Rakib Hasan ECON740

H686Z973 ESSAY 1

Question:Compare Classical Economics and Keynesian Economics.

Answer: In economics there are two main theories, Classical economics and Keynesian economics. In our essay we will compare between this two theories.

Aggregate Supply: It represents the supply of goods and services in market. By using our resources, technology, and efficiency of our economic institution we can derive the aggregate supply curve.

Classical Economics: Before describing the classical aggregate supply curve, we need to know about two additional concepts which are, the production function and the labor market. Production function is a function of capital and employment and where economy's capital stock is constant. And labor market is a place where workers find work, employers find workers who are willing to work and a place where wage rate is determined.

In classical economics an assumption made by classical economists is that, nominal wages and prices are fully flexible. Which means, if inflation rises nominal wages will also rise by same amount and the real wage ratio will be unchanged. This assumption also applies when there is a decrease in inflation. Nominal wage will decrease leaving the real wage ratio unchanged.

Economists said that, in classical economics, economy automatically and quickly adjusts recession. Prices and wages falls during recession which affects profits positively. Because more people are hired to work which increases production and economy bounces back of recession.

Assumption made by economists is that, in Classical economics AS is vertical and always at the full employment level.

This crucially important assumption will derive the slope of the classical AS curve and will be fundamentally responsible for the implications of fiscal and monetary policy in the classical world.

Keynesian Economics: The assumption made by the economists in the Keynesian economics is- If labor demand is more than labor supply then nominal wages adjusts in proportion to the changes in price. But if labor supply is more than labor demand then nominal wages do not adjust to the changes in price level and that is said to be sticky downwards. In Keynesian economics, prices and wage are inflexible, especially downward. If there is drop in AD producers will not accept price cuts and they will sell fewer goods, and for that we will have

Rakib Hasan ECON740

H686Z973 ESSAY 1

recession in the economy because we produce less output than before. Because of we are producing less the demand for labor will decrease and therefore there will be unemployment in the economy.

Policy Exercise: Increase in Government Spending and Monetary Growth.

Classical Economics: In classical economics it is said that an increase in Govt. spending is not helpful to bring an economy out of recession. Economists said that, in classical economics, economy automatically and quickly adjusts recession. Prices and wages falls during recession which affects profits positively. Because more people are hired to work which increases production and economy bounces back of recession. Government spending or tax reduction is not necessary. There is no multiplier effect stemming from an increase in G in an economy with a classical AS. These things also applies for Monetary expansion. Increase is monetary growth plays no role to bring an economy out of recession. The effect of monetary expansion is only be to make worse the rate of inflation. According to Classical economists, when it comes to interest rate or fiscal control the economy should be able to decide for itself what is unfair and what is good enough for the growth of economy.

Keynesian Economics: We already know in Keynesian economics, prices and wages are sticky downwards and they do not fall during recession. Economy does not adjust automatically as like in classical economy. In Keynesian economy, to get rid of recession Govt. spending is necessary to stimulate the economy to bring it out of a recession. An increase in G jump-starts the economy, both GDP growth and interest rate increase. In Keynesian economy there is a role for Government to stabilize the economy.

In Keynesian economy, monetary growth also plays a role to make economy stable. For monetary expansion, interest rate falls, GDP growth, employment, and private consumption and investment increases.

GDP and Employment Growth:

Classical Economics: It is said that in classical economy the Classical AS curve only increase the rate of inflation. There is no effect on GDP growth or employment. Classical economy is more focused on inflationary pressures. A Classical economists argues that, inflation is bigger danger to the economy over the GDP growth and employment growth. According to the Classicists, attempting discretionary demand-side stabilization by changing G, M, or tax rates would only change the rate of inflation. There is no role for fiscal and monetary stabilization in an economy by a vertical AS curve.

Rakib Hasan ECON740

H686Z973 ESSAY 1

Keynesian Economics: From the discussions above we already know that Keynesian economy more concerned with GDP growth and unemployment. The ability of workers and their contribution to the economy matters more than the costs of goods. In Keynesian model fiscal and monetary stabilization are effective.

From the discussions above, we can certainly say that, in Classical Economics, Classicalist are tend to more focused on long term results where Keynesians care more to short term problems, which they think need immediate attention because they believe short term problems are the best ways to influence the long term results.