Introduction
Economics as a subject is defined as the qualitative and quantitative study of the production, distribution, as well as the allocation of the resources. However, the study has various schools of thoughts including the Keynesian economics and the neoclassical economics. It is worth noting that the differences in these schools of thoughts are primarily pointed out by the approach taken in studying monetary policy, government spending, and the consumer behavior. According to the maxims of the neoclassical economics, individuals of economic agents make decisions on consumption and investment as influenced by rationality, as well as the ability to maximize their gains through utility and profits (Dompere 9). Accordingly, the rational choice theory would explain the utility maximization interest of the income constrained consumers or the profit maximization interest by the investors.
The Keynesian economics, on the other hand, focus on the sum of the overall spending within an economy and the associated effects on the inflation and the general output of the economy (Keynes 7). The thought was developed by Keynes, a British economist in the 1930s with the interests of understanding the great depression experienced over the time (Dompere 9). Accordingly, the school of thought indicates that the levels of inflation and the general performance of an economy explain the investment decisions made by economic agents (Dompere 9). Therefore, a few variances exist between the two schools of thought and their differences form the basis of this research. Therefore, the justification of this research is to provide a qualitative comparison between the ideas supported by the two schools (Keynes and Neoclassical) regarding investment.
Background of the Keynesian Economics
The Keynesian school of thought explains that in the short run, the level of the aggregate demand or the total spending influences the economic output of an economy (Blinder 1). Therefore, instead of depicting the capacity of the economy to produce, other factors such as the employment levels and inflation come to play (Keynes 7). The proponents of the Keynesian economics argue that decisions by the private sector often affect the macroeconomic outcomes negatively and, therefore, require the responses of the public sector, such as through government spending, monetary policies, as well as the fiscal policies (Blinder 1). The public sector interventions are often aimed at stabilizing or influencing the outputs and the business cycles observed in the investments. The Keynesian economists support a mixed economy that is dominated by the private sector, but with the public sector playing the interventionist roles, especially during the recession periods (Blinder 1).
John Maynard Keynes illustrated that if investments were to exceed savings, then an economy would experience inflation (Blinder 1). On the other hand, if the levels of savings would exceed the investments, then the economy would suffer the effects of a recession (Blinder 1). As such, the Keynesians would argue that the cause and the solution to both depression and inflation are factors related to the spending or savings by the economic agents. Therefore, when more savings cause the depression, then the intervention should be to encourage higher spending than saving (Blinder 1). However, according to the maxims of the thought, profits should explain higher spending as against just spending (Blinder 1). On the other hand, policies for higher levels of saving should be embraced to alleviate the challenges of inflation in an economy. In essence, the Keynesians believe that socially and economically successful economies have the strategic participation and contributions of both the public and the private sectors.
Background of the Neoclassical Economics
The neoclassical school of thought explains the performance of an economy from the perspective of market’s supply and demand (Hossein-Zadeh 1). The approach, therefore, focuses on determining the levels of prices, outputs, as well as the general distribution of incomes as influenced by the forces of demand and supply. Accordingly, the school holds that the customers are interested in maximizing the utility levels derived from the consumption of the goods or services produced in the market (Hossein-Zadeh 1). A producing organization, on the other hand, strives to maximize on own returns regarding profits. However, among the two, the customers holds the higher influence in the market through manipulating the levels of production through controlling pricing and general demand levels.
The neoclassical theorists are guided by some assumptions, which indicate that rational economic decisions are always made as influenced by the availability of complete information (Hossein-Zadeh 1). After comparing processes and other information available on the market, the consumers, make the decisions, which are influenced by the perceived level of utility. Besides, the suppliers focus on profit maximization as they operate in an economy (Hossein-Zadeh 1). As such, the equilibrium point in a market segment is only realized whenever both the suppliers and the customers realize their respective interests.
Aspects of New a Classical Economics
The school of thought existed before the neoclassical thought and argued that markets would function better without any interference from the government (Greenwald 14). The idea received a great welcome in the period that was characterized by protectionism maxims. The school advocated for the economic agents to be accorded the free and open competitive environment to pursue own interests as against being influenced by the government (Greenwald 14). In fact, the freedom from coercion allows the markets to develop systems of self-regulation, which Adam Smith regarded as the invisible hand (Greenwald 10). Through the invisible hand, the markets would then move towards the natural equilibrium that allows the consumers to choose among the competing suppliers. Therefore, the free and fair competition is the main pillar of classical economics, and the proponents cautioned against monopoly in the market (Greenwald 15). Although the theoretical approach was crafted in the early years of the 19th century, the relevance is still observed with some modern economists still alluding to the benefits of cultivating the free competition in the market with no government interference (Greenwald 7).
Investments in Keynesian economics
The ideology behind the Keynesian investment theory argued that investments play a central role in influencing the levels of employment and aggregate output (Fazarri 104). Unlike the previous thoughts that looked at the investment’s effect in the long term, the Keynesian theorists argued that the levels of investment influenced demand levels even in the short run, hence explaining the fluctuations in economic activities (Fazarri 104). Therefore, the theory of investment developed by the Keynesian economists indicates that the monetary and financial conditions of a firm affect its capital spending (Keynes 7). The liquidity levels and the profit margins were shown to have a direct effect on the levels of investment in an economy. Besides, the Keynesian theorists were concerned with the borrower’s and lender’s risks in financial markets as having direct effects on the general investments and related decisions (Fazarri 103).
The Keynesian theorists argue that there are two primary kinds of markets that have a direct effect towards the investment model (Fazarri 104). First, there are the markets whose prices of the capital goods are already predefined. The second represents the markets where financing and supply conditions have a direct influence on the market operations and the investments (Keynes 8). Accordingly, through the markets curves, one can always determine the deficits of surplus in the form of financing to a unit of investment (Fazarri 103). After the determination of the accrued surplus financing, the Keynesian theory of investment explains that the investor can, therefore, decide on the best ways to utilize the surplus financing (Fazarri 110). On the other hand, the theory postulates that an investor can make the best from the deficit observed in an investment through appropriate mechanisms of financing the deficits. Therefore, the theorists are concerned with the factors that have a direct influence on the decision-making process of an investor (Keynes 10). Besides, the money and the capital markets are the primary tools advocated for by the theorists in stabilizing the market operations by facilitating the deficits and providing investment advice on the use of any surplus finances in an investment (Fazarri 104).
The Keynesian theorists appreciate that the process of investing involves both the speculative as the known productivity performances in a field (Epstein 804). Besides, the immediate productivity or even scarcity of the returns from the initial capital determines the future flow of cash. From the concepts of the lender’s and the borrower risks, the Keynesian theory argues that the factors have a direct influence on the levels of investments (Epstein 804). On the side of the lender’s risk, the Keynesians believed that as the level of investment spending rose, then the lenders become more reluctant towards financing marginal projects. Besides, as the costs of the external finances rise, then the supply price also rises. The increase in price poses a risk in the investments, and the risk is more prevalent in the contractual kinds of investments (Epstein 804). Hence, there is a perceived direct link between the financial structure to a firm as explained from the Keynesian perspective and the corresponding levels of investment. Another aspect of investments as highlighted by the Keynesian economists is the preference to initial capital as against re-investments (Epstein 804). The internal finances from the initial investment pose lowered opportunity costs of investment as compared to borrowing from external sources for growth. Therefore, the lender’s risk entails the unwillingness of external funders to finance the operations of firms that could be in a position to finance own projects (Epstein 804-807).
The borrower’s risk as explained by the Keynesians could be easily understood as the doubts that cross the mind of an investor whenever he/she considers channeling higher amounts of finances in an investment (Greenwald 107). While the growth curve of the investment may require such a boost with external funds, arriving at the decision of investing, the higher finances face the real risk of uncertainties. Therefore, according to the theorists, the doubts have a strategic influence on the investment decisions as taken by an investor (Greenwald 104).
Investment in neoclassical economic
The neoclassical theorists have some fundamental assumptions, which have a direct influence on the investment decisions that investors embrace (Nadeau 1). First, any investor must have a clear objective of the functional aspects of the enterprise to be created. The principle-agent hypothesis as developed by Stiglitz has associated direct effects on the investment decisions made by any modern investor (Nadeau 1). Nevertheless, the assertion was taken by the neoclassical investors that all enterprises’ objectives representing the owner’s risk are challenged by the classical theorists (Keen 1). However, Keynes showed that the managers represent individual and distinct agents in an economic set up just as is the case with the enterprises established (Nadeau 1).
The proponents of the neoclassical theory argue that the aspect of higher savings has a direct connection with investment (Nadeau 1). Therefore, according to the theory, the market should always stress the essence of increased savings, a situation that would have a direct effect on the level of investments managed by an economy (Keen 1). As motioned in the new classical theory, enterprise and thrift constitute the overall output of an economy (Nadeau 1). As such, there are the two major behavioral coefficients in the theory and that have direct effects on the levels of investment. Thrift on one side indicates the propensity to save for the economic agents without being coerced into the same. The likelihood of the agents to differ the present consumption for the future, therefore, explains the propensity to save (Nadeau 1). On the coefficient of enterprise, the economic agents would show their likelihood to invest which could be influenced by the availability of investment opportunities as well as the perceived rate of return on the capital injected (Nadeau 1). Although fixed in the short run, the coefficients have no direct effect on the levels of GDP realized in an economy, but influence the composition of the GDP (Nadeau 1).
The increase in savings results in the increase of loanable funds and the real interest rates would then decrease. The low rates of interests trigger higher demand for the loans, which is expected to support the investments (Nadeau 1). Therefore, according to the neoclassical theorists, the free market operations would allow the systems to be self-adjusting and as such, the lower rates of interest created by higher savings would lead to higher investments in the economy (Nadeau 1). However, decreased rates of savings triggers higher rates of loans, hence the aspect has little motivation to higher borrowing (Nadeau 1). The low rates of borrowing by the entrepreneurs have direct implications. Hence, this indicates that the levels of investments in the economy would be relatively low. However, it is worth noting that the definition of investment and its role in an economy forms the primary distinction that could be established in understanding investment from then neo-classical economics.
Comparison: Investment in Keynes and Neoclassical
The Keynesian economist finds an error in the neoclassical and new classical economists’ supposition that microeconomic assumptions can be applied in macroeconomic situations (Keynes 7). First, the argument fronted by Keynes was that “macro” cannot be the sum of micro as would be the hypothesis of the classical thoughts (Crotty 2). For instance, when the saving habit of an individual is highly encouraged, the saving by all populations would not be desirable for an economy as that would have a negative effect on the total demand in the economy. By assuming that the aggregate demand of commodities falls, then the produced goods would not sell, a situation that would result in fewer investments (Crotty 1). While the problem could be perceived from the micro level, the effects would be felt across the economy as the general investments, output, employment, as well as income levels fall.
In another approach, the neoclassical economists call for increased savings with the assumption that all the savings are translated into investments. Keynes would develop an argument opposing the assumption that savings are directly invested because not all those who will save are investors (Haavelmo 3). In fact, according to the Keynes’ criticism, savings depict a form of hoarding, which illustrates unspent money. Hoarding money, on the other hand, is perceived as a leakage from the stream of income and in this aspect, Keynesians call for increased liquidity (Haavelmo 3). From the demand and supply illustration, increased savings cause reduced consumption, a situation that lower the aggregate demand at the macro levels.
For instance, if the production gives $50000, therefore, not all of the income is spent on investment. Some of the income could be used for consumption while some would be saved and that represents a leakage. As in the illustration below, the amount of funds saved is removed from the general circulation, and that does not imply the funds are invested as assumed by neoclassical economists.
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Accordingly, the Keynesians perceive total investment as the summation of the autonomous government investment plus the induced or private investments.
Investments = Autonomous investment + induced investment
It is worth noting that the Keynesians argue that the autonomous investments are not motivated by profit (Haavelmo 3). On the other hand, the induced investments are directly affected by the profit expectations. Whereas the interest rates play a role in motivating the induced kind of investments, the profit motive has a higher influence (Haavelmo 3). In the contrast, the neo-classical theorists would argue that interest rates alone affect the levels of investment in an economy.
One point of distinction that the Keynesians emphasize on is the difference between the funds within a firm and the household’s disposable income as is often used interchangeably by the classical economists (Greenwald 14). Accordingly, Keynes would argue that if the markets were to be perfect, then no such differences in household spending, as well as the firms spending, would be pointed out (Crotty 2). The maxims of the Keynesian school of thought illustrate that economic growth is realized through the accumulation of capital. However, the theory also insists on the essence of financing the capital growth as against setting funds aside for the sake of savings or having the funds leak from the circulation (Crotty 2). Firms should, however, be able to invest in such ventures, which would warrant realization of the highest possible profit margins for the essence of improving the safety and growth prospects. In contrast, if the firms were to focus on investments that promise little returns, then the firms would likely face challenges in growth as explained by increased risks. As such, the Keynesian thoughts would expect the decision-making dilemma on growth and safety balance in investment agendas for the investing firms (Hossein-Zadeh 1). Therefore, according to the Keynesian principles of investment, a firm’s management must balance the profit margins, the interest rates, the anticipated rate of growth, and a low sense of uncertainty when deciding on investment at ceteris paribus (Hossein-Zadeh 1).
On another dimension, when firms become pessimistic about the future or when the future of investment is uncertain, then the firms may take the least risk in deciding about financing options like loans, which would be associated with higher risks (Fazarri 103). Accordingly, such rational firms would make little or no investments in the times of such uncertainties (Fazarri 103). In the contrast, whenever a firm is optimistic about the future and when the future holds little uncertainties, the firms would take any level of risk in complementing its funds with loans, which would facilitate higher investments (Dompere 9). Increased investments with the optimistic perspective often result in higher growth and increased profitability.
The theory of an investment as developed by Keynes has some properties in the comparison discussion. First, the firm is perceived as risk-averse; the firm has an incentive of regulating competition in the environment where the capital structures are highly relevant (Haavelmo 3). The theory is quite specific on the role of the management in facilitating the risk aversion and the composition of the initial as well as the growth capital for the firm (Haavelmo 3).
The theory of investment for the neoclassical economists holds very distinct differences from the Keynesians as discussed above (Hossein-Zadeh 1). Indeed, the difference is notable in the functional roles of the enterprise. First, the neoclassical assume the ownership as well as the management aspects of the modern enterprises to be distinct from each other. As such, the enterprises could be held separate from the ownership, which was against the Keynesian maxims (Hossein-Zadeh 1). However, the foundations of the neoclassical investment thoughts indicate that the primary objectives of investment firms are the maximization of the owner’s profit margins. While the assumption may be seen as inconsistent, the ideology helps the management teams maintain autonomy in investment decision-making processes as would not be possible in the maxims of the Keynesian thought (Greenwald 104). The realization of the firm’s objectives and the management or the owners’ objectives requires the collaboration of the two or otherwise having the equal participation in decision-making processes. It is worth noting that Keynes had also developed distinctions between the ownership and the enterprise management, but on the grounds of roles or objectives. Accordingly, the Keynesians would perceive the ownership objectives as being the maximization of profits over short periods of time while the management would be interested in the long-term growth prospects of the enterprise (Greenwald 104).
Secondly, the neoclassical theorists reason that one can assign numerical figures in rating the risks associated with investment decisions (Nadeau 1). Accordingly, they perceive that with the ability to quantify or rate the risks of opportunities presented with investment in an enterprise, then they would be able to avoid high risks and doubts. However, the aspect points a major difference from the Keynesian perceptions, which does not accord such numerical certainties to the investment risks or opportunities (Keynes 8). The argument here is that the neoclassical theorists advance their rationality theory into assigning numerical probabilities to the uncertainties. The rational maxims explain that the economic agents have complete knowledge of the market environment and the decisions made to comply with the rational thoughts (Nadeau 1).
Therefore, the decision-making process, especially on investments, must be influenced by the information available as well as the objectives of the decision-makers as illustrated above. However, the neoclassical rational decision-making process would be contrasted with the Keynesian conventional decision-making process (Blinder 1). In that aspect, Keynes would argue that economic agents make investment decisions from the preconceived expectations (Blinder 1). The expectations are formed from customs, traditions, habits, and instinct. In essence, the agents would base their forecasts on such conventional assumptions, which indicate that the future would be promising as ascertained from experiences. Therefore, unlike the empirical forecast made by the neoclassical theorists on investment decisions, the Keynesians embrace the conventional approach, which is perceived as less assuring.
Therefore, from the preceding discussion on the differences between the maxims of investment in the neoclassical economists and the Keynesian economists, there are the strategic areas where they differ. However, the discussion confirms that the two schools of thought have some concerns about investments and the future of the enterprises.
Conclusion
The essay reveals that the ideological perspectives on the concept of investment fronted by the Keynesian theorists and the neoclassical theorists depict strategic differences. First, the maxims of neoclassical theorists on investment are built in the enterprises’ objective function, the risk factor, as well as the physical capital perceived as liquid assets. However, the Keynesian economists argue that it is wrong for the neoclassical economists to assume that the microeconomic assumptions can be effectively embraced to explain the macroeconomic situations. In fact, saving as embraced in the neoclassical maxims is shown to be desirable. Therefore, the theory is encouraged for all individuals because this school of thought indicates that total the savings must be translated into investments. However, the Keynesians reason differently and argue that total savings do not significantly translate into investments. In fact, the Keynesian discourage total savings because it lowers the demand level, a situation that reduces investments. Therefore, there are core assumptions, particularly on the concept of investment as developed by both the Keynesians and the neo-classical perspectives. However, the two schools of thought agree that while capital could be perceived as a stock term, the investment is a flow term. Nevertheless, the study shows that capital decisions influence the investment decisions.
Works Cited
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Dompere, K. K. The Theory of Aggregate Investment in Closed Economic Systems. Westport, Conn.: Greenwood, 1999. Print.
Epstein, Richard A. “The Neoclassical Economics of Consumer Contracts.” 2007. print. 6 Nov. 2015.
Greenwald, Bruce. “Keynesian, new Keynesian, and new classical economics.” 1987. Web. 6 Nov. 2015.
Fazarri, Steven. “Keynesian theories of investment: neo, post and new”, 1989. Print
Haavelmo, Trygve. “The Theory of Investment.” A Study in the Theory of Investment. Chicago: U of Chicago, 1960. 3. Print.
Hossein-Zadeh, Ismael. “Ideological Foundations of Mainstream Neoclassical Economics: Class Interests as “Economic Theory”” Global Research. 2014. Web. 6 Nov. 2015.
Keen, Steve. “Neoclassical Economics: Mad, Bad, and Dangerous To know.” Steve Keens Debtwatch. 2009. Web. 6 Nov. 2015.
Keynes, John Maynard. “The General Theory of Employment, Interest, and Money” 1935. Print
Nadeau, Robert. “Neoclassical Economic Theory.” Neoclassical Economic Theory. 2013. Web. 6 Nov. 2015.
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