Classical vs. Keynes

Classical vs. Keynes

The Classical model of the economy says that all markets always clear. The labor market failing to clear does not exist in the Classical model because of competitive exchange equilibrium in which prices and quantities always adjust perfectly. The Classical model is of a closed economy and the variables are real output, employment, real and nominal wages, the price level, and the rate of interest. It is easier to understand the classical model using five diagrams that are numbered one through five in Appendix One, The Classical Model. These diagrams represent the separate parts of the model that together illustrate, for the most part, the entire Classical model. Diagram one represents the production function, which shows the assumption that real output, y, is determined by the level of employment, N. So y is a function of N and from the slope of the function we can see that output rises as employment is increased. But there is a diminishing marginal productivity of labor, which means that each time employment increases, the increase in output will get smaller and smaller. Diagram one illustrates the relationship between output and employment in the short run, but does not determine the level of output or the level of employment. But when used together with other diagrams of the model, diagram one can be used to figure these things out. Diagram two is the labor market with the real wage, w, on the vertical axis and employment, N, on the horizontal axis.

In the classical model, the supply of labor depends upon the real-wage level because as the real wage rises, more people are willing to work. The line SN represents the labor supply function and the line DN represents the demand for labor. As the real wage increases so does the labor supply function, but as the labor supply function increases, the demand for labor decreases. Because the Classical model makes real wages perfectly flexible and allows it to adjust to the level that clears the labor market, the real wage and the level of employment can be figured out by using diagram two. Once given the level of employment determined from diagram two, it is possible to use diagram one to figure out the level of output. So diagrams one and two, also know as the real sector, can be used to determine employment, real output, and the real wage without any knowledge of the monetary...

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...se in bond prices. The decrease in interest rate causes an increase in investment and then this causes an increase in aggregate demand, which then causes income and employment to increase. This can be seen in diagram four, and then because of the increase in income, going back to graph three, we can see that this would cause an increase in consumption. From diagram five, we can see because of the increase in employment that this would cause a decrease in real wages. The decrease in real wages would then cause involuntary unemployment to decrease. Because of the different effects that money has on the economy in these models, they arrive at different conclusions. The Classical economy seems to be in favor of no policy since everything works itself out and ends up in equilibrium since all the markets clear. The opposite is true for the Keynes model, where they are in favor of government intervention since it is not inherently self-regulating and the markets do not clear. The Keynes model needs a little help from the government, or the central bank, to achieve equilibrium, where as the Classical model, assuming all assumptions were realistic, is self-regulating and all markets clear.