Keynesian Theory

Neoclassical economists are naturally more reluctant than Keynesians to concede that capitalism as a system might be dysfunctional or that markets might be irrational and inefficient, leading to cycles of boom and bust, mass poverty and unemployment, which happened in the 1930s and is happening again today. One of the main assumptions in the classical model is ‘full employed equilibrium’ or in other words ‘absence of involuntary unemployment.’ The classical model assumes that supply of labor and real wage are positively related. Assuming that the wages are flexible, the aggregate supply curve is vertical because a change in the price level does not affect the output. Equilibrium occurs when aggregate demand and aggregate supply intersect. In the absence of regulations, the labor market is always in equilibrium, thus the intersection point determines the real wage, and equilibrium demand and supply. Since the demand and supply are equal in the classical model, there is no involuntary unemployment.

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Under this classical model, the main causes of unemployment as a mismatch between the skills and education possessed by the workforce and those demanded by employers, or frictions between vacancies and job seekers, especially with disadvantaged groups, the long-term unemployed and those lacking the information or contacts to find employment. Employers also tend to distrust the motivation and productivity of the long-term unemployed. John Maynard Keynes argued that the real cause of mass unemployment was the lack of aggregate consumer demand in the economy which caused private investment and hiring to stagnate and decline. Keynes would have insisted that the central government had a moral duty to stabilize the economy and use deficit spending on public works and infrastructure to create jobs. Milton Friedman and other free market and monetarist economists argued that Keynesian simply did not work, and argued for central bank manipulation of money supplies and interest rates as a way of eliminating boom and bust cycles. This was the specialty of Federal Reserve Chair Alan Greenspan, a devout disciple of Friedman, Ayn Rand and other free market ideologues, but in the wake of the great crash even he had to admit that these policies had failed. Intense speculation increased tremendously in the U.S. And other economies over the past thirty years as well, while the tax system became continually less egalitarian — to the point where many wealthy corporations and individuals pay no taxes at all (Minsky160).

Keynes argued that capitalism did not produce full employment in the absence of fiscal or monetary stimulus from the central government, which would increase aggregate demand (Mankiw 770). Most Western governments have been pursuing these Keynesian policies of deficit spending to stimulate the economy despite absolutely hysterical opposition from conservative economists and political parties. Keynes was completely correct that these policies and failed in the past and were downright disastrous when attempted during the 1930s depression (Mankiw 794-95). In fact, he developed his own theories for the explicit purpose of countering them. His General Theory (1936) was a product of the Great Depression “in which inefficiency of aggregate demand was identified as the main economic problem” (Skidelsky 152). Governments had to ensure full employment to maintain maximum aggregate demand, while on the supply side taking action to ensure that monopolies and oligopolies did not keep prices artificially high.

Keynes regarded laissez faire and classical economics as a mechanistic, Newtonian philosophy of the 18th Century that may have fitted the small-scale, decentralized economy that existed at that time but no longer applied to a system of giant corporations. At other times, he described it as a “superstitious faith in the market as an end in itself,” a kind of religion that conservatives still adhere to today (Clarke 4). Wealth that was unjustly acquired or unfairly distributed was immoral, and the love of money was a mental illness. Moreover, when capitalism collapses, as it did in 1929 or in 2008-09, this leads to well justified doubts about its efficiency “for increasing material wealth” (Skidelsky 132).

Keynesianism was the dominant economic policy in the Western world from the 1940s to the 1970s, and in retrospect was more successful than the classical or laissez faire capitalism of the Calvin Coolidge or Margaret Thatcher variety. No depression or financial crash occurred in the period from 1945-73, and even though Keynesianism did not abolish the business cycle, it bottom phases were not so low and its recessions not as long as in the 1930s, the 1980s or the present (Minsky 160). During this era “full employment was maintained, real wages rose constantly, economies were relatively stable, and wealth and income inequalities were reduced,” which was definitely not the case in the 1920s and 1930s or in the last thirty years (Skidelsky 164).

2) As a Keynesian, Paul Krugman assumes that weak consumer demand and high unemployment will result in less overall private investment, even though the Federal Reserve is keeping interest rates as low as possible and has engaged in quantitative easing to stimulate the economy. The assumptions of the classical model are idealistic, yet unrealistic. When an economic crisis kicks in, both individuals and firms tend to save more than usual and there will be more involuntary unemployment. Again, it is the set of assumptions that define an economic model, but the assumptions of the classical model have numerous limitations when applied to real life contexts. Say’s law highlights that demand is passive in a classical model. In a loanable funds market of the classical model, saving is increased when spending less. This leads to a decrease in interest rate, and lower interest rate causes more demand to invest. Thus, consumption goes up again. The aggregate demand does not change here since aggregate demand in a loanable funds market is the sum of consumption and investment. (G & NX are held constant in this case). Republican conservatives and free market purist have criticized this in the usual predictable way. Some laissez faire advocates like Ron Paul would even abolish the Fed and return to the gold standard if they could, since they blame the risk of inflation, budget deficits and the weak dollar as the main causes of the Great Recession. Krugman points out that even Bloomberg noted that private investment was declining because of concerns about overall weakness in the economy. Keynes had also observed this “paradox of thrift” during the Great Depression, when private investors lacked confidence in the general economic situation and preferred to hoard savings as much as possible rather than risk making new investments.

In normal times, when the Fed cuts interest rates it makes capital cheaper and stimulates more private investment. In severe recessions like the present one, though, these mechanisms no longer work, since the natural tendency is to save and avoid risk rather than make new investments. Fiscal austerity measures of the type normally imposed by the IMF and being undertaken now in Europe are indeed a “terrible idea” since they push down aggregate demand even further and increase unemployment even further (Krugman 2009). To be sure, the Federal Reserve or other central banks do not set the actual interest rates nor can they requires banks to increase lending, which they are surely unwilling to do in the present economy. For two years now, the Fed has kept its own discount rate near zero, which is standard monetarist (and Keynesian) practice during severe recessions, when the main concern is not inflation but deflation. In the Keynesian model, this lack of private investment can only be rectified by more public spending, government jobs programs and direct state investment in the economy, rather than cutting these and imposing austerity measures as conservatives and laissez fair ideologues demand. In contrast to the neoclassical models, though, Keynesians insist that the supply of private loanable funds simply will not meet the demand in an economy of persistently high unemployment and low aggregate demand like the present, and therefore government intervention is imperative.

3) After three years of the Great Recession, nothing could be clearer than the fact that private companies are simply not hiring in large enough numbers to meet the demand for jobs, at least not in this country. They have been “finding ways to do more with fewer workers, dimming hopes that hiring will take off anytime soon” (Crutsinger and Manning 2009). Despite productivity gains, wages and incomes have been stagnant or falling, and this has been a persistent problem in the American economy for the last thirty years. According to neoclassical theory, higher productivity should translate into gains in wages and incomes, but since the 1970s almost all of the gains have been concentrated in the hands of the upper 10-20%, and especially the upper 1%. Output per hour has been increasing, but wages “remain flat or falling,” and as long as “companies can get their workers to produce more, they have little reason to hire at least until consumer spending picks up” (Crutsinger and Manning 2009). As John Maynard Keynes pointed out in the 1930s and Paul Krugman repeats today, this has the paradoxical effect or reducing consumer demand even further and trapping the unemployed in a vicious cycle which they cannot escape without government intervention. Of course, in the current Congress, conservative supporters of minimal government and laissez faire theories are in a position to block all such stimulus measures.

Neoclassical theorists would argue that once wages have fallen sufficiently in this recession and employers are unable to force more gains in productivity, they will have no choice except to hire new workers, although they may choose to do so in low-wage countries like China. There has been little sign that massive new hiring is taking place in the United States or other Western economies, even though the layoffs of hundreds of thousands per month that were common in 2008-09 have not yet been repeated. In fact, productivity gains and declines in real wages have been consistently higher than these economists expected, while unemployment has remained higher than they predicted. As Joel Naroff, chief economist at Naroff Economic Advisors, put it: “Survival meant cutting costs as rapidly as possible and fulfilling orders with the fewest number of workers” (Crutsinger and Manning 2009). They are using even more overtime and temporary workers rather than new full-time employees to lower costs, which has also been a persistent trend in the American economy over the last thirty years. Most of them also have little confidence in a rapid economic recovery or a rise in consumer demand, which makes them reluctant to hire new employees and bring back those who have been laid off. Even in 2009, though, economists believed that companies were “starting to reach the limits of how much they can produce with their shrunken workforces” (Crutsinger and Manning 2009). This has not really occurred, however, and the removal of stimulus measures and the election of laissez faire, deficit-cutting conservatives to Congress — who also seem determined to depress the economy for political reasons — kept consumer demand relatively flat, along with hiring.


Clarke, P. Keynes: The Rise, Fall and Return of the 20th Century’s Most Influential Economist. Bloomsbury Press, 2009.

Crutsinger, Martin and Stephen Manning. “Productivity Gains May Be Bad News for Job Seekers.” AP Business Writers, Nov 5, 2009.

Krugman, Paul. “We’re Still in a Paradox of Thrift World” New York Times blog post August 26, 2010, 9:38 AM

Mankiw, N.G. Principles of Economics. South-Western College Publishers, 2010.

Minsky, H.P. John Maynard Keynes: Hyman P. Minsky’s Influential Re-Interpretation of the Keynesian Revolution. McGraw-Hill, 2008.

Skidelsky, R. Keynes: The Return of the Master. Perseus Books Group, 2010.