John Meynard Keynes was the main proponent of Keynesian Economics. Although educated under Alfred Marshall, a hard-line classical economist, Keynes did not agree with the classical point of view advocated by Marshall, specially about the trade cycle.
It may be recalled that in the history of the United Kingdom, there was a time in the inter-war period when unemployment was at a very high level. The minimum recorded was 5 percent but the worst was a soaring 20 percent of the total labor force (Baddock, 1992).
In relation to this, according to classical economists (who actually are followers of Adam Smith’s and David Ricardo’s “market-driven economics”), when trade cycle experience a down turn, production decline hence the rise of unemployment levels. As demand for labor get so low, wage rates will have the tendency to fall likewise, as the workers will lower their asking price as they compete among each other for jobs. Eventually, the wage levels will be so low that businessmen will realize that a low cost in wages will enable them to make profit again. They will start to reinvest, production will rise again and so will employment. The economy will begin to expand until such time that rising prices will bring about another down turn in the trade cycle (Baddock, 1992).
Given the above, the classical economists concluded that the failure of an economy to recover may be caused by the inflexibility of wage rates even in the face of massive unemployment. Their recommendation was that the labor force must be willing to accept wage cuts to keep employment rising again.
Keynes did not agree with such classical notion. He argued that although wage cut policies may work in specific industries, a general cut in wage rates will, following the more basic macroeconomic theory, decrease the buying power of people and decrease consumption and further, will lead to the decrease in the aggregate demand and income. He held that with this chain of effects, the economic slump will be worsened.
Economists from the classical school , one of them was Arthur Pigou, did not agree with the above idea of Keynes (He was also educated under Alfred Marshall and followed the classical stance of his mentor) Pigou held that by lowering wages, the general price levels will also be lowered, and therefore, money in the hands of the people will actually have more buying power and lead to higher demand and consumption. In other words, Pigou believed that wage cuts will control or lower inflation and will cause the economic upturn. This phenomenon which came to be known as the Pigou Effect was said to be not fully proven, but Pigou insisted that this can really be stimulated when businessmen start injecting new investments and expenditures because of the low cost they have to pay for labor (Samuelson, 1982).
The Keynesian reaction to the Pigou Effect was that, if new money (investments) is what is necessary to create an upturn in the economy, then why should government not do so without necessarily cutting off wages.
From the above, a summary may be partially drawn. The Keynesian school of thought advocates government expenditure to solve unemployment and trigger economic growth. Based on this notion, Keynesian economists are batting for expansionary fiscal policy to influence aggregate demand and lower the unemployment levels. On the other hand, classical economists are batting for a restrictive monetary policy (which may be in the form of government expenditure cutbacks) to limit the money circulating in the market and thereby, control inflation.