Question

4) Explain the two main differences in the assumptions made by the Classical and Keynesian theories and the consequences of these for the business cycle?

Answer 1

1) classical assumed the existence of full employment in the economy.

It was proved wrong by the great depression of 1930's . when the depression phase of business cycle was reached, larger number of people lost their jobs , resulting in a fall In their income.

On the other hand , Keynes assumed that the equilibrium we have is not a full employment equilibrium, but an underemployment equilibrium.

His analysis meant that, even at the the boom period of business cycle economy won't be operating at full employment level. During the depression phase, unemployment situation will become the worst. In order to start recovery, government will have to step in and provide unemployment as advocated by Keynes.

2) Classicals believed that supply creates its own demand, which means that what ever is produced in the economy will be automatically demanded.

As per this assumption, economy won't fall into depression phase because aggregate demand is always equal to aggregate supply and there is no over production of commodities.This was again proved wrong by the great depression of 1930's. Goods were piled up in factories and were never sold due to lack of aggregate demand.

Keynes on the other hand believed that demand creates its own supply.

This Keynesian provided a solution to bring the economy back from recession or depression phase of recession cycle. Expansionary fiscal policy gained so much prominence since it can be used to affect aggregate demand. There for in order to deal with the cyclical fluctuations of the economy, policies that can be used to control aggregate demand can be used. Both government and Central bank can play a key role in this .