Term Paper on "Classical Model and Keynesian"

Term Paper 6 pages (1600 words) Sources: 1+ Style: MLA

[EXCERPT] . . . .

Classical Model

The New Classical theory believes that high levels of unemployment will have an adverse impact on economic growth. This is because the increases will lead to a reduction in consumption and output. The way that this will take place, is through higher borrowing rates and the drop in capital stock. This has reduces productivity by shifting the FM curve inward. It is at this point that output and employment will decrease. (Fazzari)

While the Keynesian theory, agrees with these ideas. However, what make them different are their views on demand constraint production. Under the classical approach, everyone assumes that low interest rates will help to encourage economic growth. This is because they think that the economy will hit a point of equilibrium. Whereas, Keynesians believe that changes in aggregate demand will lead to an increase in supply that is lower than output. This causes it to be constrained by having excess supplies on the market. Therefore, unemployment is considered to be involuntary by urging firms to lower sales projections (Fazzari)

This is from a decrease in aggregate demand, as firms are producing and hiring less people. While classical theories are concentrating on voluntary unemployment. This is taking place by individuals who will refuse to accept low wages and search for better jobs. At the same time, there are also labor force mismatches, where downsizing leaves someone with a lack of useable skills. This requires retraining which takes time and will keep unemployment high. Moreover, some people will stay in areas where there are little to no economic opportunities in contrast with other parts of the country. (Fazzari)

The Classical Keynesian model does not think that monetary policy will not have an effect on unemployment. This is because they believe it will not impact real wages and redundancy (i.e. The neutrality of money). Mainstream Keynesians think that this will have an influence on unemployment. This is from the changes in monetary policy leading to quicker short-term adjustments in prices and wages (which accelerates economic growth faster). (Fazzari)

While Radical Keynesians think that monetary policy will have a positive influence on unemployment. This is based on the belief that growth takes place from the private sector (in the form of tax cuts) or through government spending (i.e. The stimulus). What is happening is the aggregate demand curve is flat. To help improve the economy, something must encourage firms to make large capital purchases and hire new workers. When there are favorable monetary policies, this allows them to engage in these activities. (Fazzari)

One approach that is useful in the Beveridge curve. This analyzes job openings (i.e. vacancy rates) and unemployment figures to determine labor market mismatches. When this curve is negatively sloped the data is consistent with a struggling economy. A second tool is the mismatch model. This suggests that unemployment and vacancy rates will increase together (hence a positively sloped Beveridge curve). As far as classics are concerned, these ideas provide some compelling evidence. Yet, they are not sufficient enough to logically explain the entire problem. While Keynesians believe that Beveridge curve is good at predicting when aggregate demand is declining (from the negative slope). This is providing a better understanding of the unemployment situation. (Fazzari)

These areas are showing how there are different approaches that are used by Keynesians when addressing a host of economic challenges. The differences in their beliefs are associated with how the economy should be stimulated and the impacts that aggregate demand will have on unemployment. This will play a role in determining the tactics that are utilized in addressing these issues.

A paradox thrift is when everyone is trying to save more, but are actually saving less. The reason why is from it leading to lower aggregate savings. This occurs when individuals are saving more. Yet, the economy will continue to deteriorate further from reduced levels of consumer spending. (Fazzari)

The basic problem with increased savings is that economic activity will decline further. This takes place as consumer spending falls from everybody saving more. When this happens, businesses will see a reduction in their profit margins (leading to less capital spending and layoffs). This destroys income and the standard of living over the long-term. From the Keynesian perspective, demand is being constrained by the increases in savings. This devastates personal income and output. As a result, savings is a mechanism that limits demand. This creates a paradox shift from these declines. (Fazzari)

Under the basic classical model, Say's law states that aggregate demand is adequate to output. When people are increasing their savings, it raises the total amount of investments. These higher savings rates are enhancing available working capital. This leads to a growth in funds for lending activities to businesses and consumers. It is at this point when there is downward pressure on interest rates. (Fazzari)

However, this will only occur when output remains consistent. Krugman's view is different from the classical model. This is because he believes that there needs to be government intervention to reduce interest rates (in order to restore economic balance). Therefore, the Keynesian model is effective at understanding Krugman's ideas. As savings does not increase the availability of loans and working capital. This means that there is no downward pressure on interest rates. It is at this point that Krugman believes that interest rates will readjust (leading to an improvement in investment and consumption). (Fazzari)

Thus, the Keynesian model is effective at understanding Krugman's ideas. This is because the increased savings does not lead directly to improvements in liquidity. Instead, demand and output will become constrained (which will negatively impact economic growth). This occurs by reduced interest rates helping to stimulate economic growth. (Fazzari)

Like what was stated previously, Krugman's claim is referring to Keynesian ideals. This is based on the philosophy that one person's spending will have an impact on another's income (i.e. The paradox of thrift). The effect that this will have is to increase savings and hurt consumption / demand for new investments. This destroys personal income. (Fazzari)

As a result, Krugman believes that the more people save, the greater damage they will do to the economy. This will lead to lower vs. higher amounts of investment (which creates a paradox thrift). It is at this point that consumption will decline and personal income levels will be destroyed. This will cause the demand for investment and the supply of savings to move further to the left.

Under the classical model there are predications about the effects of higher productivity on output, unemployment, real wages and prices. This causes an increase in output, which shifts labor demand (leading to a rise in efficiency and the need for fewer employees). These improvements help to enhance everyone's ability to save (placing downward pressure on interest rates). This contributes to lower prices and increases demand. Once this takes place is when real wages will rise.

Moreover, this is fueling lower amounts of inflation (which will lead to real wage growth). It is at this point that the aggregate demand curve will begin slopping outward. Therefore, they believe that an increase in productivity will not have an effect on employment. The below chart is illustrating how this is occurring. (Fazzari)

The Mainstream Keynesian model believes that labor demand will shift higher from increased amounts of productivity. Yet, because wages are facing short-term pressure, they do not adjust and there is involuntary unemployment. This causes aggregate demand to shift outward from firms wanting to increase profit margins. However, in the long-term prices and wages will adjust. (Fazzari)

The way that this takes place is firms will reduce prices to increase sales. This improves output, which is leading to rising aggregate demand for various products and services. Yet, involuntary unemployment will occur. This will make firms reluctant to hire employees. In… READ MORE

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