely effects of the imposition of tariffs or quotas. But macroeconomics is very different. Macroeconomists disagree on fundamental issues, such as whether markets should be allowed to function independently of government, or whether intervention is required.

These disagreements often incorporate and reflect differences in political ideology, hence macroeconomists are commonly divided along partisan political lines. Indeed, it is common around the time of elections to find one group of macroeconomists lending their signatures to letters of support for a particular political viewpoint, only for an equally sized group of macroeconomists to offer their support to a diametrically opposed position.

To understand disagreement in modern macroeconomics we need to appreciate the importance of history in the development of economics. In the late 18th and early 19th century a consensus view of the macro-economy emerged from the thinking of Adam Smith and David Ricardo. Much of this reflected Adam Smith’s view of the function of the market and the efficient qualities of the ‘invisible hand’ of market production. If individual markets were efficient by virtue of the price mechanism, then the overall economy too would be efficient. This thinking dominated the emerging subject of economics.

However, in the 19th century and again in the 20th century this view was challenged by two thinkers whose legacies, though very different in political and economic terms, both remain with us today in their alternative understanding of the economy. In the 19th century Karl Marx, the German theologian and philosopher, argued that the market mechanism was not efficient, but instead created social strife and class warfare between workers and entrepreneurs through a system of trade than inherently favoured the entrepreneur and would give rise to class struggle and revolution. Much of this thinking was imbued in the Russian revolution following the first world war and remained a central tenet of Communist ideology.

While Marx critiqued the long-term effects of the capitalist system in pitting worker against entrepreneur, Keynes perceived a much more immediate shortcoming of the capitalist system. The Great Depression, during which the US economy shrank by close to one third and failed to recover for nearly a decade, was for Keynes proof that the private market system was not efficient.

For Keynes, the market system could create under-employment (and over-employment of resources). Demand and supply would not automatically balance as sticky prices and animal spirits would leave demand and supply out of equilibrium and the expectations of workers and firms disconnected from reality. Keynes saw government as the paternalistic actor necessary to intervene in the market mechanism, taxing and spending workers and firms in order to rebalance aggregate demand and supply in the economy.

Since the work of Keynes in the 1930s, different schools of macroeconomic thought, represented by their respective models, have emerged, reflecting the tensions between Keynesian thought and traditional macroeconomics.

At one extreme, the Monetarist thinking of Milton Friedman sharply disagrees with the Keynesian view, arguing instead that the role for government in the economy is minimal. Modern Real Business Cycle Models imbue this view, modelling the economy as an efficient system in which upturns and downturns in the economy are due to factors beyond the control of governments. By way of contrast, New Keynesian Models, as the name implies, hold to Keynesian thinking that the price mechanism is not efficient but that prices are ‘sticky’ slow to adjust. At an extreme of Keynesian thinking, models of indeterminacy and chaos present an economy in which the animal spirits of economic agents create a volatile and unpredictable economy that oscillates between boom and recession.

The macroeconomic institutions of a modern economy such as central banks and government treasuries – in the UK setting, Her Majesty’s Treasury and Bank of England, tend to synthesise aspects of the Neoclassical and Keynesian models in their collective thinking and actions. Indeed, there is often as much disagreement and argument over the underlying reasons for the performance of the economy within central banks and governments as there is in the news media and popular economic thought.

John has introduced several different understandings of the macroeconomy:

• Neoclassical models of the macroeconomy introduced by Adam Smith and David Ricardo

• Models reflecting class struggle introduced by Karl Marx

• Keynesian (and New Keynesian) thinking emphasizing the need for active demand management by the government

• Monetarist thinking of Milton Friedman arguing minimal role for the government in economy

Please discuss in the comments below which of these understandings most strongly resonants for you. Why do you ascribe to that particular understanding?