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Keynes and the Classical Economists: The Early Debate on Policy Activism

As you discovered in Chapter 10, unemployment and inflation impose costs on our society. Today, many Americans assume that it is the federal government's responsibility to reduce those costs by combating unemployment and inflation when they occur. But the issue of government intervention to combat macroeconomic problems provokes sharp disagreement among economists. Economists known as "activists" support a significant role for government. "Nonactivists" are economists who believe that government intervention should be avoided. This controversy originated more than 50 years ago with a debate between John Maynard Keynes and the then-dominant classical economists. The historical debate provides an important backdrop for understanding the ongoing controversy about policy activism.


We will begin our exploration of the activist-nonactivist debate by considering the views of the classical economists. The term classical economist describes the mainstream economists who wrote from about 1776 through the early 1930s. For our purposes the most important element of classical economic thought was the belief that a market economy would automatically tend toward full employment. Virtually all the major classical economists held that belief, and apparently people were satisfied with this description of the real world until the Great Depression caused them to question its validity.

Say's Law

The classical economists based their predictions about full employment on a principle known as Say's Law, the creation of French economist J. B. Say (1776-1832). According to Say's Law, "Supply creates its own demand." In other words, in the process of producing output, businesses also create enough income to ensure that all the output will be sold. Because this theory occupies such an important place in classical economics, we will examine it in more detail, beginning with a simple circular-flow diagram, Exh. 1.

Exhibit 1 shows that when businesses produce output, they create income, payments that must be made to the providers of the various economic resources. Assume, for example, that businesses want to produce $100 worth of output to sell to households. To do that, businesses must first acquire the economic resources necessary to produce those goods and services. The owners of the economic resources are households, and they expect to be paid—in wages, rent, interest, and profits (remember, profits are the payment for entrepreneurship). Therefore, $100 in income payments flows to the household sector. If households spend all the income they receive, everything that was produced will be sold. Supply will have created its own demand.

Because the classical economists accepted Say's Law, they believed that there was nothing to prevent the economy from expanding to full employment. As long as job seekers were willing to work for a wage that was no more than their productivity (their contribution to the output of the firm), profitseeking businesses would desire to hire everyone who wanted a job. There would always be adequate demand for the output of these additional workers, because "supply creates its own demand."

Many students will immediately recognize that saving could disrupt that simple process. If households decided to save a portion of their earnings, not all of the income created by businesses would return in the form of spending. Thus, the demand for goods and services would be too small for the supply, and some output would remain unsold. Businesses would then react by cutting back on production and laying off workers, thus causing unemployment.

But the classical economists did not see saving as a problem. Saving would not cause a reduction in spending because businesses would borrow all

EXHIBIT 1. Say's Law: Supply Creates Its Own Demand

Say's Law: Supply Creates Its Own Demand

the saved money for investment—the purchase of capital goods, such as factories and machinery. Why were the classical economists so sure that the amount households wished to save would equal the amount businesses wanted to invest? Because of interest rates. In the classical model the interest rate is determined by the demand for and supply of loanable funds, money available to be borrowed. If households desired to save more than investors wanted to borrow, the surplus of funds would drive down the interest rate. Because the interest rate is both the reward households receive for saving and the price businesses pay to finance investment, a declining interest rate would both discourage saving and encourage investment. The interest rate would continue to fall until the amount that households wanted to save once again equaled the amount businesses desired to invest. At this equilibrium interest rate there would be no uninvested savings. Businesses would be able to sell all their output either to consumers or to investors, and full employment would prevail.

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