CH 9: Classical & Keynesian Economics
Classical & Keynesian Economics
Classical Model
Prior to the great depression of the 30s, the prevailing economic theory was dominated by the
classical economic viewpoints. The classical economists believed that a continuing depression is
impossible because markets will eliminate persistent shortages or surpluses. They believed that
the economy will always tend to move towards full employment.
The centerpiece of classical economics is the Say’s law. The Say’s law states that “Supply creates
its own demand”. That means that whatever is produced all gets sold. Further, a person produces
more than what he consumes because he wants to consume other items by exchanging his
produce.
Say’s law is basically a full employment theory. If something is produced, that good will be bought
by the people. If the price is too high, producers will lower the price and sell whatever is produced.
Under the Say’s Law, unemployment is only short-lived. If producers have to lower the price, they will also
pay a lower wage. And, even if the wage is low, people will work rather than stay unemployed.
People will work because they want money to buy things. When they work they will be paid.
Generally speaking, producers produce goods that consumers want and consumers have the
money to buy things because they are paid.
Classical model assumes that
 Price competition exists in all markets.
 Wages and prices are flexible
 People are motivated by self interest
 People cannot be fooled by money illusion
Says law assumes that all income is used up, because of unlimited wants of the consumers. As long
as people spend everything that they earn, the economy will be at full employment. Thus, to the
classical economists capitalism would guarantee an equilibrium level of economic activity at full
employment. Flexible wages, prices, and interest rates would ensure this.
But, the economy begins to have problems when people save part of their incomes. However,
investment in capital goods is crucial to economic growth; and investment comes from saving.
Consumer Goods and Investment Goods
Think of production as consisting of two products: consumer goods and investment goods (ignoring
government goods for the time being). Total expenditure on consumer goods and investment
goods will be equal to C+I. That is, as total spending, GDP = C+I. Income received by people either
will be consumed or saved. That is to say that as income received, GDP = C+S.
This implies that
GDP = C+I = C+S.
Or,
I=S
That is, if the market were to perform well, whatever income is saved has to be invested. The
problem starts when investment is not equal to savings.
CH 9: Classical & Keynesian Economics
Question:
What if people save? Will there be any unemployment of resources?
NO?
Because, S= I
The Fund Market
Although S= I for the entire economy, it is not true for each individual. Some people save more
than they consume and the fund will be made available to others who want to borrow to invest.
These groups meet in the market for loanable funds. Savings and investments are determined in a
competitive fund market. The fund market is assumed to be in equilibrium. Demand and supply of
savings are determined by the interest rates (Price/cost of saving).
If interest is too high, there will be more people trying to save (high supply of fund) but investors
will not invest much (low demand of fund). If interest rate is too low, fewer people will like to save
(low supply of fund) but many investors like to borrow to invest (high demand of fund). Saving will
be equal to investment at right interest rate.
The Labor Market
Similarly, classical economists assumed that the labor market is also in equilibrium. That means
they have assumed that there will be no unemployment. There may be unemployment for a short
period but wage rate will be flexible enough to go back to equilibrium.
CH 9: Classical & Keynesian Economics
If unemployment exists with the wage rate of W1, unemployed workers will accept the lower wage.
This means that the unemployed people will exert pressure to the market so that wage rate will go
down to ‘We’ level in which the labor market is in equilibrium. Unemployment will exist if wage rate
is too high.
If everybody in the population is employed, total production, and hence total GDP cannot be
increased.
Because of all flexible prices, wages, interest rates, all markets are in equilibrium at full
employment level. In classical model there will be only one aggregate supply curve, the LRAS.
Everything adjusts quickly, and there is no need to have any extra time for adjustment.
Aggregate supply curve in classical model is thus vertical.
So AD shift will simply bring the price changes, not the real GDP. The economy will always be in the
full employment level.
CH 9: Classical & Keynesian Economics
The effect can be explained as:
Example
Suppose that due to concerns over mental health, Americans decide to work less and spend two
months per year staying close with the family instead of working. Analyze the effects of such a
decrease in the labor supply in the American economy using the classical model. What are the
effects on the quantity of labor, wage rates, GDP, and prices?
Effects on Labor Market
After decrease in labor supply, at the original wage rate w0 there will be a shortage of labor
in the market which will bid up the labor wage. So equilibrium wage rate goes up (from w0
to w1), and quantity of labor goes down (from L0 to L1), that is producers will hire less labor
at higher wage rate.
Effects on GDP
This change makes the AS curve to shift to the left as shown in AS/AD graph below.
CH 9: Classical & Keynesian Economics
AS/AD graph in classical model:
With the decrease in labor supply, aggregate supply (AS) curve shifts to the left. The real national
income decreases from Y0 to Y1. And price level goes up from P0 to P1.
Keynesian Model
We can summarize the result of classical model in a simple sentence.
 There will be no unemployment of resources.
But this did not happen. The model could not capture the real world situation. This did not
happen in Europe after WWI; unemployment remained high for a long time. Classical model
simply could not explain the economy of that time. Then Keynes came to rescue and
offered an explanation for that.
 Keynes argued that
o If there is a large amount of excess capacity and unemployment, a positive
aggregate demand shock will not raise price (and a negative shock will not reduce
price).
What he meant is that, if the economy is below full employment level then the price
will not rise by shifting AD to the right. That is, the SRAS is horizontal below potential
GDP level.
CH 9: Classical & Keynesian Economics
Under these circumstances the real GDP is completely demand determined. This SRAS is called
‘Keynesian SRAS curve’. Part of the SRAS curve is horizontal (part AB), at which GDP is
determined solely by the aggregate demand, other part of the curve is vertical (Part C and above)
at which real GDP is determined solely by the supply of resources in the economy and a part of the
SRAS curve (part BC) is upward sloping first slowly and then rapidly. When the economy
approaches to full employment level, SRAS and LRAS will be identical. Keynes also did not deny
that the LRAS is vertical as classical economists believed. In classical model there is no SRAS curve.
Keynes focused on aggregate demand as being the key determinant to the level of macroeconomic
activity when the economy is in depression and not on long run aggregate supply which was the
major focus of the classical economists.
Aggregate demand equals the sum of consumption, investment, government and net export
spending. So when the economy is in depression, the focus should be on the government spending
because individually a general household cannot influence expenditure of the total economy.
Businesses also cannot have a big role to play in such a situation. Then, government has to come
to rescue if the economy is in trouble.
Why so?
Classical economists believed that the wages are flexible. If there are some unemployed
workers, they will bid down the wage and will move to full employment.
Keynes argued that the wages are sticky downward. This may be because of long term
contracts and unions. Further, we don’t see the price level falling even at high
unemployment and situations with excess capacity. Only we see reduction of GDP with no
fall in price. That is, SRAS must be horizontal.
CH 9: Classical & Keynesian Economics
Note that Keynes was referring to the situation when the real GDP was way below the
potential GDP. If GDP is at or near the potential GDP, a slight increase in the price level
may be observed when demand increases (aggregate demand shift to the right). Once
GDP reaches to the potential level, then the economy will behave to be the same as in
the classical model. Further, if the economy tries to shift the AD beyond potential GDP, it
will increase price level but not the GDP.
Aggregate Demand and Aggregate Supply in an Open Economy
How does a weak dollar affect economy?
We cannot import more with weak dollar; the demand for domestic consumption goes up.
That is, AD shifts to the right. Similarly, firms cannot import more inputs without paying
higher price in domestic money; their cost of production goes up. Hence, SRAS shifts to
the left with weaker dollar.
Net result depends on which curve shifts more. If AD shifts very little and SRAS shifts a lot GDP
would decline as result as shown in the graph.
The new equilibrium point has moved from E0 to E1. In this case, weak dollar could not push the
aggregate to a higher level as much as it pushed the SRAS curve and the GDP dropped.
On the other hand if AD increases a lot relative to the SRAS curve, the new equilibrium point will be
E1 and the real GDP will increase as shown in the graph.
CH 9: Classical & Keynesian Economics
It is to be noted that in both the cases price level will go up. In other words, a weak dollar may bring
some inflationary pressure to the economy whether the economy improves or not. Note that the
equilibrium as presented in either of the graphs is not a full employment level of equilibrium. Full
employment level is reached at the LRAS curve (not shown in the graph).
Economic Growth in Aggregate Demand and Supply
Framework
Economic growth simply is a situation where GDP increases as a result the LRAS curve shifts to the
right. Economic growth can occur with or without inflation.
Factors that make the LRAS shift
GDP increases and the LRAS shifts due to
 The expansion of resources
 Even if no new natural resources are found, increase in human
resource can be considered as expansion of resources. More people
mean more production.

The expansion of technology
 Technologies always are being developed somewhere in the world.
How well the country adopts the new technology that will determine
the extent of expansion and the increase in production.

The expansion of capital investments
 To increase the productive capacity of a nation, investment on new
capital goods has to be made. With more capital goods in the
economy, more production can be expected in the future.
CH 9: Classical & Keynesian Economics
As the long run productive capacity grows, SRAS moves along with the aggregate demand
due to population increase and rising per capita income. This means that both the AD
and the AS shift.
The net result of the shift will be the growth in real GDP. But this growth may be with or
without inflation, depending on the size of the sifts in the AD and the AS curve.
Is buying stock and bonds an investment?
In general conversation we may use the term investment to mean the purchase of stocks
and bonds as well. However, in economic sense purchase of stocks and bonds is not
considered investment. When you buy 100 shares of newly issued Wal-Mart stock, there
will only be an exchange of financial assets. If Wal-Mart buys new equipment with it, then
the purchase will be an investment.
Empirical evidence however shows the economy grows with inflation. Not only the US but it
is true for all the countries around the globe.
Major reason for growth with inflation is that many times governments push hard
with extra flow of money in the economy.
 The extra supply of money has a tendency of raising price level.
 Increased price level reflects more profit for the firms in the short run.
 The price response is ahead of the changes in wages.
 Wages are adjusted only after the increase in price.
 In addition there is a demonstration effect. That is, consumers follow leaders
even if they could not afford
CH 9: Classical & Keynesian Economics
Effects of a massive increase in government spending in classical and fixed price
Keynesian models
Consider an equilibrium level of GDP at Y0 (see the graph). At this level, total expenditure made by
various sectors is presented by the line denoted by C + I + G + Xn. Here, C represents the
expenditure made by households, I is investment expenditure by businesses, G is the government
and Xn is the net from the foreign sectors. Also, suppose that this equilibrium is at a lot lower than
full employment level of GDP, YF. This means that economy is at equilibrium but not at the full
employment level. Our goal is to reach to a full employment level.
Now government decides to increase its expenditure from G to G’. This would reflect in the line C +
I + G’ + Xn. The increased amount of expenditure is the difference G’ – G. This increased should
lead to the increase in national income from Y0 to Y1 according to the fixed price Keynesian model.
When the economy is at depression, Keynes assumes that the price level does not change. The
reason why in Keynesian model price level does not change, can be explained using aggregate
demand (AD) and aggregate supply (AS) format as shown in the graph below.
CH 9: Classical & Keynesian Economics
Since government demand expenditure increases while the price level remaining constant means
that the supply curve is assumed horizontal in that part. The total national income then increases
from Y0 to Y1 according to fixed price Keynesian view.
On the other hand according to classical point of view, national income increases by the increase of
real factors. Economy cannot be in depression. Economy will come back quickly to the full
employment level. Aggregate supply curve will be vertical.
If aggregate demand increases by artificial measures, by increasing government expenditure, it
will simply press the price to go up from P0 to P1, and not the national real income. Real national
income will remain at Y0, as portrayed by the graph.
CH 9: Classical & Keynesian Economics
Effect of Tax cut
Let’s suppose that Congresses passes a large tax cut that actually will be enacted this year. The
effects of such tax cut would be predicted differently in
a. The classical model.
b. The fixed price Keynesian model (horizontal AS curve)
c. The Keynesian model with an ordinary (upward-sloping) AS curve.
Let us discuss them in each of these cases.
A. Classical model:
There will be no change in GDP. Economy will always remain at full equilibrium according to
classical model. Price adjusts quickly. If there is no increase in real resources (like if there is no
labor manpower increase or raw materials for production, land for agricultural production or even
improvement in technology) national income will not increase.
b. Fixed price Keynesian model;
There will be a full realization of income increase in this model.
CH 9: Classical & Keynesian Economics
c. Keynesian model with an ordinary (upward-sloping) aggregate supply curve.
This could be more realistic assumption. We cannot completely think that full effect of price will be
realized immediately. May be in the longer run price may adjust, and GDP will be associated with
the real factors. Similarly, we cannot justify to assume that price will remain constant. They are two
completely opposite assumptions. In this model short run aggregate supply curve slopes upward.
In the long run however, everybody believes that GDP is determined by the real resources in the
country.
With the reduction of tax, AD will shift to the right causing national income to go up (from Y0 to Y1)
and the price level to go up (from P0 to P1)
Example
Suppose SRAS is horizontal as believed by Keynesian economists and is given by P = 102
and that the aggregate demand curve is
P = 120 - Q
Where,
P: price level
Q: real GDP (in billion $)
Now suppose that the SRAS shifts upward from P=102 to P = 105. What will happen to the
real output?
Answer
Here we have
Aggregate demand curve, P = 120 – Q
That is
120 - Q = P
-Q = P – 120
Q= -P + 120
If P = 102,
CH 9: Classical & Keynesian Economics
then
Q
= -102+120
= 18
Thus, with price level P=102, the GDP turns out to be $18 billion.
Similarly with price level, P=105, the GDP turns out to be $15 billion.
It can be shown in the graph as:
When price level increased in the economy, the real GDP dropped because of the real income effect.
When price level increased from 102 to 105,
=
105 − 102
∗ 100 = 2.94%
102
Increased inflation made the real income lower and the aggregate demand to go down.
CH 9: Classical & Keynesian Economics
Questions for discussion
1.
Describe in words and graphically the relationship between consumption spending and real disposable
income.
2.
Graphically reflect the impact of changes in the non-income determinants of consumption spending on
the consumption function.
3.
Define the MPC and illustrate how changes in the MPC affect the consumption function.
4.
Suppose that Congress is successful in passing a large tax increase that actually be enacted this
year. Using three separate aggregate supply and aggregate demand graphs, show the effects of such
a tax in
a. the classical model
b. the fixed price Keynesian model; and
c. the Keynesian model with an ordinary (upward-sloping) aggregate supply curve.
Explain briefly for each case.
5.
How does a strong dollar affect US economy? Analyze the situation with the help of AS-AD curves.
6.
Suppose that in voting fraud around the country the government is forced to spend billions of dollars in
legal fees. Analyze the effects of such a massive increase in government spending in both the classical
and fixed price Keynesian models when the economy is at recession. Show graphically and explain.
7.
Suppose that OPEC raises oil prices by 50 % in 1998. What effect will this have on the US aggregate
demand curve? On the US short run aggregate supply Curve?
8.
Suppose SRAS is horizontal as believed by Keynesian economists and is given by P = 110 and that the
aggregate demand curve is
P = 200 - 2Q
Where, P: price level
Q: real GDP ( in billion $)
Now suppose that the SRAS shifts upward from P=110 to P = 115. What will happen to the inflation
rate? What will happen to the real output?
Multiple Choice Questions
1. According to Say's law, there cannot be overproduction of goods and services because:
a. planned aggregate expenditures sometimes fall short of total output.
b. prices and wages are "sticky" or inflexible in the downward direction.
c. demand creates its own supply.
d. supply creates its own demand.
CH 9: Classical & Keynesian Economics
2. The popular theory prior to the Great Depression that the economy will automatically adjust to achieve full
employment in the long run is:
a. supply-side economics.
b. Keynesian economics.
c. classical economics.
d. mercantilism
3. Classical economic theory predicted that in the long run the economy would experience:
a. below full unemployment.
b. rising rate of inflation.
c. full employment.
d. idle factors of production.
4. If the economy were left on its own without the interference of government or the Fed, it would move
toward an equilibrium rate of growth that would produce, with only minor interruptions, full employment
without inflation. What school supports this view?
a. Classical.
b. Keynesian.
c. Monetarism.
d. Supply-side.
e. Neo-Keynesian.
5. According to the Keynesian view, the prolonged unemployment of the Great Depression:
a. was surprising because Keynesians believed that wage rates would decline and direct the economy
to full employment.
b. was surprising because Keynesians believed that lower interest rates would direct the economy to
full employment.
c. resulted because the total expenditures on goods and services were less than the full-employment
rate of output.
d. resulted because the federal government ran large budget deficits during the 1930s.
6. John Maynard Keynes and his followers argued that the Great Depression was primarily the result of:
a. excessive government spending.
b. large budget deficits.
c. the perverse monetary policies of the Fed.
d. insufficient aggregate spending on goods and services.
7. The consumption function shows the relationship between:
a. planned consumption expenditures and disposable income.
b. permanent income and savings.
c. business inventory and real GDP.
d. aggregate demand and aggregate consumption.
8. When economists say that private investment is "autonomous," they mean that it:
a. will never change.
b. is not dependent on the current level of disposable income.
c. is determined by the "animal spirits" of business decision makers.
d. is determined by the level of saving.
9. Using the Keynesian aggregate expenditures model, which of the following is true?
a. Macro equilibrium may occur at levels of real GDP other than full-employment real GDP.
b. At any macro equilibrium, the actual rate of unemployment must equal the natural rate of
unemployment.
c. If an economy is operating below full employment capacity, the Keynesian model indicates that
lower wage rates will automatically adjust the economy back to full employment.
d. All of these are correct.
10. According to the Keynesian aggregate expenditures model equilibrium and full employment:
a. always occur at the same income level of real GDP.
CH 9: Classical & Keynesian Economics
b. may differ, but there is an automatic mechanism that directs the economy toward full-employment
equilibrium.
c. could never occur at the same level of real GDP.
d. do not necessarily occur at the same level of real GDP.
11. In the Keynesian aggregate expenditures model, "aggregate expenditures" refer to:
a. the amount of GDP that could be produced if unemployment were zero.
b. the combined expenditures of consumers, businesses, governments, and foreigners (net exports).
c. the amount of demand for consumer goods that would arise if all citizens had all the income they
wanted.
d. consumer spending measured in constant prices.
12. When the spending of consumers, businesses, government, and foreigners (net exports) is less than the
aggregate output level of the economy, the Keynesian model result is that:
a. output will rise.
b. output will fall.
c. prices will rise.
d. inventories will tend to decline.
13. Within the framework of the Keynesian model, if aggregate expenditures exceed aggregate output, then:
a. the inventories of firms would decline, and the firms would expand output in order to restore their
inventories to desired levels.
b. the inventories of firms would increase, and the firms would reduce output until inventories were
cut back to the desired level.
c. the current level of income would persist in the future.
d. firms would reduce their investment, and the economy would fall into a recession.
14. In the Keynesian model, if aggregate expenditures exceed aggregate output and inventories of firms fall,
then the aggregate output and the business sector could be expected to:
a. increase output.
b. decrease output.
c. decrease investment.
d. hire fewer workers.
15. Within the Keynesian aggregate expenditures model, if the economy is below equilibrium, then there will
be:
a. an increase the demand for goods and services.
b. an increase in real GDP.
c. lower interest rates, which will stimulate aggregate demand and keep the economy at full
employment.
d. a lower price level, which will quickly guide the economy to full-employment equilibrium.
16. Using the aggregate expenditures model, if aggregate expenditures (aggregate demand) is $10 trillion
and aggregate output is $10.3 trillion:
a. businesses will accumulate inventories, and output will decline.
b. real output will increase if the full-employment capacity of the economy is greater than $10.3
trillion.
c. inflation will be a problem if the full-employment capacity of the economy exceeds $10.3 trillion.
d. both b and c are correct.
17. If consumption expenditures are $200 billion, total investment is $50 billion, government purchases are
$40 billion, exports are $45 billion, imports are $40 billion, aggregate expenditures must be:
a. $275 billion.
b. $295 billion.
c. $320 billion.
d. $395 billion.
CH 9: Classical & Keynesian Economics
18. Suppose consumers and business decision makers become more optimistic about the future, and
aggregate expenditures increase. The most likely result is that:
a. real GDP and employment and income to decline.
b. real GDP and employment rise.
c. real GDP rises and employment falls.
d. real GDP falls and employment rises.
19. Within the Keynesian aggregate expenditure-output model, if an economy operates below full
employment:
a. a reduction in wage rates and resource prices will soon restore full-employment equilibrium.
b. a reduction in the real interest rate will soon restore full-employment equilibrium.
c. an increase in the real interest rate will soon restore full-employment equilibrium.
d. the economy may remain below full employment unless aggregate expenditures increase.
20. In the aggregate expenditures model, if an economy operates below equilibrium GDP, there will be:
a. unplanned inventory depletion.
b. unplanned inventory accumulated.
c. a decrease in GDP.
d. a decrease in employment.
21. In the aggregate expenditures model, if an economy operates above equilibrium GDP, there will be:
a. unplanned inventory depletion.
b. an increase in GDP.
c. an increase in employment.
d. a decrease in GDP.
Questions 22-24 refer to thefollowing Keynesian aggregate-expenditures model graph
22. As shown in the graph, equilibrium GDP is:
a. $1 trillion.
b. $3 trillion.
c. $5 trillion.
d. $6 trillion.
e. $7 trillion.
CH 9: Classical & Keynesian Economics
23. As shown in the graph, if GDP is $3 trillion, the economy experiences unplanned inventory:
a. depletion of $1 trillion.
b. depletion of $2 trillion.
c. accumulation of $1 trillion.
d. accumulation of $2 trillion.
24. As shown in the graph, if GDP is $7 trillion, the economy experiences unplanned inventory:
a. depletion of $1 trillion.
b. depletion of $2 trillion.
c. accumulation of $1 trillion.
d. accumulation of $2 trillion.
25. If a nation imports more than it exports, then its net exports are:
a. positive.
b. negative.
c. zero.
d. unstable.