When the economy moves away from market-clearing equilibriums in employment we see a substantial decrease in GDP and the possibility of a recession or worse – a depression. There are, however, several theories on solutions to this problem and below I discuss the 2 most well known: The Classical Solution and the Keynesian Solution.
Classical Solution
According to those Economist who believe in the classical solution would say for the government to do nothing. They would say the Free Market is built in such a way that everything eventually meets equilibrium; everything is supposed to be correctible by the economy itself and outside regulations need not interfere. This theory has everything to do with the power of the Free Market. According to the fundamental laws of the Free Market economy – all things should balance themselves out. The keyword though is should. It all depends on how much government interferes with the Free Market.
The ways in which the government interfering with the Free Market causes the equilibrium to not take place:
Minimum Wage
This is because in a 100% Free Market there are no minimum wages – this allows for the average wage to increase or decrease based on all the factors that have to do with lack of full-employment. When there is no minimum wage then the wages are set in such a way to create equilibrium wage wise.
Price Caps
This is because in a 100% Free Market there are no price ceilings or floors. This allows for prices to be set by the consumer as Free Market is intended to operate – and businesses are able to change their prices in order to obtain market clearing equilibrium.
Keynesian Solution
According to those economists who believe in the Keynesian solution; the best way to end a recession or bring an economy back up to full-employment is for the government to create Fiscal and Monetary policies that allow businesses to correct themselves. Keynesian believed that controlling the economy was all about the flow of money – by re-directing the flow of money to go more into the population it will allow for more money in turn to be spent on goods and services and thus more jobs to create these additional goods and services.
Some of the policies used for this effect:
Decrease in interest rates
-With the decrease in interest rates more money becomes available to the economy and also allows for more investing can be done.
Increase in Government Spending
-Increased Gov. Spending means more jobs and money flowing into the economy.
Increase in Gov. Transfer payments (like unemployment checks)
-Things like this also put more of the governments money into the hands of it’s citizens.
Decrease Taxes
– Former President Reagan especially believed in decreasing taxes for the benefit of the economy. Specifically, decreasing taxes for the wealth because he believed in “trickle down economics”; the concept that savings made by those people on the top of companies means savings that are passed down to the middle and lower classes.
