Contrast Keynesian and Neo-classical macroeconomics

1.         Contrast Keynesian and Neo-classical macroeconomics.

UK economist John Maynard Keynes (1883-1946) founded a school of economic thought that was further developed by his supporters. According to his theory, the free markets do not have any self-balancing mechanisms which could lead to full employment. ("What Is Keynesian Economics? - Back to Basics - Finance & Development, September 2014", 2017) In contrast, neoclassical economics does relate demand and supply to a person’s level-headedness and capability to maximize utility or profit. Moreover, neoclassical economics makes use of mathematical equations to analyse different facets of the economy.

Keynes professed enhanced government expenditure and lesser taxes in order to fuel demand and yank the global economy out of Depression. Keynesian economists desire and validate the government's involvement in the economy in the form of public policies that strive to accomplish full employment as well as price stabilization. On the other hand, the neoclassical version includes economic "agents," households or firms that optimize, subject to the various related limitations. Value is associated with infinite desires and wants that collide with constraints or inadequacy.

The major disagreement between neo-classical economists and new Keynesian economists is mainly over how swiftly wages and prices adjust. Neo-classical economists have based their macroeconomic theories on the hypothesis that wages and prices are flexible. (Dequech, 2007) They are of the view that the prices “clear” markets, and balance both supply and demand through swift adjustments. New Keynesian economists, on the contrary, are of the view that market-clearing models cannot clarify short-run economic variations and hence they profess models having “sticky” wages and prices. New Keynesian theories largely depend upon this stickiness of wages and prices to clarify the presence of involuntary unemployment and why monetary policy has such a profound effect on economic activity.

With respect to the distribution of income, the major contention between the two economic visions was regarding the constitution of an "acceptable" theory of the distribution of income. The post-Keynesian position on the distribution of income was "best" described by the power differences between workers and capitalists, whereas the neo-classical position was established from the market theory of factor prices.

2.         Keynesian economics dominated macro policy discussions in the period from the 2nd World War to the sixties, why was this and why did this policy era end?

Keynesian economics has been a dominating factor in macroeconomic policy in the period following World War II and continued till 1970. Keynesian economics was formulated by the British economist John Maynard Keynes in the 1930s in an effort to comprehend the Great Depression. However, following the war, it came to a halt owing to the perils of inflation and slow growth of the economy in a situation called “stagflation.”

Keynesian theory of macroeconomics was heightened at a time when the economy around the world was engulfed in the Great Depression. In the 1930s, at the time of the Great Depression, the prevalent economic policy was not able to understand the reasons for the extreme global economic crisis. Neither was it able to give an explanation as to how to initiate production and employment. British Economist John Maynard Keynes came up with a solution when he proposed a theory that was in contrast to the existing idea that a free economy would offer full employment, provided that everyone seeking employment can get a job given they provided flexible wage demands. (Rittenberg and Tregarthen, 2014) The economic theory of Keynesian was demand driven. He asserted that aggregate demand which is measured as the total amount of expenditures done by families, corporates, and the government—is the most important factor in an economy. he refurbished the thinking that free markets have self-balancing techniques that result in full employment. Keynes emphasized government spending and decreasing taxes to boost demand and get the economy out of the clutches of the Depression. Gradually, Keynesian theory became popular and propagated that optimum use of economic activities is possible and recessions averted by influencing aggregate demand through activist balance and intervention of government expenditures. It substantiates the laws made by the government as an intervention strategy to accomplish full employment and price constancy.

Towards the mid-1970s, the Keynesian theory was criticized with the advent of the new theory of neo-classical economics. The new economic thought asserted that government intervention is ineffective as the local market is able to assess the alterations in the policies and regulate the market forces to offset the impact. Monetarist economists didn’t have any confidence in the government’s capability to control inflation and the business cycle with financial policy. It claimed that cautious handling of fiscal policy, especially the regulation of money supply to impact interest rates could escalate the crisis. (Bleaney, 1985) Criticism of Keynesianism was witnessed in three major spheres – the scholars, in politics, and in the business world and the public domain. They were inclined more toward a free economy than relying upon a mixed economy which had the excessive role of government intervention.

3.         What might be the impacts of increased government spending on the level of private investment?

An Increase in government spending invariably has a positive impact on economic growth as it accelerates the pace of economic activities. The linkage between private and public spending is associated with the crowding-out effect of public expenditure as well as the extent to which one can substitute and complement the other. (Mitchell, 2017) The rise in government expenditure has for quite some time been one of the primary reasons for economic growth. From a Keynesian perspective, public deficits could smoothen the instabilities of economic activity. Therefore, in case of a depression, an increase in government spending could stimulate private expenditure; the overall net effect on economic activity would vary in accordance with the crowding-out effect exerted by the tendency to import and the gradual softening of the real interest rate.

According to various studies, government capital expenditure has a direct influence on private investments and hence has an indirect influence on growth. Private investments are greatly influenced by the trends and extent of public investment, especially in the infrastructure space. Thus government capital expenditure does have a positive influence on private investments as well as economic growth. Neoclassical economists are of the view that government expenditure and taxes only redirect resources to the government and hence crowd–out private spending. The proverb “supply creates its own demand” exemplifies a scenario wherein the economy is at full employment with all resources being fully employed. In such a scenario, an additional amount of government expenditure would need a transfer of resources from the private sector in order to finance government activity. Therefore, any additional government spending will only crowd out a similar amount of private spending. (Sinevi?ien?, 2015)

The Keynesian theory nevertheless supports government expenditure for influencing growth in private investments as well as economic growth. Keynes contended that government expenditure had a multiplier effect on the economy. The Keynesian view holds that not only does an additional amount of government expenditure raise the national income by the original amount spent, but also has a multiplier effect of several amounts. (Gilbert & Orfé, 2015) The rise in household consumption would raise the demand for the company’s products. This augmented demand for the company’s products is a clear signal to companies to raise their level of production. Hence, the companies would raise their investment demand for capital goods. Thus, an increase in government expenditure would lead to an increase in private investments. Such a mechanism has been recognized as a micro foundation for the effect of government spending on aggregate investments.

4.         What caused the Great Recession?

The global financial crisis of 2007 impacted the economy of several countries leading to what is often referred to as the ‘Great Recession’. It all began with the bursting of the housing bubble during mid-2007, and the financial crisis in the US then went on to assume enormous proportions impacting numerous countries to become the worst global recession the world had witnessed over the past six decades. There were several indicators of the impending crisis that were surprisingly overlooked or ignored. Some of them have been discussed herewith:

The US housing market – Undoubtedly, the biggest constituent of U.S. demand is household consumption. Hence, the major decline in household consumption in association with the closely-linked fall in the demand for new housing construction turned out to be the immediate cause of the Great Recession. The extraordinary borrowing of American households was largely assisted by innovative mortgage lending which created a bubble in home prices. Spiraling home prices created more home equity which facilitated further borrowings. The housing bubble ruptured when interest rates increased and re-financing was put in abeyance, compelling more homeowners to sell off. This led to a fall in home prices. Lenders feared default and decided to cut off credit. (Love & Mattern, 2011) With falling home prices and a major slowdown in re-financing, over-leveraged homeowners started to default on their mortgages. This led to a financial panic causing demand for both consumptions as well as new houses to collapse and triggering the Great Recession.

Monetary policy - the monetary policy was a tad too flexible for several years prior to the crisis. It allowed an unprecedented boom in the housing sector thereby creating a bubble that made the bust worse. The robustness of the US economy at the start of the 2000s encouraged major capital inflows which fueled the asset boom as well as speculations. ("Who Caused the Great Recession?", 2017)

Mismanagement of the risk and the onset of the crisis – Since the 1970s, banks had disassociated the risks of mortgages from their balance sheet and passed them on to investors. This Shadow banking system had grown over a period of time and exceeded the size of the depository system but was never subjected to the same kind of pre-conditions and safeguards. CDOs were generally used in corporate loans wherein default prospects of various firms were known, however, no such data was made available for mortgages. The crisis broke out owing to the collapse of the US mortgage market caused by the rising number of defaults in mortgages, especially by the sub-prime borrowers which further triggered unprecedented falls in the value of the mortgage-backed assets (CDOs, etc.). (Love & Mattern, 2011) This resulted in the runs of the assets in the primary broker’s balances as well as in the repo and commercial paper markets. This led to a vast majority of the “shadow banks” that operated in those markets becoming bankrupt. Their bankruptcy ricocheted into the balance sheets of banks and triggered a freeze on the inter-bank lending market causing the systemic crisis.

5. What is meant by the ‘zero lower bound’ for interest rates and why does it matter?

The Zero Lower Bound (ZLB) refers to the situation where the short-term nominal interest rate is at or near zero, creating a liquidity crunch and restricting the limit that the central bank has to boost economic growth. Having the “zero lower bound” for interest rates refers to the situation wherein they cannot go any further below zero. The money market is expected to function within positive rates of interest. This might get disturbed if the interest rates go below ‘zero’. To think otherwise, the interest rates going below zero would imply that one bank is offering a commission to another bank to borrow money. To avoid such a situation, lawmakers try to maintain interest rates above the zero mark. These laws make for the foundation of the ‘zero lower bounds’. (Furth, 2013)

The main assumption of financial policy is set by the interest rates set by the Central Bank. In times of low inflation and negative economic growth, the Central Bank reduces the interest rates to boost the money demand and stimulate economic growth. On the contrary, there can be situations when the interest rates have fallen to zero and hence cannot go any further down. This situation is called zero lower bound rates when the interest rates have gone as much lower as it is possible to go. The ‘zero lower bound’ scenario is not regarded as a practical phenomenon. Nobody would want to give money to borrow when the interest rate is negative. They would prefer holding on to the money, as lending money in such a situation implies that it gets further depreciates owing to the negative interest rates. Thus, the Central bank could no longer manipulate the interest rates to boost economic growth. They cannot lower the interest rate further below the zero mark to stimulate the money market, as the interest rates cannot go any further, and doing so would not give any returns to the investors.  This is often referred to as the liquidity trap. (Libertystreeteconomics.newyorkfed.org, 2017) However, to think this way that handling a large amount of transactions in cash can be inconvenient and lack safety. The cost of making a secure large amount of transactions such as purchasing an asset or house rent is expensive. Thus, many people would find it more convenient and useful to keep money deposited in banks even if it charges negative interest rates.






Bleaney, M. (1985). The rise and the fall of keynesian economics. 1st ed. New York: St. Martin's Press.

Dequech, D. (2007). Neoclassical, mainstream, orthodox, and heterodox economics. Journal Of Post Keynesian Economics, 30(2), 279-302.

Furth, S. (2013). Research Review: Zero Lower Bound Interest Rates. [online] The Heritage Foundation.

Gilbert, N. & Orfé, C. (2015). The Effects Of Government Spending On Private Investments And Economic Growth In Cameroon. International Journal Of Management And Economics Invention, 1(4).

Love, N. & Mattern, M. (2011). The Great Recession: Causes, Consequences, and Responses. New Political Science, 33(4), 401-411.

Who Caused the Great Recession?. (2017). The Huffington Post.

Keynes, J. (1936). The general theory of employment, interest and money (1st ed.). Macmillan.

Libertystreeteconomics.newyorkfed.org. (2017). Why Is There a “Zero Lower Bound” on Interest Rates?   Liberty Street Economics. [online]

Mitchell, D. (2017). The Impact of Government Spending on Economic Growth. [online] The Heritage Foundation.

Rittenberg, L. and Tregarthen, T. (2014). Principles of Macroeconomics. 2nd ed.

Sinevi?ien?, L. (2015). Testing the Relationship between Government Expenditure and Private Investment: The Case of Small Open Economies. Journal of Economics, Business and Management, 3(6), pp.628-632.


What Is Keynesian Economics? - Back to Basics - Finance & Development, September 2014. (2017). Imf.org. Retrieved 14 March 2017, from http://www.imf.org/external/pubs/ft/fandd/2014/09/basics.htm

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