Question

Discuss how the starting point differs between the original Keynesian and Classical schools of thought per video discussions.

a. Classical models assume the long-run equilibrium in the macro-economy is at potential GDP (per class discussion).

b. How does the original Keynesian differ from this assumption? What are the long-run policy implications of the Keynesian model?

c. Discuss how modern theories are nearly all anchored to potential GDP and actual GDP cycles around.

Answer 1

(a) The classical economists believed that an economy always functions at the level of full employment if it is in equlibrium, or all the resources are fully employed in the long run and reach at the level of potential GDP. They did not rule out any possibility of unemployment but they believed if there would be unemployment, it would be temporary as it could be avoided by cutting off wages. Besides, they accepted the possibility of existing voluntary unemployment and frictional unemployment in an economy.

(b) The keynesian model differs from this assumption of classical economists as it offers the theory of underemployment equilibrium. The keynesian approach says, "It is not necessary that an economy will always function at the full employment level, an economy can also be in equilibrium at underemployment level." The keynesian approach prefers the aggregate demand rather than wages or interest rates. Apart from voluntary unemployment and frictional unemployment, Keynes also includes the possibility of involuntary unemployment.

Long run policy implications of the keynesian model:

• Labor market is not certain, therefore, wages can be sticky downward.
• Aggregate demand influences income, output, and employment. So, if AD goes decline, negative multiplier effects can be seen in an economy.
• The paradox of thrift can take place in an economy if people start saving more and spend less, which means the fall in aggregate demand.

(c) The level of production of goods and services that an economy is capable of achieving if all its resources are fully employed is known as potential GDP. On the other hand, the actual output of goods and services achieved by an economy is known as actual GDP. All the modern theories are nearly concerned with the actual and potential GDP because the health of an economy depends on the GDP gap. The GDP gap exist when actual or potential GDP exceeds each other.

Actual GDP exceeds potential GDP if the demand for goods and services exceeds production due to factors like an increase in government expenditure, which results in an inflationary gap.   

Potential GDP exceeds actual GDP when an economy producing less than that of its potential, which will result in negative output and create a situation of deflationary gap or recession.