The Clash of the Neoclassical Thoughts and the Keynesian Theory

A capitalist economy is a system with free-market movements, where individuals enjoy complete economic freedom with private property rights and intense competition among private firms prevails for higher profits.  Blauwhof (2012) argued that a capitalist system has become an integral part of the modern economic world with properties and manufacturing factors possessed privately by individuals and organisation of an economy. The neoclassical and Keynesian economics are two different schools of thought, which have different views towards the concept of a capitalist economy. Thus, this concerned study aims to discuss the features of a capitalist economy from the perspective of Keynes and differentiate his views with that of the ideas of neoclassical economists with the help of the illustrations of the Australian economic system. According to J.M. Keynes, in a capitalist economy restriction from the government helps in controlling aggressive recessions, whereas, neoclassical economics argues that recession can be controlled only when the law of Laissez-faire economy is followed (Wolff & Resnick 2012). Moreover, Keynesian economics achieves full-employment by targeting aggregate demand with government intervention, whereas, neoclassical economists focus on aggregate supply and the empowerment of private entrepreneurs. Therefore, this essay initially discusses the Keynesian thoughts of a capitalist economy and later compares Keynesian economies with neoclassical theory with illustrations from the Australian economy.

Capitalism or a capitalist economy is usually defined as a free market economy, where supply and demand adjust to meet the equilibrium point. In addition to this, capitalism favours the individual’s right to properties, the profit motive of corporations with freedom of operation and control, the sovereignty of the consumers and market competition (Goodwin & Punzo 2019). In contrast to this, Keynes’s views were more restrictive and included the intervention of the government for a well-functioning economy. J.M. Keynes emphasised that capitalism can lead to economic downfall due to the excessive freedom of organisations. As a result, he suggested that an economy should be supervised by a government of that country to control or limit the power of the organisations. Moreover, the supervision of authorities is necessary because together with a profit motive and freedom from laws organisations tend to ruin consumer’s demand patterns and labour laws. Till (2014) argued that organisations increase prices of products and lower wages to increase their profit. Another research by Bedo et al. (2011) suggested that organisational goal of earning profits leads to an increase in unemployment and affects aggregate demand. Hence, this distorts the welfare of consumers and labour rights. However, Keynes did not relate money supply and inflation and focused only on the impact over aggregate demand (Kara 2015). Thus, on the whole, Keynes suggested that capitalism requires government intervention to prevent the economy from losing welfare and rights.

The thoughts of Keynes and neoclassical economics contradicted concerning the role of the state and the mode of achieving full-employment equilibrium. Keynes also proposed that capitalism should be operated from the demand side of the economy regulated by the state (Galí 2013). This is because higher demand initiates an increase in market supply, which can be attained by increasing productivity that leads an economy to achieve potential GDP. De Haan (2014) argued that public spending helps in enhancing the welfare of the state and the public. As a result, there is an increase in employment opportunities created by the state and the economy can achieve a full-employment level of productivity. On the other hand, neo-classical targets aggregate supply to achieve full-employment GDP, which brings higher output for the economy. This is because entrepreneurs create employment for the workforce, which can be generated by increasing production in the firms. However, both views have been criticised for their structural flaws. Keynesian economics is criticised about not including the crowding-out effect of increased government borrowing on interest rates and financial markets, and neoclassical economics leads to the distortionary power of entrepreneurs leading to collapse like the US during the Great Recession of the 1930s (Thomas n.d). However, Keynesian thoughts are known to be realistic compared to neoclassical thoughts of a capitalist economy.

The Australian economy operates as one of the least controlled capitalist nations in a modern capitalist world. The country is a free market economy where the forces of demand and supply adjust itself to reach equilibrium prices and quantities. The Australian economy enjoys one of the highest Economic Freedom Index and is placed in the fourth position, which is about 82.6 out of 100 (Statista 2020). This figure indicates fiscal freedom of Australia with the limited intervention of the state as mentioned in neoclassical economics. Shido-Ikwu (2017) argue that a completely free market economy is not feasible in a real market scenario, and several external and internal shocks require governments’ intervention. The money supply and the Cash Rate are regulated by the Reserve Bank of Australia and the limitation on property markets, land-usage and tax rates imposed on business firms is evidence of government control over the economic operation of Australia. Moreover, the Australian economy uses both fiscal and monetary policies to balance economic situations as it used during the Great Recession of 2007-2008. Furthermore, private businesses and individuals own capital goods and enjoy property rights under the supervision of the government (Savage 2011). Other than this, the Australian government supports farmers, domestic exporters and employers with benefits to address economic uncertainties. Thus, this implies that it is not completely a laissez-faire economy as defined by neoclassical economics and follows the Keynesian state-controlled capitalist system with a limited restriction on business and property rights of individuals.

The neoclassical and Keynesian economics are two different schools of thought in economies that have acquired much attention in the subject. Neoclassical economists are in favour of the supply side and a free market economy. According to the views of neoclassical economists, the economy operates with the forces of demand and supply, and adjust itself during a crisis with the use of the fiscal policy (Means 2017). This view of a laissez-faire economy is opposed by John Maynard Keynes. After the Great Depression of the 1930s, Keynes highly criticised the thought of a self-correcting economy and introduced the importance of government intervention in the market. Thus, the Australian economy being a free market economy is unable to attain full-employment equilibrium and faces turmoil in the property market. According to Keynes, government supervision is mandatory in a market because it can tackle the recessionary phase with the help of both fiscal and monetary policy (Backhouse & Bateman 2011). This implies that during a recession government should increase spending to motivate individual expenditure. Due to proper management of the government, the Australian economy skilfully handled shocks during the Global Crisis 2007-2008. However, Galí (2013) argues that an increase in public borrowing increases the interest rate, which discourages private sector investment. As a result, the economic productivity weakens and hampers GDP growth rate, which is a case of the Australian economy.

Apart from the above-mentioned difference, the neoclassical and Keynesian thoughts coincide in terms of the determining factor of GDP. Neoclassical economics argues that aggregate supply determines consumption and the movements in GDP (Lapavitsas 2013). This implies that aggregate demand is fixed and depends entirely on aggregate supply. Petri (2015) implied that according to neoclassical theory potential GDP or full-employment can be achieved by targeting the supply-side factors. In contrast to this, Keynes favours aggregate demand and believes that total demand is unstable (Backhouse & Bateman 2011). Thus, supply should adjust and move according to the movements in demand. In addition to this, he suggested that demand creates productivity and employment. Therefore, demand should be regulated to achieve a full-employment level of output. Australian financial market and money markets are supervised by the government and the RBA (Bloxham, Kent & Robson 2011). The supply sector such as export and local production receives government support under crisis. However, there is about 5.2% in unemployment due to a lack of job opportunities, which implies faulty policy adoption (Trading Economics 2020). Thus, the government uses monetary tools to correct crisis. Recently, the RBA has implemented an easing monetary policy to reduce cash rate and target aggregate demand to increase productivity. Therefore, the Keynesian view of targeting aggregate demand is supported by the administration of the economy.

The neoclassical economists are in favour of a self-adjusting economy and direct a country to avoid fiscal and monetary policy implementations in the short run. According to this theory, implementation of government policy in the short run makes a country worse-off (Petri 2015). On the other hand, in the long run, only fiscal policies should be used to reach potential levels of GDP. The Keynesian perspective opposes this view and suggests to use a combination of monetary and fiscal strategies to overcome recessionary situations. Additionally, both in the short run as well as in the long-run fiscal and monetary policies should be used to maintain aggregate demand and raise potential GDP (Dejuán, Paños & González 2013). Let’s take an instance from the Australian economy, currently, Covid-19 has negatively affected the GDP growth. To maintain aggregate demand and protect the economy from moving into recession the government is using both fiscal and monetary policy to influence aggregate demand. The Australian government has spent about 320 billion AUD to support the economy (Treasury Government of Australia 2020). Moreover, the RBA has reduced the cash rate by 0.25 basis point to inject liquidity in the economy and influence aggregate demand and investment (Reserve Bank of Australia 2020). Therefore, the Australian economy is effectively employing fiscal and monetary methods to stabilise the economy from the volatile economic condition. Thus, on the whole, Australia follows Keynesian thoughts to stabilise its economic variables.

The study includes the contradictions between the Keynesian thought of a capitalist economy and the neoclassical economics along with illustrations from Australia’s economic system. Keynes believes in an economy with a significant intervention of the State authority. Contrary to this, neoclassical thought believes in a free market and self-regulating economy with high production efficiency and output. The difference between these two schools of thought is not limited to this point, there view clashes in terms of GDP determining factor, short-run and long-run policy implementation. The neoclassical theory believes that efficiency and potential GDP can be achieved by targeting aggregate supply because demand is fixed, whereas, Keynes believes potential output and employment can be achieved by stabilising the volatile aggregate demand. Additionally, Keynes focuses on rectifying short-run economic disputes and the implementation of both fiscal and monetary techniques to tackle recession, whereas, neoclassical aims at long-run adjustments using only fiscal policy. These views are related to the system of Australia and can be concluded that the economy has similarities with the Keynesian school of thought with limited State intervention. The Australian economy operates in an open market where firms enjoy full economic freedom and individual rights with substantial government intervention from both fiscal and monetary aspects stabilise volatility and economic recession.