Question

(20 PTS) Compare and contrast the Classical Macroeconomic Model with the Keynesian Macroeconomic Model. More specifically, I want you to answer the following questions.

a. What assumptions does the Classical Model make to arrive at this result for the impact of monetary policy?

b. Can fiscal policy increase real economic output in the Keynesian Model why or why not?

c. Can monetary policy increase real economic output in the Keynesian Model why or why not?

Answer 1

The classical model can be, in narrow-manner, stated by the Say's law that supply creates its own demand. The Keyensian model however, emphasizes more on the demand side. The different aggregate supply curves and the assumption about full employment also explains the difference in classical and keynesian models.

(a) The classical model beleives in the quantity theory of money, which is stated as , where P is price level, Y is real output, M is money supply and V is velocity of money. It is to be noted that PY will be the nominal GDP. The classical assumes that while V is constant over time, and economy is always at full-employment, an increase in M would not increase Y, but would increase only P, in the same proportion. Hence, according to the classicals, the increase/decrease in money supply would only affect Pm, resulting in inflation/deflation. The other supporting assumption to this are that wages are fully flexible in both directions (they can increase or decrease as well), and rejection of Phillip's curve even in the short run. This is the reason that classicals stressed that the economy should be laissez faire, and that government intervention during recession would only affect P, and not Y.

(b) The fiscal policy does affects the real output in the Keynesian model, but to some extent. According to them, an expansionary fiscal policy would increase the real GDP when the economy is away from the full employment.

The change in AD1 to AD2 to AD3 to AD4 is caused by the government spending. The AS is the long run AS. The output in AD1 and AS is less than the potential output. As AD shifts, the output increases, but it is no use to increase it further than the AD4, as that would increase only price and not the real GDP. Expansionary fiscal policy would only affect the output untill the economy reaches its potential GDP, which is equal to the vertiacal portion of the AS (which is aka the classical portion of AS).

(c) Keynesians argue that monetary policy doesn't directly affect the Y, but it does indirectly. Keynesian model states that change in money supply results to changes in loanable funds market, which causes changes in interest rate, and that causes change in Y. If there is an increase in money supply, then the interest rate decreases, and that increases the investment expenditure, increasing the Y. However, they don't emphasize it due to assumptions on the interest rate sensitivity of the economy for lower interest rate.