Classical and Keynesian

Economics: Contending
Approaches to
Macroeconomics

Classical Economics
WHO?
Adam Smith, David Ricardo, John
Stuart Mill, Alfred Marshall

CENTRAL PRINCIPLE:
The economy is best organized
as a self-regulating system of
markets.

Classical Economics
1.

MARKETS CLEAR
No surplus or shortage.

a) SAYS Law: Supply

Creates
Its Own
Demand
b) All Unemployment is
voluntary.
.

Classical Economics
2.

WAGES AND PRICES ARE FULLY

FLEXIBLE
in order to clear markets rapidly.

3.

ECONOMY OPERATES AT FULL

EMPLOYMENT most of the time.

Classical Aggregate Supply Curve

is
vertical.

Classical Economics
4.

INVESTMENT DEMAND IS A
FUNCTION OF INTEREST RATES.

5.

A BALANCED FISCAL BUDGET

is the desirable fiscal stance of
government.

Classical Economics
6.

MINIMAL GOVERNMENT
INTERVENTION

reflecting distrust of government

and
belief in its inefficiency.

KEYNESIAN ECONOMICS
WHO?
John Maynard Keynes.

CENTRAL PRINCIPLE:
The economy often operates at
less than full employment;
market system does not self
adjust.

KEYNESIAN ECONOMICS
Keynes: Demand creates its own
Supply
Focus on what drives planned
expenditures.
I.e., Spending creates Income.

KEYNESIAN ECONOMICS: KEY

IDEAS
1.
IF

MARKETS CLEAR ONLY SLOWLY,

AT ALL.

A) Demand creates its own

supply,
turning Says law on its
head.
B) In a depression or recession,
much unemployment is
involuntary.

KEYNESIAN ECONOMICS
2.
WAGES AND PRICES ARE
STICKY
OR INFLEXIBLE.
Why?
* Large corporations have power
to administer or fix output
prices.
* Labor Unions -- wage
inflexibility
& labor contracts.

KEYNESIAN ECONOMICS
Ratchet Effect -- wages and prices
are flexible upwards but are
inflexible downwards. They ratchet
upwards.
3.

ECONOMY OFTEN OPERATES AT

LESS THAN FULL EMPLOYMENT
Since markets dont clear.
Keynesian Aggregate Supply

KEYNESIAN ECONOMICS
4.

DEMAND FOR INVESTMENT

SPENDING IS DRIVEN BY
BUSINESS EXPECTATIONS OF
PROFITABILITY.
I. is much less sensitive to
interest
rates.

KEYNESIAN ECONOMICS
5.
BALANCING THE FISCAL
BUDGET
MAY NOT ALWAYS BE
DESIRABLE.
Pump Priming of total demand
by
budget deficit spending.
6.
GOVERNMENT INTERVENTION
MAY
BE DESIRABLE TO STABILIZE
THE
BUSINESS CYCLE.