Keynesian and Classical Economic Schools of Thought Compare and Contrast

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The Federal Reserve was forced to adopt a deflationary economic policy to remain on the gold standard: to be fiscally responsible it increased its discount rate, the rate at which member banks could borrow from the central bank, effectively raising the interest rate the banks were forced to charge to consumers (Smiley 2008). The economy thus continued in its downward spiral of allowing less money for investment, decreased production, increased unemployment, and decreased consumer demand.

The solution to this spiral was government spending, according to the Cambridge-educated British economist John Maynard Keynes: "Keynes believed that consumption was the key to recovery and savings were the chains holding the economy down. In his models, private savings are subtracted from the private investment part of the national output equation, making government investment appear to be the better solution. Only a big government that was spending on behalf of the people would be able to guarantee full employment and economic prosperity. Even when forced to rework his model to allow for some private investment, he argued that it wasn't as efficient as government spending because private investors would be less likely to undertake/overpay for unnecessary works in hard economic times" (Beattie 2010). For the world to extricate itself from the Great Depression, said Keynes, the government must intervene in the market.

Keynes' rationale is one reason that the current administration's stimulus package in response to the recent economic downturn has been termed Keynesian in nature. Keynes advocated spending money and increasing the deficit during recessions, and avoiding deficits during expansionary periods to stem inflation. Because of his fear of a 'hoarding' effect Keynes also tended to view a higher level of overall employment as a greater necessity than classical economists. Due to Keynes' influence, the federal government increased in size, nearly doubling within a few scant years: "during the 1920s, there were, on average, about 553,000 paid civilian employees of the federal government. By 1939 there were 953,891 paid civilian employees, and there were 1,042,420 in 1940" (Smiley 2008). Keynes also advocated a 'loose' money policy and lowering interest rates to encourage investment during recessions. Rather than an invisible hand, Keynes conceived of a government that was forever tinkering with the economy.


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