Classical vs Keynesian

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1. Explain the different viewpoints of Classical and Keynesian economists. How did the economy that existed at the time these theories were developed influence these theories? Which theory seems to be more appropriate for the economy today?

Keynes saw the aggregate supply curve as being horizontal at outputs less than the full-employment output and vertical only at full employment. Declines in aggregate demand do not change the price level because wages and prices are assumed to be "sticky" - they move upward with ease, but are inflexible downward. The AD curve is inherently unstable because of the volatility of investment spending. Decreases in AD can cause a recession as the lack of spending ripples through the economy. Unless the government intervenes the economy can spiral into a depression. The economy does not automatically adjust because the economic trend overwhelms individuals' responses to it.

On the contrary, classical economics argues that adjustments in prices would automatically make demand tend to the full employment level. Known as Say's law, it states that the wages and profits paid out during the production of goods are equal to the total sum required to buy them, and that therefore they can always be sold, in a type of barter system. Thus unemployment can be caused only by high and rigid real wages. The proper solution is to cut wages. In Classical theory the AS curve is perfectly vertical. When prices fall, real profits do not decrease because wages fall by the same percentage. With constant real profits, firms have no reason to change the quantities of output they supply. AD is stable so long as the monetary authorities hold the money supply constant. This means that there is little threat of either inflation and deflation. A decline in demand will bring the economy to a new equilibrium as wages and price adjust.

The argument, Keynes points out, depends on supposing that, whenever someone saves, the labor and commodities they would otherwise have consumed are 'automatically invested in the production of capital wealth'. But this type of barter system doesn't apply in a money economy. If such saving can occur, then some of the money paid out in wages and profits is not spent on goods, and all the goods produced need not be bought. An overproduction of goods in relation to the market for them can then arise.

The Keynesian view seems more consistent with the facts of the Great Depression; in that period, real output declined by nearly 40 percent in the United States and remained low for a decade. However, Keynesian economics would have predicted a return to stagnation after the war, as lack of aggregate demand or investment demand (after ...