Classical Economics and KeynesThis is a featured page

Two Theories:

The Classical View
  • In this view, the AS curve is vertical & is the only determinant of the level of real output, while the AD curve is stable and is the single determinant of the PL.
  • Adam Smith believed in laissez-faire (government should not intervene in any economic affairs) because full employment is norm to market economy therefore government should not intervene but "let it be."
  • Prices and wages are flexible.
  • If PL ↓, the economy will self correct.
  • According to this view, the economy is relatively stable.

  • Vertical Aggregate Supply Curve:
    • Economy will operate at its full-employment level of output because wage and prices are flexible. Output does not change in response to PL changes.
    • The view is that input costs would fall along with product prices, so real profits and output will not change.
  • Stable Aggregate Demand:
    • The amount of real output that can be purchased is determined by:
      • the amount of money households possess
      • the purchasing power of that money
    • As we move down the vertical axis, PL ↓ = the purchasing power ↑. if supply of money ↑ --> AD shifts right, demand-pull inflation occurs.


The Keynesian View
  • Product prices and wages are downwardly inflexible or sticky over very long time periods: therefore is graphically represented as a horizontal AS curve.
  • AD is subject to periodic changes caused by changes in the determinants of AD.
  • John Keynes believed laissez-faire capitalism is subject to the recurring recessions that bring about widespread unemployment.
  • In this view, it is believed that active government policy is required to stabilize the economy as well as to prevent valuable resources from going to waste.
  • AS is horizontal up to the full employment level, and then becomes vertical
  • leads to more unemployment, lower GDP.
  • more government involvement e.g. when spending declines, the government does whatever it can do to solve it, using expansionary fiscal policy as well as expansionary monetary policy.
  • According to this view, economy is relatively unstable.

  • Horizontal Aggregate Supply Curve (to Full-Employment Output):
    • This AS curve only exists when the economy is fully employing its resources. (This includes the natural rate of unemployment) At full employment, AS becomes vertical.
  • Unstable Aggregate Demand:
    • Unless there is increased AD, output will be below the full-employment output. Government policies are needed or else recession and depression will occur.



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