[MUSIC] Welcome to the power of macro economics. The purpose of this lesson is to first illustrate why classical economics gave way to Keynesianism in the 1930s. This discussion sets the stage for the development of one of the most important tools used in macro economics. The aggregate supply-aggregate demand framework. The debate between classical economists and Keynesians ranks as one of the most important in macroeconomics. It is a debate that goes back to the 1930s in the Great Depression. However, it remains a very important one, even today. This is because many of the macroeconomic policies now favored by conservatives, have their roots in classical economics. While those on the other side of the ideological spectrum, are generally much more supportive of the Keynesian approach. In analyzing this debate, the most important point we'll make is that the classical versus Keynesian controversy is primarily a dispute over how an economy adjusts during a recession and finds its way back to full employment. On the one hand, the classical economists believe that a price adjustment mechanism would cure the economy. Specifically, they believe that in the event of unemployment, prices, wages and interest rates would all fall. This would in turn increase consumption, production and investment, and quickly return the economy back to its full employment equilibrium. In contrast, the Keynesian school argued that before the price adjustment mechanism had time to work, it would be overpowered by a more deadly income adjustment mechanism. To the Keynsenians when an economy sinks into a recession people's incomes fall. This fall in income causes them to both spend less and save less, while businesses respond by investing and producing less. This reduction in consumption, savings, investment, and output in turn drives the economy deeper into recession rather than back to full employment. You can see now why this debate is so important. One school of economics, the classical approach, believes that the best cure for a recession is to leave the free market alone. This approach is also known as Laissez faire. And laissez faire economists are those who believe that most government policies will probably make things worse, not better, so the best policy is relatively little government. On the other hand, the other schools, the Keynesians, prescribes large-scale government expenditures to prime the economic pump. Keynesians typically are activist economists who believe that the government can create and implement policies that will positively affect the economy. To frame this debate, let's start with classical economics. Classical economics has its roots in the free market writings of eighteenth century economists like Adam Smith, David Ricardo, and most importantly, Jean Baptiste Say. These classical economists believe that the problem of unemployment was a natural part of the business cycle. That it was self-correcting, and most importantly, that there was no need for the government to intervene in the free market to correct it. They blamed unemployment on wages that were too high and believed that in the event of a recesion, unemployed workers would be willing to work for less. Wages would then fall back down to levels where it once again made it profitable for firms to hire the workers and the recession would end. Thus in terms of our discussion of unemployment in the first lecture, classical economists agreed that frictional and structural unemployment could exist. But they did not agree that cyclical unemploymnet could be caused by a shortage of aggregate demand. Between the Civil War and the roaring 20s, America sustained periodic booms and busts recording no less than five official depressions. However, after ever bust the economy always bounced back exactly as the classical economists predicted. That was true until the classic economists met their match in the Great Depression of the 1930s. While President Herbert Hoover kept promising that prosperity was just around the corner, and the classical economists kept waiting for what they viewed as the inevitable recovery, a towering figure walked on to the macroeconomic stage. Economist John Maynard Keynes. John Maynard Keynes was born in 1883, the son of a British economist famous in his own right, John Neville Keynes. Maynard Keynes was by all accounts a genius who made millions as a stock market speculator. He was also a distinguished patron of the arts. A faculty member at Cambridge University, and a key appointee to the British Treasury. In 1946, with the global economy flat on its back, Keynes published the general theory of employment, interest, and money. In that book Keynes flatly rejected the classical notion of a self-correcting economy that would solve unemployment through adjustments in wages and prices. Keynes argued that patiently waiting for the eventual recovery was fruitless. Because in the long run we're all dead. And Keynes believed that under certain circumstances a recessionary economy would only not naturally rebound. But even worse, fall into a deep spiral. To Keynes, the only way to get the economy moving again was to prime the economic pump with massive government expenditures. From an historical perspective, it is important to emphasize that, at the time Keynes' approach was economic heresy. Indeed, the Keynesian prescription was initially rejected by the entire economics profession. Far worse, Keynes and his followers were branded as socialists or even communists for advocating such an activist role for the central government. To his credit, Keynes stuck to his guns and, as the Depression wore on, his teachings gained both adherents and disciples.
