Critique of Classical Theory & the Rise of Keynesian Theory Classical Economic Theory

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Critique of Classical Theory
&
The Rise of Keynesian Theory
Classical Economic Theory

Classical theory of economics states that a free market economy is self-regulating and that with full employment, the economy would reach equilibrium. The classical theory is fundamentally based on the Say's Law which states that "Supply creates its own Demand". This also made the classical economists believe that there was nothing to prevent an economy from growing and hence attaining a state of full employment. This would be achievable as long as employees are willing to work for a wage that was no more than their productivity and in this situation, the profit-seeking businesses would want to employ everyone.

According to the Classical economists, full employment of real GDP stays the same regardless of the price level. During a recession or a depression, the aggregate demand in the economy would fall and in the current price levels, consumption reduces and thus there would be an excess of goods in the market. This excess supply would result in the fall of the prices as well as wage rates and hence go back to the state of equilibrium.

The Great Depression & critique on the classical economic theory

But this theory was proven wrong by the Great Depression as it was seen that when output is below the full employment level, price levels did not fall because wages and resource prices did not fall as they were sticky. In order to have more employees, the employers needed to earn more to provide higher wages. Hence, the market balancing itself out was far from possible; in turn contradicting the classical theory. This was one of the reasons that gave way to the Keynesian theory.

Aside from the labour market, classical theory also believed that the credit market would level itself out using the laws of supply and demand. During this recession, the focus on saving was…...

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