Classical Vs. Keynesian Assumptions: An Introduction

Today, I’m starting to do a series of posts where I contrast some of the key assumptions of the Classical and Keynesian models of economic theory. I cannot stress enough the importance of such an exercise. For any student of economics, it’s critical to understand how the basic assumptions of these two schools of macroeconomic thought differ, in order for her to appreciate how two economists can offer such conflicting solutions to the same problem. They’re both looking at the same problem, but are using models with diametrically opposite assumptions to reach their respective policy recommendations. 

The following are the assumptions of the two models that I am going to discuss and contrast in detail in the following posts.

Assumption #1: Market Structure

Classical theory
Markets are highly/perfectly competitive, and thus always tend to move towards “full employment” levels.

Keynesian theory

Real-life markets are not highly/ perfectly competitive. There are powerful monopolies and oligopolies out there that do not produce at the levels required for full employment. 

Assumption #2: Price Flexibility  

Classical theory

Wages and prices are completely flexible. They adjust rapidly to ensure that demand = supply in output and labour/factor markets. 

Keynesian theory

Wages and prices are NOT flexible in the short term. Rather, they are “sticky”. They do not adjust to ensure the equality of demand and supply. 

Assumption #3: Full Employment

Classical theory

Output is always = Spending; Saving is always = Investment; and the economy always moves towards/is at the “Full employment” level. 

This assumption has its roots in Say’s law. Those of you who want to take a deep dive into Say’s law, read my posts Say’s Law: Context, Criticism and Keynes’s Refutation - Part 1 and Say’s Law: Context, Criticism and Keynes’s Refutation - Part 2. 

Keynesian theory

Refutes this classical assumption. Believes that there are NO natural forces to make Output = Spending or Saving = Investment at full employment levels. The economy can reach equilibrium much below full employment levels and stay there indefinitely.

Assumption #4: Velocity of Money

Classical theory

MV = PY is the quantity equation, where M = money supply, v = the income velocity of money, P = price level and Y = real GDP. Classicals believe that “v” is constant, which implies that ΔM = ΔPY i.e. money supply determines the level of nominal GDP. This is what is commonly known as the “Quantity theory of money”.

Based on the Quantity theory of money, Classicals assert that fiscal policy is ineffective in changing real GDP. Why? Because fiscal policy cannot change MV (LHS of the quantity equation) and thus per the classical view, cannot end up changing PY (RHS of the quantity equation). 

They go on to assert that monetary policy (changing money supply) is also ineffective in changing real GDP, since prices adjust rapidly (see assumption #2) to keep real GDP at the full employment level. As a result, all an increase in money supply accomplishes is an increase in the price level/ inflation. 

Keynesian theory

Keynesians believe that “v” fluctuates. It moves with real output (Y). When the economy is strong and Y is rising, people circulate money more rapidly i.e. “v” rises. When the economy is weak i.e. Y growth is anemic, people circulate money relatively slowly and “v” falls.

This means that fiscal policy works per Keynesians. An increase in government spending can increase “Y” on the RHS of the quantity equation and “v” on the LHS. 

I am going to discuss in detail the above-mentioned opposing Classical and Keynesian assumptions on each of the four listed subjects in following posts.