Classical and Keynesian Theories of Economics
Throughout the last few decades, the two main lines of economic thought were the classical or monetarist and the Keynesian economic thought. The classical school is largely credited to the works of Milton Friedman and Adam Smith. Classical economists believe that the role of government is to control inflation by controlling the money supply. They believe that markets are typically clear and that participants have rational expectations. The classical economists also believe in flexible factor prices that will restore equilibrium. They believe in the free market system without government intervention. Keynesian economics was largely founded on the basis of the works of John Maynard Keynes. Keynesians focus on aggregate demand as the principal factor in issues like unemployment. Keynesian economists believe that the economy can be managed by active government intervention through fiscal policy. Classical economists agree with Say's law which states that supply causes demand and that there is never excess supply. The Law states that people will supply things to the economy so that they can get money to buy other goods that are of the same value they have supplied.
The Role of Flexible Prices
The classical economists further believed that even if the rate of interest fails to equate saving and investment, any resulting decline in total spending would be neutralized by proportionate decline in the price level. That is, consumer A’s $200.0 can buy 4 pants at $50.00 each but consumer B $100.00 can buy 4 pants if the price falls to $25.00 a pants. Therefore, if consumers save more than firms wish to invest, the resulting fall in spending will not result in a decline in real output, real income and the level of employment once product prices also fall in the same proportion. Therefore, price changes will restore equilibrium.
The Role of Flexible Wages
Classical economists also believed that a decline in product demand would lead to a fall in the demand for labour which will result in unemployment. However, the wage rate would also fall and competition among unemployed workers would force them to accept lower wages rather than remain unemployed. The process will continue until the wage rate falls enough to clear the labour market of the excess supply of labour. A new lower equilibrium wage rate will be established which will result in there being no surplus or shortage of labour. Therefore, involuntary unemployment was logical impossibility in the classical model.
The quantity of real GDP demanded is the sum of real consumption expenditure, (C), investment (I), government purchases (G), and exports (X) minus imports (M). It is of interest to be able to derive and know the relationship between the price level, P and aggregate demand (AD), holding all of the other variables which affect AD fixed. The AD curve is more complicated than the market or industry demand curve. The AD curve is not a market demand curve and is not the sum of all demand curves as in microeconomics. In addition, the fundamental assumption of ceteris paribus is not applicable to the AD curve.
For the market demand curve in microeconomics, we assume that all other prices and incomes are fixed. For movements along a market demand curve, when the price of a good rises, the quantity demanded of the good falls in part because the prices of other goods do not rise as well. The good becomes more expensive relative to other goods so consumers move away from this good to other cheaper goods. Since income is held fixed, when the price of the good rises, real income falls which may lead to a lower quantity demanded as well.
Even though it is true when we consider movements along the AD curve when P changes that some factors that affect AD are assumed constant. It is also true that some other things do change for movements along the AD. For example, when the overall price level of products rises, not only these prices, but also wage rates and incomes rise together. Thus, all other things do not remain constant.
In microeconomics, the demand curve is downward sloping because of the negative relationship between price and quantity demanded; as price rises, quantity demanded will fall. However, the reason for the downward sloping pattern of the AD curve is much more complex. The AD curve is downward sloping for the following reasons:
- Real Balance Effect - as the price level increases, the value of household wealth and asset holdings will lose purchasing power. Therefore fewer units of real output are purchased. Therefore, as price rises, AD will fall which is one of the reasons why he AD curve is downward sloping.
- Interest Rate Effect - as the price level rises, interest rate also tends to rise. Higher interest rates lead to a rise in the cost of investments and a subsequent fall in investments which cause aggregate demand to decline.
- Net Exports Effect - a higher local price level tends to make local goods more expensive compared to foreign goods. Imports will then rise because consumers substitute cheaper imported goods for domestic goods. An increase in the price of local goods in foreign markets also causes local exports to decline and also aggregate demand. This condition is the net exports effect.
The aggregate supply (AS) curve depicts the quantity of real GDP that is supplied by the economy at different price levels. The reasoning used to construct the aggregate supply curve differs from the reasoning used to construct the supply curves for individual goods and services. The supply curve for an individual good is drawn under the assumption that input prices remain constant. As the price of good X rises, sellers' per unit costs of providing good X do not change, and so sellers are willing to supply more of good X‐hence, the upward slope of the supply curve for good X. The aggregate supply curve, however, is defined in terms of the price level. Increases in the price level will increase the price that producers can get for their products and thus induce more output. However, an increase in the price will also have a second effect; it will eventually lead to increases in input prices as well, which, ceteris paribus, will cause producers to cut back. So, there is some uncertainty as to whether the economy will supply more real GDP as the price level rises. In order to address this issue, it has become customary to distinguish between two types of aggregate supply curves, the short‐run aggregate supply curve and the long‐run aggregate supply curve.
Classical Aggregate Supply Curve
The presumption underlying the short run aggregate supply (SRAS) curve is that input providers do not or cannot take account of the increase in the general price level right away so that it takes some time–referred to as the short‐run–for input prices to fully reflect changes in the price level for final goods. During the short‐run, sellers of final goods are receiving higher prices for their products, without a proportional increase in the cost of their inputs. The higher the price level, the more these sellers will be willing to supply. The SRAS as shown in the following graph is therefore upward sloping, reflecting the positive relationship that exists between the price level and the quantity of goods supplied in the short‐run.
The long‐run aggregate supply (LAS) curve describes the economy's supply schedule in the long‐run. The long‐run is defined as the period when input prices have completely adjusted to changes in the price level of final goods. In the long‐run, the increase in prices that sellers receive for their final goods is completely offset by the proportional increase in the prices that sellers pay for inputs. The result is that the quantity of real GDP supplied by all sellers in the economy in the long run is independent of changes in the price level. Therefore, the LAS curve will be a vertical aggregate supply curve as can be seen in the following graph.
The Keynesian Aggregate Supply Curve
Keynes considered the situation of economic depression when the economy was operating in a recession or at less than full employment of resources. He further believed that in such a situation money wage rates were sticky i.e. remained constant not flexible as in the case of the classics. Keynes stated that when the economy is operating at less than full employment (Yf), increases in spending will lead to increases in output but prices will remain fixed until the full employment level is reached. The aggregate supply curve will be horizontal up to Yf as can be seen in the following graph. Only beyond Yf will increases in spending lead to increases in the price level which is from P0 to P1. Therefore, up to output level Yf which is the short run, the aggregate supply curve will be horizontal or perfectly elastic; beyond Yf which is the long run, aggregate supply curve will be vertical or inelastic. It is important to note that along the horizontal part of the aggregate supply curve, there can be equilibrium (AD=AS) but the economy will not be at full employment.