Question

How is high unemployment explained by (a) a Keynesian and (b) a classical economist?

Short answer

Keynesians attribute unemployment to low demand and suggest government intervention; classical economists blame market imperfections and advocate wage flexibility.

Step-by-step solution

Understanding Keynesian Economics

Keynesian economists attribute high unemployment mainly to insufficient aggregate demand in the economy. They argue that when there is a lack of demand for goods and services, businesses do not hire workers, leading to unemployment. Keynesians suggest that government intervention, such as increased public spending or tax cuts, can stimulate demand and reduce unemployment.

Analyzing Classical Economics

Classical economists, on the other hand, believe that high unemployment is a result of market imperfections, such as wage rigidity. They argue that if wages and prices are flexible, the labor market will naturally adjust, and unemployment will fall. They often suggest that government intervention is unnecessary and that natural market forces should be allowed to correct the unemployment problem over time.

Comparing the Two Perspectives

The key difference between the two schools of thought is their view on government intervention and market flexibility. Keynesians advocate for proactive government measures to stimulate demand, while classical economists believe in the self-correcting nature of free markets and emphasize the importance of flexibility in wages and prices to allow the labor market to adjust.

Key concepts

Keynesian Economics

Keynesian Economics, named after the British economist John Maynard Keynes, emphasizes the role of aggregate demand in the economy. According to Keynesians, during economic downturns, there is often an insufficient demand for goods and services, which can lead to high unemployment. This lack of demand can cause businesses to reduce their production and workforce, increasing unemployment rates. A key solution proposed by Keynesian economists is government intervention. This can include measures such as increased public spending or implementing tax cuts to boost consumption and investment. By doing so, aggregate demand is stimulated, leading to job creation and lower unemployment. Keynesian Economics essentially advocates for a more active fiscal policy, seeking to stabilize the economy through direct governmental actions.

Classical Economics

Classical Economics offers a different perspective on unemployment, rooted in the belief of self-regulating markets. Originating from 18th and 19th-century thinkers like Adam Smith and David Ricardo, this school of thought contends that the economy can adjust itself over time without outside interference. According to classical economists, unemployment arises from market imperfections such as wage rigidity. They assert that if wages and prices are allowed to fluctuate freely, the labor market can reach equilibrium where demand for labor meets supply. The classical viewpoint posits that government interventions are often unnecessary and can even be detrimental, potentially distorting natural market mechanisms. Hence, they advocate for minimal governmental involvement, trusting that the market forces will naturally correct unemployment even without external aid.

Aggregate Demand

Aggregate Demand represents the total demand for all goods and services in an economy at a given overall price level and in a given period. It's a crucial concept in both Keynesian and Classical Economics, but each interprets its role differently. In Keynesian Economics, aggregate demand is seen as the driving force behind employment levels. When aggregate demand is high, businesses increase production, leading to more jobs. Conversely, low aggregate demand results in decreased production and higher unemployment.

Keynesians argue that external factors, often governmental, can and should be used to manage aggregate demand. This can stabilize output and employment. On the other hand, classical economists view fluctuations in aggregate demand as part of natural economic cycles. They believe these should be allowed to correct themselves through market dynamics, with minimal intervention. Thus, the management and interpretation of aggregate demand are central to the ongoing debate between Keynesian and classical thought.

Wage Rigidity

Wage Rigidity is a concept that refers to the inflexibility of wages in the labor market. This inflexibility can prevent wages from adjusting to changes in the market conditions, leading to unemployment. In the classical economic framework, wage rigidity is considered a primary cause of sustained unemployment. They argue that if wages were flexible, they would decrease during economic slumps, allowing more workers to be employed.

Several factors contribute to wage rigidity, including labor contracts, minimum wage laws, and social norms. These factors can prevent wages from dropping to a level where labor supply equals labor demand. Classical economists believe that addressing wage rigidity, primarily by allowing wages to adjust freely, can help reduce unemployment levels.

On the other hand, Keynesians might see wage rigidity as a lesser problem compared to low aggregate demand. They would propose enhancing demand through fiscal policies rather than focusing solely on wage adjustments. These differing perspectives highlight the varied approaches to tackling unemployment between the two economic schools.