Question

Explain the differences between the simple Keynesian (demand-side) model and the classical (supply side) model with respect to fiscal policy, what can change Y (Real GDP), and any other things that you think are relevant.

To answer this question correctly, you would need to:

A) Explain why fiscal policy does not change the Yd curve in the classical model but does in the

simple Keynesian model.

B) Explain that in the classical model Y only changes if Ys changes.

C) Explain that in the simple Keynesian model Y only changes if E or Yd changes.

D) Explain that there is no limit to rises in Y in the simple Keynesian model, but there are in the

classical model.

E) Explain that taxes change Ys in classical model but not in simple Keynesian model.

F) Explain that simple Keynesian model explains equilibrium in terms of inventories changing.

Classical model does not do this.

Please provide graphs/diagrams along with your explanation.

Answer 1

A) In the classical model the output is determined through supply side not from demand side. Here in classical model government has no role as long run aggregate supply is vertical then if there is change in aggregate demand there will be no change in real output and only price rise will be there. As government has no intervention in this model and Yd is determined through consumption and investment and i.e why fiscal policy has no effect on Yd.

On the other hand in simple Keynesian model government has a role to affect the aggregate demand. Yd is determined through consumption, investment and government expenditure. Here real output can change with change in fiscal policy. Fiscal policy can affect the real output through change in aggregate demand. As in simple Keynesian model government has a role to play i.e Yd changes through fiscal policy.

B) In classical model the real output is determined through Ys i.e through aggregate supply. As aggregate supply is vertical in classical model and for this any change in aggregate demand do not affect Y. Y changes only through Ys because if Ys or aggregate supply changes Y can change. It is a supply side economy. Let suppose Ys and Yd intercept at point E. Then corresponding to E, output is Y. If Ys changes to Ys1 to right side of Ys. Then equilibrium could be E1 and output can be Y1. Y1 will be greater of Y as Ys1 is more than Ys.

C). In simple Keynesian model Y changes through change in Yd or aggregate demand. As Keynesian model is demand determined model and output is determined through change in demand. Here supply will be matched by demand i.e any demand can be adjusted by supply. If Yd changes then output can change because Yd curve will shift left or right with its change and as a result it's output Y can also change.

D) In the classical model there is a limit of LRAS and output can not go beyond the level of long run aggregate supply. But in Keynesian model output can increase at any level. The short run output can be more than its potential level. It means in short run actual output can be more than potential level in case of simple Keynesian model. So output rise or rise in Y has no such limit in simple Keynesian model.