Critically examine the classical theory of Income and employment.
Answers
Criticism of Classical Theory:
Keynes vehemently criticised the classical theory of employment for its unrealistic assumptions in his General Theory.
He attacked the classical theory on the following counts:
(1) Underemployment Equilibrium:
Keynes rejected the fundamental classical assumption of full employment equilibrium in the economy. He considered it as unrealistic. He regarded full employment as a special situation. The general situation in a capitalist economy is one of underemployment.
This is because the capitalist society does not function according to Say’s law, and supply always exceeds its demand. We find millions of workers are prepared to work at the current wage rate, and even below it, but they do not find work.
(2) Refutation of Say’s Law:
Keynes refuted Say’s Law of markets that supply always created its own demand. He maintained that all income earned by the factor owners would not be spent in buying products which they helped to produce.
A part of the earned income is saved and is not automatically invested because saving and investment are distinct functions. So when all earned income is not spent on consumption goods and a portion of it is saved, there results in a deficiency of aggregate demand.
(3) Self-adjustment not Possible:
Keynes did not agree with the classical view that the laissez-faire policy was essential for an automatic and self-adjusting process of full employment equilibrium. He pointed out that the capitalist system was not automatic and self-adjusting because of the non-egalitarian structure of its society. There are two principal classes, the rich and the poor.
The rich possess much wealth but they do not spend the whole of it on consumption. The poor lack money to purchase consumption goods. Thus there is general deficiency of aggregate demand in relation to aggregate supply which leads to overproduction and unemployment in the economy. This, in fact, led to the Great Depression.
(4) Equality of Saving and Investment through Income Changes:
The classicists believed that saving and investment were equal at the full employment level and in case of any divergence the equality was brought about by the mechanism of rate of interest. Keynes held that the level of saving depended upon the level of income and not on the rate of interest.
Similarly investment is determined not only by rate of interest but by the marginal efficiency of capital. A low rate of interest cannot increase investment if business expectations are low. If saving exceeds investment, it means people are spending less on consumption.
(5) Importance of Speculative Demand for Money:
The classical economists believed that money was demanded for transactions and precautionary purposes. They did not recognise the speculative demand for money because money held for speculative purposes related to idle balances.
But Keynes did not agree with this view. He emphasised the importance of speculative demand for money. He pointed out that the earning of interest from assets meant for transactions and precautionary purposes may be very small at a low rate of interest.
(6) Rejection of Quantity Theory of Money:
Keynes rejected the classical Quantity Theory of Money on the ground that increase in money supply will not necessarily lead to rise in prices. It is not essential that people may spend all extra money. They may deposit it in the bank or save.
(7) Money not Neutral:
The classical economists regarded money as neutral. Therefore, they excluded the theory of output, employment and interest rate from monetary theory. According to them, the level of output and employment and the equilibrium rate of interest were determined by real forces.
(8) Refutation of Wage-Cut:
Keynes refuted the Pigovian formulation that a cut in money wage could achieve full employment in the economy. The greatest fallacy in Pigou’s analysis was that he extended the argument to the economy which was applicable to a particular industry.
Reduction in wage rate can increase employment in an industry by reducing costs and increasing demand. But the adoption of such a policy for the economy leads to a reduction in employment. When there is a general wage-cut, the income of the workers is reduced. As a result, aggregate demand falls leading to a decline in employment.
(9) No Direct and Proportionate Relation between Money and Real Wages:
Keynes also did not accept the classical view that there was a direct and proportionate relationship between money wages and real wages. According to him, there is an inverse relation between the two. When money wages fall, real wages rise and vice versa.
(10) State Intervention Essential:
Keynes did not agree with Pigou that “frictional maladjustments alone account for failure to utilise fully our productive power.” The capitalist system is such that left to itself it is incapable of using productive powerfully. Therefore, state intervention is necessary.
The classical theory emphasizes on full employment condition for the economy to function in a normal situation. Unemployment is a temporary condition and will pass due to the economic situations
Explanation:
- The classical theory of Income and employment is based on normal conditions of a market which operates economically. If there were any changes that are caused in the economy it would be a passing phase since the economic factors would help with adjustments in the economy.
- The changes in demand and supply of goods will return to it normal flow where the supply of goods will create the demand for the products. There would be no situation of over production and the goods would be sold in the markets.
- The prices, interest rate and wages all work under flexible conditions which help in maintaining the level of stability and equilibrium in the economy. The interest rates introduced by the government helps to stabilize the level of investment and savings.
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