Question

Discuss the Keynesian versus classical business cycle (class notes) (Lesson 17).  Discuss the implications with regards to government intervention in the economy. What are the political implications?

Answer 1

The New Classical model has four important elements, the assumption of rational expectations, the assumption of the natural rate hypothesis, the assumption of continuous market clearing, and an assumption that agents have imperfect information. The imperfect information assumption was quite clever in that it allowed proponents of this model to explain correlations between money and income without acknowledging that systematic, predictable monetary or fiscal policy would have any effect at all on real output and employment In other words, only unexpected changes in monetary policy matter, expected changes are fully neutralized by private sector responses to the policy.

Keynesian macroeconomics destroys the classical dichotomy by abandoning the assumption that wages and prices adjust instantly to clear markets. This approach is motivated by the observation that many nominal wages are fixed by long-term labor contracts and many product prices remain unchanged for long periods of time. Once the inflexibility of wages and prices is admitted into a macroeconomic model, the classical dichotomy and the irrelevance of money quickly disappear

In contrast to both the Keynesian and the early new classical approaches to the business cycle, real business cycle theory embraces the classical dichotomy. It accepts the complete irrelevance of monetary policy, thereby denying a tenet accepted by almost all macroeconomists a decade ago. Nominal variables, such as the money supply and the price level, are assumed to have no role in explaining fluctuations in real variables, such as output and employment.

Consider the case of a temporary increase in government purchases. Almost all macroeconomists agree that such a change causes an increase in output and employment,

Real business cycle theory emphasizes the intertemporal substitution of goods and leisure. It begins by pointing out that an increase in government purchases increases the demand for goods. To achieve equilibrium in the goods market, the real interest rate must rise, which reduces consumption and investment. The increase in the real interest rate also causes individuals to reallocate leisure across time. In particular, at a higher real interest rate, working today becomes relatively more attractive than working in the future; today's labor supply therefore increases. This increase in labor supply causes equilibrium employment and output to rise.

While Keynesian theory also predicts an increase in the real interest rate in response to a temporary increase in government purchases, the effect of the real interest rate on labor supply does not play a crucial role. Instead, the increase in employment and output is due to a reduction in the amount of labor unemployed or underutilized

Both real business cycle theory and Keynesian theory thus conclude that increases in government purchases increase output and employment