Question

Discuss in detail the classical and keynesian theories of aggregate supply. Pointing out clearly differences and similarities between the two.

Answer 1

In macroeconomics, Classical theory of aggregate supply is based on the assumption of Say's law that supply creates its own demand and in the long run the economy will move towards full employment.i.e. when all the resources are utilised to their maximum ability and any deviation from this full employment output is a temporary phase. It also emphasised the fact that it is a free market which is self regulatory.

This theory was refuted by Keynes with intriducing another model which asserted that an economy always works below full potential or full employment output and there is always certain level of unemployment in the economy. Also the importance of government intervention is necessary to maintain any equilibrium level of output especially during recession or any other economic shocks.

In terms of long run aggregate supply curve, we can distinguish the two theories where in the classical case supply curve is inelstic in the long run and any increase in aggregate demand leads to higher inflation and not higher output as the economy has already used all its resources at full employment. in the keynesian case, as it is assumed that economy operates below full employment so any increse in aggregate demand will increase the level of output as well as price level.

In terms of unemployment, classical economists believed that supply side factors like real wage, frictional unemployment etc are responsible for the same while keynesian theory emphasised on low economic growth or low aggregate demand in the economy is responsible.

Both agreed that in the short run there is a trade off between unemployment and inflation but for the long run it doesnot hold was asserted by classical theorists.

Classical theory believed in the assumption of wage price flexibility but keynes believed that wages are sticky downwards and aggregate demand is the driving force for change.