Question

10.9 According to Classical theory, does an increase in G promote greater output? Concisely

EXPLAIN

(20 words and one IS-LM-FE diagram, MAX).

Answer 1

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 say that in the short term, you might be able to reduce unemployment below the natural rate by increasing AD. But, in the long-term, when wages adjust, unemployment will return to the natural rate, and there will be higher inflation. Therefore, there is no trade-off in the long-run. In the classical model, there is an assumption that prices and wages are flexible, and in the long-term markets will be efficient and clear. For example, suppose there was a fall in aggregate demand, in the classical model this fall in demand for labour would cause a fall in wages. This decline in wages would ensure that full employment was maintained and markets ‘clear’. The classical model is often termed ‘laissez-faire’ because there is little need for the government to intervene in managing the economy. Classical economics places little emphasis on the use of fiscal policy to manage aggregate demand. Classical theory is the basis for Monetarism, which only concentrates on managing the money supply, through monetary policy. A classical view will stress the importance of reducing government borrowing and balancing the budget because there is no benefit from higher government spending. Lower taxes will increase economic efficiency.