“The failure of classical full employment equilibrium paved the way for Keynes' theory of underemployment equilibrium." Discuss critically.

Classical Full Employment Equilibrium: Foundations and Assumptions

Classical economics, rooted in the works of Adam Smith, David Ricardo, and Jean-Baptiste Say, advocated for a laissez-faire approach, believing that market forces would naturally lead to optimal outcomes, including full employment. The core tenets of classical full employment equilibrium are:

• Say's Law of Markets: "Supply creates its own demand." This fundamental principle asserted that the act of production generates an equivalent amount of income, which is then spent on goods and services, thus preventing general overproduction and unemployment.
• Flexible Wages and Prices: Classical economists assumed that wages and prices were perfectly flexible. In the event of unemployment, wages would fall, making labor cheaper and encouraging firms to hire more workers, thereby restoring full employment. Similarly, falling prices would stimulate demand.
• Interest Rate as an Equilibrating Mechanism: The rate of interest was believed to equate saving and investment. If savings exceeded investment, the interest rate would fall, discouraging saving and encouraging investment until equilibrium was restored.
• Money Neutrality: Money was considered a mere medium of exchange, having no impact on real economic variables like output and employment in the long run.
• Perfect Competition and Rational Expectations: Markets were assumed to operate under perfect competition, with economic agents making rational decisions.

Under these assumptions, any deviation from full employment was considered temporary and self-correcting. Unemployment was viewed as voluntary, resulting from individuals choosing not to work at the prevailing wage rate, or as frictional, due to the natural movement of labor.

The Failure of Classical Full Employment Equilibrium

The global economic crisis of the 1930s, known as the Great Depression, delivered a devastating blow to the credibility of classical economic theory. The scale and duration of unemployment and economic contraction during this period defied classical explanations and predictions.

• Persistent Mass Unemployment: Contrary to the classical assertion of temporary unemployment, the Great Depression witnessed prolonged periods of mass involuntary unemployment. In the United States, unemployment rates soared to 25% by 1933, and similar figures were observed in other industrialized nations. This demonstrated that market forces alone were not bringing the economy back to full employment.
• Breakdown of Say's Law: The crisis showed that supply does not automatically create its own demand. A significant portion of income was being saved rather than spent, leading to a deficiency in aggregate demand. Businesses reduced production and laid off workers because they couldn't sell their goods, not because of high wages.
• Wage and Price Rigidity: While classical theory predicted wage and price reductions would stimulate demand and employment, in reality, wages and prices proved to be "sticky downwards." Even with falling wages, unemployment persisted, as businesses lacked the incentive to hire in the face of falling demand. Moreover, significant wage cuts could further depress aggregate demand by reducing worker purchasing power.
• Failure of Interest Rate Mechanism: The interest rate mechanism failed to equate saving and investment effectively during the Depression. Despite low interest rates, investment remained subdued due to a lack of business confidence and bleak future expectations, a phenomenon Keynes would later term "animal spirits."
• Deflationary Spiral: Falling prices, instead of boosting demand, often led to a deflationary spiral, where consumers postponed purchases anticipating further price drops, exacerbating the economic downturn.

Keynes's Theory of Underemployment Equilibrium

John Maynard Keynes, in his seminal work "The General Theory of Employment, Interest and Money" (1936), offered a radical departure from classical thought, providing a theoretical framework to explain the persistent unemployment observed during the Great Depression. Keynes argued that an economy could achieve equilibrium at a level below full employment, known as underemployment equilibrium.

Key Concepts of Keynes's Theory:

• Principle of Effective Demand: Keynes argued that the level of employment is determined by the level of effective demand (total spending in the economy). If effective demand is insufficient, firms will reduce production and employment, leading to an equilibrium with involuntary unemployment.
• Aggregate Demand as the Driver: Unlike classical theory which emphasized supply, Keynesian economics places aggregate demand (sum of consumption, investment, government spending, and net exports) as the primary determinant of output and employment.
• Role of Expectations and Animal Spirits: Investment decisions are heavily influenced by business confidence and expectations about future profitability, which Keynes called "animal spirits." A decline in these can lead to a drastic fall in investment, even with low interest rates.
• Wage and Price Stickiness: Keynes highlighted that wages and prices are not perfectly flexible, especially downwards, due to factors like labor contracts, minimum wage laws, and psychological resistance to wage cuts. This rigidity prevents automatic adjustment to full employment.
• The Multiplier Effect: Keynes introduced the concept that an initial change in autonomous spending (e.g., government investment) could lead to a much larger change in national income and employment. This justified government intervention to stimulate demand.
• Liquidity Preference: Keynes introduced the concept of liquidity preference, explaining why individuals might prefer holding cash (liquidity) over investing, especially during times of uncertainty, thereby contributing to insufficient aggregate demand.
• Government Intervention: Keynes advocated for active government intervention through fiscal policy (government spending and taxation) and monetary policy (interest rate management) to manage aggregate demand and steer the economy towards full employment. He argued that waiting for self-correction was "in the long run, we are all dead."

Comparison of Classical and Keynesian Views on Employment

The fundamental differences between classical and Keynesian theories regarding employment equilibrium are summarized below:

Feature	Classical Theory	Keynesian Theory
Normal State of Economy	Full employment equilibrium (normal, automatic)	Underemployment equilibrium (normal, common)
Determinant of Employment	Supply of labor and demand for labor (flexible wages)	Aggregate demand (effective demand)
Say's Law	Valid ("Supply creates its own demand")	Invalid (Demand can be insufficient)
Wage/Price Flexibility	Perfectly flexible (self-correcting)	Sticky downwards (prevents self-correction)
Role of Interest Rate	Equilibrates saving and investment	Influences investment, but savings depend on income; can't guarantee full employment
Role of Government	Minimal (Laissez-faire)	Active intervention (fiscal and monetary policies)
Cause of Unemployment	Voluntary or frictional; wage rigidity caused by external factors	Involuntary due to insufficient aggregate demand

The failure of classical theory during the Great Depression demonstrated that economies could indeed get "stuck" in prolonged periods of high unemployment, challenging the very notion of an automatic return to full employment. This paved the way for Keynes's underemployment equilibrium, which provided both an explanation for the crisis and a prescription for policy action, fundamentally altering the course of macroeconomic thought and policy.