The classical doctrine—that the economy is always at or near the natural level of real GDP (full employment)—is based on two firmly held beliefs: The assumption of the full employment of labour and other productive resources Belief that prices, wages, and interest rates are flexible. Keynesian Theory

1. Central Agricultural University
1
College of Post Graduate Studies in Agriculyural Sciences, Umiam
Ri-Bhoi District- 793101
Meghalaya.
AG.ECON-502
Classical theory vs Keynesian theory
Presented By
Athawale Snehal Shivlal
School of Social Sciences
Ph.D (Agri. Economics) 1st Year

2. Points to be discussed…. 2
Classical Theory of Employment
Postulate of classical theory of
Employment
Modern View
Three ranges of Short-run aggregate
supply curve
Keynesian Economics
Keynesian theory of
employment
Wage rate Flexibility
Aggregate Demand-Aggregate
Supply Model (with Price Flexibility)
Aggregate Demand
Aggregate Supply
Interest rate flexibility Keynesian Versus Classical Theories of
Aggregate Demand
Keynes’s Monetary Theory : Money
affects real variables
Saving-Investment Relation
Are Savings automatically Invested ?
Classical Dichotomy and Neutrality of
Money
Unemployment and Full
Employment

3. Classical Theory of Employment
Central Principle: ‘The fundamental principle of the classical theory is that the economy is self‐regulating. Classical
economists maintain that the economy is always capable of achieving the natural level of real GDP, which is the level of real
GDP that is obtained when the economy's resources are fully employed.
National output or income was determined by real factors such as capital stock, state of technology, labour supply and in no
way was affected by the general price level which was determined by the quantity of money. This classical doctrine is
generally referred to as classical dichotomy.
•While circumstances arise from time to time that cause the economy to fall below or to exceed the natural level of real GDP,
self‐adjustment mechanisms exist within the market system that work to bring the economy back to the natural level of real
GDP.
• The classical doctrine—that the economy is always at or near the natural level of real GDP (full employment)—is based on
two firmly held beliefs:
1. The assumption of the full employment of labour and other productive resources
2. Belief that prices, wages, and interest rates are flexible.
• The general over production, and hence general unemployment, is impossible.
•The normal situation is stable equilibrium at full employment.
•The classical economist believe that the policy of laissez-faire guaranteed normal full employment. They had great
faith in free and perfect competition, efficacy of the profit motive and price mechanism to remedy the temporary ills
of the economic system and ensure full employment.
•Prof. Pigou says, “With perfectly free competition, there will always be at work a strong tendency for wage rates to be
so related to demand that everybody is employed.”
•They treated money as a mere medium of exchange. (Transaction motive)
3

4. Postulate of classical theory of Employment 4
Interest rate flexibility
Through the free market
interaction,
Demand for investment and
supply for saving will be same
Balance Budget
Government must maintain its
revenue and expenditures in
equilibrium.
Wage rate Flexibility
Unemployment is of a temporary
nature and this could be
corrected by wage cut policy.

5. Interest rate flexibility
The classical economist believed that through the free
market interaction. ‘II’(demand for investment)and ‘SS’
(supply of savings) will be equal.
‘II’ (Investment) demand is an inverse function to the rate
of interest ‘i’ whereas saving ‘SS’ is a direct function to the
rate of interest ‘i’ this is the belief of the classical economist
that, there is always fluctuations and through these, the
economy achieve equilibrium automatically.
The classical economist believe that all savings are invested
‘II’ is the investment demand as the rate of interest is high
investment is low, and as rate of interest is low investment is
high i ∝ 1/II and where as the savings is directly related to
interest rate. In other words i ∝ SS.
In the diagram ‘II’ and ‘SS’ interact at point ‘E’ which
determines the rate of interest ‘i’. If there is shift o the right
hand side of II (increase in investment)then the interest will
increase to O1 savings and investment will be shifted to a
new equilibrium ‘E1’ and there will be increase in ‘SS’ and I1I1
to OQ2.
5

6. Wage rate Flexibility
•The classical economist believed that “Unemployment
is of a temporary nature and this could be corrected by
wage cut policy.”
•Voluntary employment may exist but involuntary
employment could be corrected by wage cut policy,
which through self adjusting process in which economy
will lead to full employment.
•In free enterprise economy: if wages are allowed to find
there own level, then through perfect competition
involuntary unemployment will disappear.
•In the diagram ‘MRP’ Marginal revenue productivity is
given. At ‘OW’ wages the total employment is ‘ON’, if
the wages will reduce to ‘OW1’ then employment will
increase upto ‘ON1’.
6

7. Keynesian Economics 7
“ Raising Keynes:
An old economist finds new rock-
star status”
Central Principle: The
economy often operates at less
than full employment; market
system does not self adjust.
•Markets clear slowly, if at all. In
a depression and recession,
much unemployment is
involuntary.
•Economy often operates at less
than full employment since
markets don’t clear.
•Government intervention may be
desirable to stabilize the
business cycle. (Fiscal and
Monetary Policies)
•Equilibrium is there but no
reason for full employment.
•Money wage rates are sticky
(i.e. remain constant)
The term “Keynesian economics” was used to refer to the concept that optimal
economic performance could be achieved and economic slumps prevented by
influencing aggregate demand through activist stabilization and intervention
policies by the government.

8. Keynesian theory of employment 8
“ Raising Keynes:
An old economist finds new rock-
star status”
Principle of effective demand
Greater the aggregate effective demand, greater will
be the volume of employment, and vice versa.
Unemployment is the result of a deficiency of total
demand.
Effective demand represents the total money spent
on consumption and investment. The total national
expenditure is equal to the total national income which
is equal to the national output.
Deficiency of effective demand is due to the gap
between income and consumption.
The gap must be filled up by increasing investment
and hence effective demand, in order to maintain
employment at a high level.

9. Aggregate Demand-Aggregate Supply Model
(with Price Flexibility) 9
“ Raising Keynes:
An old economist finds new rock-
star status”
Aggregate Demand
Aggregate demand is the total desired quantity of
goods and services that are bought by consumer
households, private investors, government and
foreigners at each possible price level, other things being
held constant.
 Thus aggregate demand is not any quantity demanded
at a particular price level but is a whole schedule of total
output demanded at various price levels and is
represented by a curve.
The aggregate demand has four components:
1)Consumption demand
2)private investment demand
3)Government purchases of goods and services
4) net exports.
Thus, aggregate demand curve depicts the total output
of goods and services which households, firms, and
Government are willing to buy at each possible price
level.
Aggregate Demand Curve with Varying Price Level
Factors responsible for AD curve slope downward
are-
1) Real Balance Effect
2) Rate of interest effect
3) Foreign Trade effect

10. 10
“ Raising Keynes:
An old economist finds new rock-
star status”
Fig. Aggregate Supply Curve : Classical View Fig. Keynes’s Aggregate Supply Curve
In the classical theory, the aggregate supply curve
of output is perfectly inelastic (i.e. a vertical straight
line).
They assumed that full employment of resources
in the economy. According to them, if at any time
there is deviation from this full-employment level,
the wages, interest and prices quickly and
automatically adjust or change to restore
equilibrium at the full employment level.
Aggregate Supply
Aggregate supply curve shows the various amounts of aggregate output which the producers in
the economy are willing to produce and sell in the market at various price levels.
Shows the relationship between price level and the
aggregate production (supply) during the period of
depression and involuntary unemployment where it will be
seen that aggregate supply is a horizontal straight line (i.e.
perfectly elastic) up to the level of full employment.
Since output of goods and services cannot be increased
beyond the full-employment level, Keynes’s aggregate
supply curve becomes vertical at aggregate output level
YF which represents full-employment level of output.

11. Modern View
Three ranges of Short-run aggregate supply curve
11
“ Raising Keynes:
An old economist finds new rock-
star status”
At times of depression or severe recession, the more can be
produced without much rise in marginal cost of production and
therefore the aggregate supply curve is nearly flat rather than
perfectly horizontal. This first range is therefore called nearly
flat range.
 With the given stock of capital (i.e. plant and equipment)
when output is expanded beyond this range the diminishing
returns and rising marginal costs occur which ultimately cause
the aggregate supply curve to slope upward gently. Thus there
is a part of gently rising short-run aggregate supply curve which
represents intermediate range of short run aggregate supply
curve..
As the firms in the economy approach near their capacity
output their marginal costs rise sharply which cause sharply
rising aggregate supply curve. Beyond the level of capacity-
output, that is, when the given resources of the economy are
fully employed, short-run aggregate supply curve (SAS)
becomes a highly steep curve. Thus, aggregate demand curve
depicts the total output of goods and services which
households, firms, and Government are willing to buy at each
possible price level.
Fig. Short-run Aggregate Supply Curve with Three Ranges

12. 12
Fig. Classical Aggregate Supply Curve and Price Output Determination
•National output does not change in response to changes
in aggregate demand or the price level.
•Since classical aggregate supply curve is vertical, output
and employment in this theory is completely supply-
determined and the level of aggregate demand does not
play any role in determining national output and
employment.
Keynesian Versus Classical Theories of Aggregate Demand
Fig. Keynes’s View of Aggregate Demand
•Keynesian view the level of aggregate demand is an
important factor determining the level of output and
employment, if the economy is working at less than full
employment level.
•He lays stress on the stickiness of money wages.
•At the full-employment, increase in aggregate demand
will cause rise in price level with national output
remaining unchanged.

13. Saving-Investment Relation
Are Savings automatically Invested ?
13
“ Raising Keynes:
An old economist finds new rock-
star status”
Classical view : Always a full-employment equilibrium
1) Based on Say’s law according to which every
supply creates its own demand.
2) Self-employed individual producers.
3) Financial markets had not yet developed.
4) Every act of saving also constituted the act of
investment.
5) Changes in interest rate provided a mechanism
which ensured equality of saving and investment.
Keynesian view: Classical economist failed to take account of
the changes in income that come about from any change in
saving or investment. And the classics failed to realise that
what people intend to save .
From fig 1 fall in investment would lead to the decline in level
of income.
From fig 2 increase in saving implies decline in consumption
demand. Decline in consumption expenditure would also lead
to the decrease in income.
Fig.1
Fig.2

14. Classical Dichotomy and Neutrality of Money
Economic variables are classified into-
1) Real variable: A real variable measured in terms of goods or services. These real variables,
according to the classical theory, depend on such factors as labour supply, capital stock,
technology etc. and further that money plays no role in determining output, employment
and real wages
2) Nominal variable : whereas a nominal variable is measured in monetary units such as
rupees or US dollars.
classical economists thought national output or income was determined by real factors such as
capital stock, state of technology, labour supply and in no way was affected by the general
price level which was determined by the quantity of money. This classical doctrine is
generally referred to as classical dichotomy.
In Keynes’s theory, money supply determines rate of interest which influences investment
which, in turn, plays an important role in determining output and employment in the
economy.
14

15. Classical Dichotomy and Neutrality of Money
15
Graphically illustrate classical dichotomy
Panel (a) determination of price
level through classical vertical
aggregate supply curve AS and
downward-sloping aggregate
demand curve AD is shown. With
money supply equal to M0,
aggregate demand curve is AD0
which intersects aggregate supply
curve AS at point E0 and determine
price level P0.
Panel (b) shows labour market equilibrium which
determines real wage rate equal to W/ P0and
labour employment equal to ONF. From panel (c) it
will be observed that with ONF amount of labour
employed, full-employment level of output YF is
determined.
Suppose that money supply is reduced to M1 (M1 <
M0) resulting in the fall in aggregate demand curve
to AD1 which causes price level to fall to P1 while
real national output remains unchanged at YF. Now,
with the money wage equal to W, the fall in price
level (P1 < P0) will bring about rise in real wage rate
to W/P1 . But, with this higher real wage rate labour
market will be thrown into disequilibrium with
emergence of excess supply of labour (see panel
(b)). According to classical theory, to restore labour-
market equilibrium money wage rate will quickly fall
to W1 so that real wage returns to the original level
W/P0.
In labour market equilibrium, labour employment
remains at full-employment level ONF. In panel (c),
with ONF amount of labour employed, national
output remains at YF though the quantity of money
has been reduced from M0 to M1
As determination of real variables is
concerned, money is said to be neutral. Suppl
of money determines only nominal variables

16. Keynes’s Monetary Theory : Money affects real variables 16
money is non-neutral
Keynes brought about integration of money market and real goods
market.
He showed that rate of interest was determined by demand for
money and supply of money.(increase in the supply of money will
lower the rate of interest)
in panel (a) money market equilibrium is shown. Given money
supply equal to M1, money supply curve MS1 intersects money
demand curve Md at rate of interest r1. It will be seen from panel
(b) that at rate of interest r1, investment is I1. Then, in panel (c)
with the consumption function curve C and investment equal to I1,
aggregate demand curve is C + I1 which intersects the income line
OZ at point E and determines level of real national income equal to
Y1.
Suppose that there is increase in money supply from M1 to M2
which causes shifts in money supply curve from MS1 to MS2.
As a result in panel (a), rate of interest falls from r1 to r2, and
as a result of fall in interest rates in panel (b) investment
increases from I1 to I2. With this increase in investment (DI),
aggregate demand curve shifts above to the position C + I2 in
panel (c). With this increase in aggregate demand, level of real
national income increases from Y1 to Y2. Corresponding to this
increase in real national income the level of labour
employment will also rise.
Keynes succeeded in integrating money market with goods market
and with this he showed that money supply plays an important
role in determining real variables such as real investment.

17. Unemployment and Full Employment
Meaning of Unemployment: Unemployment is defined as a state of affairs when in a country
there are a large number of able-bodied persons of working age who are willing to work but
cannot find work at the current wage levels. People who are either unfit for work for physical
or mental reasons, or don’t want to work, e.g., sadhus, idle rich etc. are excluded from the
category of the unemployed.
Everyman’s Dictionary of Economics defines unemployment as “involuntary idleness of a
person willing to work at the prevailing rate of pay but unable to find it.”
Mere engagement in some productive occupation does not necessarily mean absence of
unemployment. People, who are only partially employed or are engaged in inferior jobs,
though they can do better jobs, are not adequately employed. It is called a state of
underemployment which is equally bad for the prosperity of a country.
17

18. 18
There are three main types of unemployment:
01 02 03
Frictional Unemployment
1. Lack of adjustment
between demand for
and supply of labour.
2. Lack of necessary skills
3. Labour immobility
4. Breakdowns of
machinery
5. Shortages of raw
materials,
6. Period between losing
one job and finding
another
Structural Unemployment
1. Economic changes are
massive, extensive, deep-
seated, amounting to
transformation of an
economic structure.
2. Result of mismatch
between demand for and
supply of labour.
3. Unemployed workers lack
skills.
4. Also known as long term or
Marxian unemployment
Cyclical Unemployment
1. Deficiency of effective
demand.
2. Also called cyclical
‘Keynesian
unemployment’
3. Income and output fall
4. Reduction in extent of
utilization of factors of
production.
5. Increases during periods
of recession or
depression.

19. 19
Other types of unemployment:
04 02 03
Seasonal Unemployment
1. Seasonal fluctuations in
demand.
2. Season bound
production activities.
3. Unemployment during
Slack season
4. Eg. Ice-cream sellers
remain unemployed
during winter.
Technological Unemployment
1. Technological change tends
to increase output per
man-hour which has the
effect of raising the
potential total output in
the economy.
2. Modern production
process displacing existing
workers.
3. Eg. Mechanization
displaces labour, resulting
unemployment.
Disguised Unemployment
1. People are prepared to
work but they are unable
to find work throughout
the year due to the lack
of complementary
factors.
2. A person is considered to
be underemployed if he is
forced by unemployment
to take a job that he
thinks is not adequate for
his purpose.

20. MEASURES TO ACHIEVE AND MAINTAIN FULL EMPLOYMENT
Fiscal Policy
Public finance,
expenditure, taxation
and debt
Monetary Policy
Credit control,
investment.
Income Policy
Limiting wages and
prices.
Encourage self-
employment
By providing raw
materials and technical
training.
Price Policy
Determining the
prices of goods and
services
International
measures
Loans from IMF and
World Bank

21. Full Employment
Meaning of full employment: Full employment may be defined as the situation wherein all
those who are willing and able to work at prevailing wage rates are in fact employed for the
work in which they are trained.
 Full employment does not mean that every one is employed. Some people like children, old
men and physically or mentally handicapped people are not able to work, these people are not
included in the labour force of the country. Full employment will exist in spite of their not
working.
Some people called ‘idle rich’ though able to work are not willing to work because they get
enough unearned incomes to live. These people are also not included in the labour force of
the country.
Full employment is said to exist in the economy even if there is prevailing some amount of
frictional and structural unemployment in the economy. If the number of unemployed is
greater than frictional and structural unemployment, only then we shall say that full
employment does not prevail. (Lord Beveridge estimated frictional unemployment of 3% in a
full employment situation for England).
Keynesian full employment is, by definition, the maximum level of employment that private
enterprise countries can attain without experiencing strong inflationary pressure.
.
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22. Thank you!