What are Keynesian vs Neoclassical Macroeconomic Policy Recommendations?

Let’s summarize what neoclassical economists recommend for macroeconomic policy. Neoclassical economists do not believe in “fine tuning” the economy. They believe that a stable economic environment with a low rate of inflation fosters economic growth. Similarly, tax rates should be low and unchanging. In this environment, private economic agents can make the best possible investment decisions, which will lead to optimal investment in physical and human capital as well as research and development to promote improvements in technology.

We can compare finding the balance between Keynesian and Neoclassical models to the challenge of riding two horses simultaneously. When a circus performer stands on two horses, with a foot on each one, much of the excitement for the viewer lies in contemplating the gap between the two. As modern macroeconomists ride into the future on two horses—with one foot on the short-term Keynesian perspective and one foot on the long-term neoclassical perspective—the balancing act may look uncomfortable, but there does not seem to be any way to avoid it. Each approach, Keynesian and neoclassical, has its strengths and weaknesses.

The short-term Keynesian model, built on the importance of aggregate demand as a cause of business cycles and a degree of wage and price rigidity, does a sound job of explaining many recessions and why cyclical unemployment rises and falls. By focusing on the short-run aggregate demand adjustments, Keynesian economics risks overlooking the long-term causes of economic growth or the natural rate of unemployment that exist even when the economy is producing at potential GDP.

The neoclassical model, with its emphasis on aggregate supply, focuses on the underlying determinants of output and employment in markets, and thus tends to put more emphasis on economic growth and how labor markets work. However, the neoclassical view is not especially helpful in explaining why unemployment moves up and down over short time horizons of a few years. Nor is the neoclassical model especially helpful when the economy is mired in an especially deep and long-lasting recession, like the 1930s Great Depression. Keynesian economics tends to view inflation as a price that might sometimes be paid for lower unemployment; neoclassical economics tends to view inflation as a cost that offers no offsetting gains in terms of lower unemployment.

Macroeconomics cannot, however, be summed up as an argument between one group of economists who are pure Keynesians and another group who are pure neoclassicists. Instead, many mainstream economists believe both the Keynesian and neoclassical perspectives. Robert Solow, the Nobel laureate in economics in 1987, described the dual approach in this way:

At short time scales, I think, something sort of ‘Keynesian’ is a good approximation, and surely better than anything straight ‘neoclassical.’ At very long time scales, the interesting questions are best studied in a neoclassical framework, and attention to the Keynesian side of things would be a minor distraction. At the five-to-ten-year time scale, we have to piece things together as best we can, and look for a hybrid model that will do the job.

Many modern macroeconomists spend considerable time and energy trying to construct models that blend the most attractive aspects of the Keynesian and neoclassical approaches. It is possible to construct a somewhat complex mathematical model where aggregate demand and sticky wages and prices matter in the short run, but wages, prices, and aggregate supply adjust in the long run. However, creating an overall model that encompasses both short-term Keynesian and long-term neoclassical models is not easy.

Related Topics

• Keynesian Perspective of Aggregate Demand
• Recessionary and Inflationary Gap
• Consumption Expenditure
• Investment Expenditure
• Government Spending in Aggregate Demand
• Net Exports in Aggregate Demand
• Keynesian Economic Analysis
• Wage and Price Stickiness 
• Coordination Argument of Wage Stickiness
• What are Menu Costs
• Keynesian Assumptions in the Aggregate Demand and Aggregate Supply Model
• Macroeconomic Externality
• Expenditure Multiplier
• The Phillips Curve
• Keynesian Approach to Unemployment and Inflation
• Keynesian Perspective on Market Forces
• NeoClassical Economics
• Long Run Potential GDP
• Physical Capital Affects Productivity
• Potential GDP in the Aggregate Demand Aggregate Supply Model
• Prices are Flexible in the Long Run
• Keynesian and NeoClassical View of Long-Run Aggregate Supply and Demand
• Speed of Macroeconomic Adjustment of Wages and Prices
• Paradox of Rationality
• Rational Expectations Theory
• Shapley Value
• Mechanism Design Theory
• What is the Adaptive Expectations Theory
• Measure Inflation Expectations
• Neoclassical Phillips Curve Tradeoff
• Neoclassical View of Unemployment
• Neoclassical View of Recessions
• Keynesian vs Neoclassical Macroeconomic Policy Recommendations