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Mainstream economic thought before Keynes emphasized the of supply-side aspects of macroeconomic system. The classical economists did not concern themselves with demand issues. They had faith in say's Law of Markets. According to this law, a general overproduction of goods relative to total demand is impossible since supply or production creates its own demand. Say's law is based on the view that people do not work just for the sake of working, but they work to obtain the income required to purchase the desired goods and services. The capacity to purchase the desired products is generated by the production process in the form of wages and salaries, rent, interest and profits. Classical economists believed that is possible to produce too much of same of goods (implying full employment) and not enough of other type (implying no overproduction). In case of any discrepancies between demand and supply, the mechanism of wage-price flexibility would come into play automatically.
- The Great Depression and its adverse impact on world economy undermined the classical view and provided the foundation for the Keynesian analysis of the Great Depression, which was completely a demand side approach. Keynes rejected the classical view and offered a completely new concept of output determination. He believed that spending induced business firms to supply goods and services. From th1S he argued that if total spending fell due to pessimistic or unfavorable expectations about future, then business firms would respond by cutting production which in turn led to less spending and less output and employment. The classical economists were also aware of this possibility, but they believed the labor surplus would drive down wages, reducing costs and lowering prices until the surplus was eliminated and the economy was directed to full employment within reasonable time. Keynes and his followers rejected this view, arguing that wage-price flexibility is an impossible proposition, particularly in a downward direction in modern economies characterized by large corporate sectors and powerful trade unions. Keynes also introduced a completely different concept of equilibrium. In the Keynesian framework equilibrium takes place at a less than full employment level of output. The Keynesian view of less than full employment or less than full capacity output could be explained as aggregate expenditure or aggregate demand leads to current level of output and employment. The business sector will produce only the quantity of goods and services it believes households (i.e. domestic consumers and investing community), government and foreigners will plan to buy. If this aggregate expenditure consumption, investment, government spending and net exports is less than the economy's full capacity output, output will fall short of its potential capacity, which is the full employment level of output. When aggregate expenditure is deficient, there are no automatic forces, as believed by classical economists, capable or assuring full employment. The result is that the actual output will be less than capacity output which in turn results in prolonged unemployment and decline in output. This was how Keynes explained the Great Depression highlighting the drawbacks of self-regulating private enterprise economies.
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