Classical Theory

Keynesian Theory

1

Equilibrium level of income and employment is established only at the level of full employment. The premise of full employment runs throughout the whole structure of this theory.

1

Equilibrium level of income and employment is established at a point where AD = AS. But this need not be a full employment level since equilibrium can be below the level of full employment.

2

Full employment equilibrium is a normal situation. There is no possibility of under-employment equilibrium in the long-run.

2

Under-employment equilibrium is a normal situation while full employment equilibrium is an ideal and special situation.

3

The theory is based on the belief that "supply creates its own demand” which implies that whole of output is demanded and sold out. Hence there is neither general over-production nor unemployment.

3

Supply by itself cannot create a matching demand which generally results in overproduction and unemployment. On the contrary, "demand creates its own supply”.

4

In case of Temporary situation of unemployment, a cut in money wage increases employment.

4

Employment can be increased by increasing effective demand (or AD) and not by money wage cut.

5

Variation in rate of interest establishes equilibrium between saving and investment.

5

Variation in income brings about equilibrium between saving and investment.

6

Economy by itself brings about full employment equilibrium through flexible system of interest rates, wages and prices.

6

Prices, wages and interest rates may not be flexible due to presence of monopolies and trade unions.

7

Advocated policy of laissez faire and opposed government intervention since equilibrium is established automatically by market forces of demand and supply.

7

Advocated government intervention to bring about equilibrium between AD and AS through monetary and fiscal measures and to ensure full employment and its continuity.

8

The theory is based on the assumption of long-run full employment equilibrium.

8

The theory is meant for short period equilibrium of full employment.