Question

Discuss some short comings of the Classical Model in explaining the Great Depression of the 1930s. What feature(s) of the Keynesian Model explains the Great Depression more effectively, relative to the classical model?

Answer 1

Classical Theory is based on the idea of "Laissez-Faire". It says the economy is self-adjsuting and is capable of reaching at natural level of output on its own through supply-demand interactions. The theory discourages the role of the Government in solving macroeconomic issues. They assumed full wage and price flexibility.

During the Great Depression, many firms went bankrupt due to sudden fall in the stock prices. Consumer confidence, therefore, turned negative about the future outlook of the economy. Consumers started spending less and save more money. The demand for money in the hands of the public increased manifold. On the production side, lower consumer spending lead to fall in aggregate demand. Lower AD discouraged the producers to produce more. As a result, output fall and the wages of the workers started showing negative trend. But during this time, both prices and wages becomes rigid so much so that the imbalance between demand and supply created huge unemployment. The old classical theory suggestions failed as the equilibrium between demand and supply could not be maintained.

Shortcomings of Classical Model:

- Assumption of full price and wage flexibility

- Assumption of economy being at full employment level in the long run

- No Government intervention

Economy was characterized by the situation of Liquidity Crisis where the monetary policy becomes completely ineffective to raise the output level.

The Keynesian model, however, however gave practical and effective solutions to the existing crisis. Keynes argued that the government has to intervene in the market to boost the consumers and investors confidence. The government has to incur huge expenditure on its infrastructure so that the positive signs are given to the consumers that the economy is growing up.

He also argued that price and wages not flexible and does not adjust to supply and demand conditions. These suggestions help the nations to revive their economies. The respective governments started to spend more and tax less. Consumers confidence thus showed a boost and the aggregate demand started rising.

**if you liked the answer, then please upvote. Would be motivating for me. Thanks.