In: Economics
1. Compare and contrast the Classical and Keynesian Models of macroeconomics. In your answer, be sure to: • Identify the key assumptions of each Model, • Describe how its contrasting variable (potential output in the Classical Model and planned aggregate expenditure in the Keynesian Model) is calculated, • Explain how each Model defines short-run equilibrium output, • Graph (label all axes!) how each Model would show a recessionary gap, and • Discuss how each Model describes what long-run equilibrium output looks like.
Shape of long-run aggregate supply
A distinction between the Keynesian and classical view of macroeconomics can be illustrated looking at the long run aggregate supply (LRAS).
Classical view of Long Run Aggregate Supply
The Classical view is that Long Run Aggregate Supply (LRAS) is inelastic. This has important implications. The classical view suggests that real GDP is determined by supply-side factors – the level of investment, the level of capital and the productivity of labour e.t.c. Classical economists suggest that in the long-term, an increase in aggregate demand (faster than growth in LRAS), will just cause inflation and will not increase real GDP
Keynesian view of Long Run Aggregate Supply
The Keynesian view of long-run aggregate supply is different. They argue that the economy can be below full capacity in the long term. Keynesians argue output can be below full capacity for various reasons:
Keynesians argue greater emphasis on the role of aggregate demand in causing and overcoming a recession.
2. Demand deficient unemployment
Because of the different opinions about the shape of the aggregate supply and the role of aggregate demand in influencing economic growth, there are different views about the cause of unemployment
3. Phillips Curve trade-off
A classical view would reject the long-run trade-off between unemployment, suggested by the Phillips Curve.
Classical economists say that in the short term, you might be able to reduce unemployment below the natural rate by increasing AD. But, in the long-term, when wages adjust, unemployment will return to the natural rate, and there will be higher inflation. Therefore, there is no trade-off in the long-run
Keynesians support the idea that there can be a trade-off between unemployment and inflation.
In a recession, increasing AD will lead to a fall in unemployment, though it may be at the cost of higher inflation rate.
4. Flexibility of prices and wages
In the classical model, there is an assumption that prices and wages are flexible, and in the long-term markets will be efficient and clear. For example, suppose there was a fall in aggregate demand, in the classical model this fall in demand for labour would cause a fall in wages. This decline in wages would ensure that full employment was maintained and markets ‘clear’.
A fall in demand for labour would cause wages to fall from W1 to We
However, Keynesians argue that in the real world, wages are often inflexible. In particular, wages are ‘sticky downwards’. Workers resist nominal wage cuts. For example, if there were a fall in demand for labour, trade unions would reject nominal wage cuts; therefore, in the Keynesian model, it is easier for labour markets to have disequilibrium.Wages would stay at W1, and unemployment would result.
A Keynesian would argue in this situation the best solution is to increase aggregate demand. In a recession, if the government did force lower wages, this might be counter-productive because lower wages would lead to lower spending and a further fall in aggregate demand.
5. Rationality and confidence
Another difference behind the theories is different beliefs about the rationality of people.
Difference in policy recommendations
1. Government spending
2. Fiscal Policy
3. Government borrowing
4. Supply side policies
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