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Classical vs Keynesian

Week 2: Discussion Questions

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?

2. Why do Keynesian economists believe that market forces do not automatically adjust for unemployment and inflation? What is their solution for the stabilization of economic fluctuations? Why do they believe changes in government spending impact the economy differently than changes in income taxes?

3. What is the difference between contractionary and expansionary fiscal policy? Which do you think is more appropriate today? Explain your answer. How might contractionary and expansionary fiscal policy affect your organization?

4. Have you experienced an economic recession? How did it affect hiring practices at your place of employment?

5. How do Classical and Keynesian economists differ in their solutions for inflation and unemployment problems?

6. Inflation, on average, makes people neither richer nor poorer. Therefore it has no cost. True or false? Explain.

7. What roles do specialization and division of labor play in economists' support of free trade?

8. If the economy were close to high potential output, would policymakers present their policy prescriptions to increase real output any differently than if the economy were far from potential output? Why?

9. What is the current state of U.S. fiscal policy? Would you advise the United States to change its fiscal policy? Why?

10. Why does cutting taxes by $100 have a smaller effect on GDP than increasing expenditures by $100?

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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 ...

Solution Summary

Classical vs Keynesian economics on inflation and unemployment

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