Keynesian vs. Classical Model of Aggregate Demand and Supply

Keynes' Critique of the Classical Model

• Disagreed with classical model assumptions, especially the short-run/long-run dichotomy.
• Criticism of wage assumptions:
  • Wages being flexible in the long term is unrealistic.
  • Considered wages "sticky" downwards; workers resist wage cuts during recessions.
  • Famous quote: "In the long run, we are all dead." Waiting for long-run wage adjustment leads to prolonged suffering.

Keynes' Aggregate Supply Framework

• Aggregate supply (AS) is not different between short-run and long-run; it remains the same.
• Determined by the level of spare capacity in the economy.
• Full Employment Level of Output (Y_FE): Point beyond which production cannot sustainably increase.
  • Agree with classical model that Y_FE represents maximum use of all factors of production.
• AS Curve:
  • Horizontal when there is significant spare capacity (e.g., in a recession).
  • Vertical at full employment level, indicating no sustainable increase beyond this point.

Keynesian vs. Classical Economic Management

• Classical view: Economy self-heals, long-run wage flexibility adjusts the economy back to full employment.
  • Keynes: This assumption is flawed; waiting for wage adjustments is impractical.
  • Keynes' assertion: During recessions, without intervention, the economy can remain below full employment indefinitely.

Policy Recommendations

• Active Demand-Side Management needed during recessions:
  • Increase government spending.
  • Reduce income tax and corporation tax to boost aggregate demand (AD).
  • Borrows necessary during recessions, repaid during economic booms through increased tax revenues and reduced government spending.

Political Appeal of Keynesian Economics

• Promotes a greater role for government, appealing to politicians:
  • Allows targeting inflation reduction without significant conflicts.
  • Enables governments to claim credit for economic improvements.
• Popular during the Great Depression due to its practical solutions in the absence of effective classical responses.

Conclusion

• Keynesian model effectively addresses the limitations of the classical model's wage flexibility assumptions.
• Advocates for active government intervention to achieve full employment and economic stability.