Question

Summarize the difference between the Classical Model (Hayek) and the Keynesian Model (Keynes) Make sure to discuss fiscal policy and monetary policy responses.

Answer 1

Keynesian economic theory comes from British economist John Maynard Keynes, and arose from his analysis of the Great Depression in the 1930s.The differences between Keynesian theory and classical economy theory affect government policies, among other things.One side believes government should play an active role in controlling the economy, while the other school thinks the economy is better left alone to regulate itself.The implications of both also have consequences for small business owners when trying to make strategic decisions to develop their companies.Classical economics emphasises the fact that free markets lead to an efficient outcome and are self-regulating.In macroeconomics, classical economics assumes the long run aggregate supply curve is inelastic; therefore any deviation from full employment will only be temporary.

The Classical model stresses the Keynesians argue that the economy can be below full capacity for a considerable time due to imperfect markets.Keynesians place a greater role for expansionary fiscal policy (government intervention)to overcome recession.Shape of long-run aggregate supply.A distinction between the Keynesian and classical view of macroeconomics can be illustrated looking at the long run aggregate supply (LRAS).

Classical view of Long Run Aggregate Supply:-

The Classical view is that Long Run Aggregate Supply (LRAS) is inelastic. This has important implications. The classical view suggests that real GDP is determined by supply-side factors – the level of investment, the level of capital and the productivity of labour e.t.c. Classical economists suggest that in the long-term, an increase in aggregate demand (faster than growth in LRAS), will just cause inflation and will not increase real GDP>.Classical economists argue that unemployment is caused by supply side factors real wage unemployment, frictional unemployment and structural factors.They downplay the role demand deficientunemployment.Keynesians place a greater emphasis on demand deficient unemployment. For example the current situation in Europe (2014), a Keynesian would say that this unemployment is partly due to insufficient economic growth and low growth of aggregate demand (AD).

Monetary policy refers to central bank activities that are directed toward influencing the quantity of money and credit in an economy. By contrast, fiscal policy refers to the government’s decisions about taxation and spending. Both monetary and fiscal policies are used to regulate economic activity over time. They can be used to accelerate growth when an economy starts to slow or to moderate growth and activity when an economy starts to overheat. In addition, fiscal policy can be used to redistribute income and wealth.The overarching goal of both monetary and fiscal policy is normally the creation of an economic environment where growth is stable and positive and inflation is stable and low. Crucially, the aim is therefore to steer the underlying economy so that it does not experience economic booms that may be followed by extended periods of low or negative growth and high levels of unemployment. In such a stable economic environment, householders can feel secure in their consumption and saving decisions, while corporations can concentrate on their investment decisions, on making their regular coupon payments to their bond holders and on making profits for their shareholders.