From the classical presumption to the Keynesian revolution

Detail

1. The classical presumption (before 1936)

• Classical tradition: the main school of economic thinking before Keynes. It rested on two beliefs:
• Full employment of labour: every labourer who is ready to work finds a job.

• Full use of capacity: all factories work at full capacity.

• Supply-determined output: total output depends on how much the economy can produce, not on how much people want to buy.

• What limits output is labour, capital and technology.

• Demand does not limit output.

• The mainstream view before the 1930s was that free markets would automatically bring full employment, as long as workers were flexible about their wage demands [2].

Two ideas that supported the classical view

• Say's law: "supply creates its own demand".
• A firm makes goods → it pays wages, rent and profit → these incomes are spent on goods.

• So, in this view, the economy can never produce "too much" in total. There is never a general shortage of demand.

• Flexible wages and prices: wages and prices move up or down freely until every market clears. A market clears when the quantity supplied equals the quantity demanded.

• Suppose there is unemployment (more people want jobs than there are jobs).
• Then wages fall.

• Firms hire more people until everyone who wants a job has one.

• The result: any unemployment is only voluntary (people choose not to work at the going wage) or frictional (people are between jobs for a short time).

• The different schools of thought are covered in detail in economic-thought.

2. The Great Depression broke the presumption

• Great Depression (1929 and after): a very long and deep fall in output and employment.
• It began in Europe and North America.

• It then spread to other countries.

• USA, 1929–1933 (NCERT Class 12, Introduction):

• The unemployment rate rose from 3% to 25%.
• Aggregate output (the total output of the economy) fell by about 33%.

• The IMF also puts the US unemployment peak of the Depression at 25% [3].

• Worse than a war: in many countries, output fell more during the Great Depression than it had during World War I [3].

• Falling prices made it worse:
• Prices fell (this is called deflation).
• So the real value of old debts rose. A loan of ₹100 now bought more goods, so it was harder to repay.
• Borrowers cut their spending.

• This pushed aggregate demand down even further [3].

• What people saw on the ground:

• Demand for goods was low.
• Many factories lay idle.

• Workers were thrown out of their jobs.

• None of this fits the classical picture. Factories were idle and workers wanted jobs, but the markets did not "clear".

Unemployment rate: formula and worked example

• Unemployment rate = (number of people not working but looking for jobs) ÷ (number of people working or looking for jobs) × 100
• The bottom part of the formula (people working + people looking for work) is called the labour force.
• Example: a town has 200 people.
• 120 people have jobs.
• 40 people have no job but are looking for one.
• 40 people are neither working nor looking (students, retired people). They are not counted.
• Labour force = 120 + 40 = 160.

• Unemployment rate = 40 ÷ 160 × 100 = 25%. This is the US figure for 1933.

• Output example: if US output was 100 units in 1929, a fall of about 33% leaves about 67 units by 1933.

The lesson

• An economy can stay stuck in long-lasting unemployment. It does not always correct itself.
• The existing economic theory could not explain why the collapse happened. It also could not offer good policy answers [2].
• A new theory was needed.

3. Keynes and the birth of macroeconomics

John Maynard Keynes: profile

• A British economist, born 1883.
• Educated at King's College, Cambridge. He later became its Dean.
• Took part in diplomacy after the First World War.
• A shrewd foreign-currency speculator. He bought and sold currencies to profit from changes in their prices.
• Bretton Woods link (extension):
• In September–October 1943, Keynes led the British delegation in nine meetings in Washington with a US group led by Harry Dexter White. They discussed plans for the post-war monetary system [4].
• The Bretton Woods Conference opened on 1 July 1944, with delegates from 45 countries [4].
• It ended on 22 July 1944 [4].
• It created the IMF and the World Bank.

Two landmark books

• The Economic Consequences of the Peace (1919): predicted that the peace settlement after the First World War would break down.
• The General Theory of Employment, Interest and Money (1936): one of the most influential economics books of the 20th century.
• Its core claim: a free-market system does not automatically create full employment. So the government should use its economic power to help reach full employment [5].

Keynesian economics: the core ideas

• Keynesian economics: the approach Keynes set out in 1936.

• It studies the economy as a whole, and how its sectors (households, firms, government, the rest of the world) depend on each other.

• Aggregate demand (AD): the total planned spending in the economy. It is the sum of spending by households, businesses and the government [2].

• Keynes treated AD as the most important driving force in an economy [2].

• Involuntary unemployment: people are willing to work at the going wage but cannot find a job.

• Keynes explained why it can last a long time: deficient aggregate demand, meaning too little total spending.

• Too little demand → firms cannot sell → they cut output → they lay off workers.

• Sticky wages and prices: prices, and especially wages, respond slowly to changes in supply and demand. This causes periods of shortage and surplus, especially of labour [2].

• So the classical idea that "wages fall, and then everyone is hired" does not work quickly.

• Active role of the State: Keynes supported countercyclical fiscal policy, meaning government policy that moves against the business cycle [2]:

• In a slowdown: the government spends more and runs a deficit (spends more than it earns) to lift demand.

• In a boom: the government raises taxes to stop inflation (a general rise in prices).

• Fiscal multiplier (preview): if the fiscal multiplier is greater than 1, then ₹1 of extra government spending raises total output by more than ₹1 [2]. The multiplier is covered in detail later in this topic.

• Birth of a subject: with Keynes, macroeconomics became a separate subject in the 1930s. Macroeconomics is the study of the whole economy: total output, employment and the price level.

Classical vs Keynesian: comparison

	Classical	Keynesian
Normal state	Full employment	Can get stuck below full employment
What sets output	Supply (labour, capital, technology)	Aggregate demand
Key law or idea	Say's law: supply creates its own demand	Demand deficiency; aggregate demand drives output
Wages and prices	Flexible, so markets clear	Rigid ("sticky") in the short run
Unemployment	Voluntary or frictional only	Involuntary, caused by too little demand
Self-correction	Automatic	Not automatic, or very slow
Role of the State	Minimal	Active demand management (countercyclical fiscal policy)

4. Method: ceteris paribus in two stages

• Ceteris paribus: Latin for "other things remaining equal".
• To solve for one variable, we hold all the others constant.

• It works like solving two equations by substitution: fix one unknown, then solve for the other.

• NCERT Class 12, Determination of Income and Employment, works in two stages:

• Stage 1: the price level is fixed and the interest rate is constant. We solve for national income (the total income of the country). This whole note works at this stage.

• Stage 2: prices are allowed to vary, and the equilibrium is analysed again.

• Why the interest rate matters: investment depends on the interest rate. If the interest rate is held constant, investment can be treated as a fixed amount.

• Worked example (Stage 1):
• Consumption: C = 100 + 0.8Y (here Y is income).
• Investment is fixed at I = 50, because the interest rate is held constant.
• In equilibrium, output equals planned spending: Y = C + I.
• Substitute: Y = 100 + 0.8Y + 50.
• So 0.2Y = 150, which gives Y = 750.
• Prices do not appear anywhere. They are "held equal" (ceteris paribus).

Prelims Hooks

• Say's law = "supply creates its own demand". It is a classical idea, not a Keynesian one.
• In the classical view, output is supply-determined (by labour, capital and technology). In the Keynesian view, output in the short run is demand-determined.
• Unemployment rate = people not working but looking for jobs ÷ labour force (people working or looking for jobs). People who are not looking for work are left out of both the top and the bottom of the formula.
• USA, 1929–1933: unemployment rose from 3% to 25%, and output fell by about 33%.
• The General Theory of Employment, Interest and Money = 1936. The Economic Consequences of the Peace = 1919. Do not mix up the two years.
• Keynes explained involuntary unemployment by deficient aggregate demand, not by high wages alone.
• Macroeconomics became a separate subject in the 1930s, after the Great Depression.
• Bretton Woods Conference: 1–22 July 1944, 45 countries. It created the IMF and the World Bank. Keynes led Britain in the talks before the conference [4].
• Ceteris paribus = "other things remaining equal". In NCERT's Stage 1, the price level and the interest rate are fixed.
• Trap: "Keynes assumed wages and prices are fully flexible." This is wrong. That is the classical assumption. Keynes treated them as sticky in the short run.

Mains Points

• Market self-correction vs State action (GS-III):
• The Great Depression showed that markets can stay stuck below full employment for years.
• This gives the reason for countercyclical fiscal policy: spend more in slowdowns and tighten in booms [2].

• India's stimulus after 2008 and its spending push during COVID-19 are examples of demand management in this spirit.

• Demand-side vs supply-side constraints in India:

• The classical view explains long-run growth (labour, capital, technology). The Keynesian view explains short-run slowdowns.

• An answer should use both. Supply-side reforms raise potential output. Demand support fills the gap when private spending is weak.

• Deflation and the debt burden:

• Falling prices raise the real burden of debt, and this pushes demand down further [3].

• This is one reason central banks such as the RBI target mild positive inflation rather than zero inflation.

• Institutional legacy:

• Keynes's ideas shaped the post-war order through the IMF and the World Bank (Bretton Woods, 1944) [4].
• This is useful for GS-II answers on global economic governance and on reforming the Bretton Woods institutions.