Classicals Versus Keynesians
The classical approach and the Keynesian approach are the two major intellectual traditions in macroeconomics. We discuss the differences between the two approaches briefly here and in much greater detail later in the book.
The Classical Approach. The origins of the classical approach go back more than two centuries, at least to the famous Scottish economist Adam Smith. In 1776 Smith published his classic, The Wealth of Nations, in which he proposed the concept of the "invisible hand." The idea of the invisible hand is that, if there are free markets and individuals conduct their economic affairs in their own best interests, the overall economy will work well. As Smith put it, in a market economy, individuals pursuing their own self-interests seem to be led by an invisible hand to maximize the general welfare of everyone in the economy.
However, we must not overstate what Smith claimed: To say that an invisible hand is at work does not mean that no one in a market economy will be hungry or dissatisfied; free markets cannot insulate a nation from the effects of drought, war, or political instability. Nor does the invisible hand rule out the existence of great inequalities between the rich and the poor, because in Smith's analysis he took the initial distribution of wealth among people as given. Rather, the invisible-hand idea says that given a country's resources (natural, human, and technological) and its irtitial distribution of wealth, the use of free markets will make people as economically well off as possible.
Validity of the invisible-hand idea depends on a key assumption: The various markets in the economy, including financial markets, labor markets, and markets for goods and services, must function smoothly and without impediments such as minimum wages and interest rate ceilings. In particular, wages and prices must adjust rapidly enough to maintain equilibrium a situation in which the quantities demanded and...
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