Classical and Keynesian Approach

Output and Employment

  • The output is defined as the total goods and/or services produced in a country over a specific period.
  • Employment is the process of hiring labour for performing specific tasks to generate Output. For an economy to remain stable, there should be a balance between its employment and output.

Aggregate Supply and Aggregate Demand

  • Aggregate Supply is the value of final goods and services that will be produced and sold at a given price in an economy.
  • Aggregate Demand is the total value of demand for all final goods and services in an economy during a period at specific price levels.
  • The total supply of a firm depends upon the availability of capital and labour in the market. Capital is provided by the investors/shareholders of the company and the labour is supplied from the population.

Supply of Money and Specific Price Level

  • Supply of Money is the total value of cash in hand and cash in the bank of a country over a specific period, this money is completely liquid and can be used for any transaction. In other words, it is the total money in the country that can be used to purchase goods or services.
  • Specific Price Level is the average cost at the current prices of all the goods/and services in the economy. Any change in Specific Price Levels affects the Aggregate Demand, Demand of Labour, Supply of Labour.

Supply and Demand of Labour

  • Labour is among the key input for generating supply in an organization. For increasing the supply, Labour is demanded by the organizations that are employed from the available workforce in the country.
  • Available Workforce implies the total number of unemployed persons in the population that may be employed in some work whereas Workforce or Total Workforce implies the total number of employed and unemployed persons in a country that are eligible for work.
  • Supply and Demand for Labour depend on the wage rate:
    1. If the Wage Rate is High: Supply of Labour is more, and Demand of Labour is less
    2. If Wage Rate is Low: Supply of Labour is less, and the Demand for Labour is more.

Equilibrium and Level of Output

  • Aggregate Supply (AS) and the Aggregate Demand (AD) are plotted together on a graph with X-axis as the output and Y-axis as the Price to determine the equilibrium. Equilibrium is the point at which the Aggregate Demand and Aggregate Supply is the same, and this is the required level of output.
  • It is necessary to determine the required level of output so that sufficient output is generated to keep the economy balanced.
  • Demand and Supply in the economy vary with the price, when the price is high the supply is high but at the same time due to the increased price, the demand is low. In the above graph, ASis the supply level in the economy and ADis the demand in the economy.
  • Supply ASincreases with price and Demand ADdecrease with an increase in price. The intersection point ASand ADare known as the equilibrium point. The output Qis the desired level of output at price P1.
  • Let us assume that due to a reduction in money supply the demand in the economy has reduced to AD2, the intersection point of  AS1 and AD1 has also shifted and hence the equilibrium point will also shift to the Intersection point of  ADand AS1. Corresponding to the new equilibrium, we have new output and price levels Q2  and  Prespectively.
  • In the above graph, the only open question is the speed of shift of price and output to maintain the Equilibrium. There are various theories to explain the shift, we will look into the Classical Theory and the Keynesian Theory in the upcoming section.

Classical Theory

Classical Theory is based on the following assumptions:
  1. Say’s Law: Supply Creates its own demand. In other words, the production of goods will generate enough income in the economy that will be sufficient to buy all the output produced.
  2. Flexible Prices: The prices of goods and labour are flexible in the market; it may increase or decrease.
  3. Self-Regulating Market: When markets are free from any external influence, they regulate themselves. Classical Theory believed that there should be no interference in markets.
  4. Full Employment: No one is unemployed in the market as the entire workforce will be employed to produce more supply that will create its demand; hence the economy will work on Full Employment.
Supply Creates its Demand, this is achieved through flexibility in prices. If the demand decreases, the price will also decrease and if the demand increases the price will also increase. The Classical Theory assumes constant/fixed Supply on Full Employment and changes Price to adjust any change in demand. Refer to the following graph,
  • The supply is constant at AS when the demand shifts from ADto  ADthere are no changes in the Output. To attain the equilibrium, the price level changes from P to  P2. This automatic shifting of the price level to meet equilibrium is known as a self-correcting mechanism.
  • Hence, as per Classical Theory, the reduction in demand will not affect the Output and Supply in the economy and the economy will continue to function in Full Employment Mode by correcting its price levels.

Keynesian Theory

  • Classical Theory was based on Say’s Law that supply creates its demand, which is practically impossible and results in overproduction (due to fixing the output) and unemployment (reduced price levels). The Keynesian theory addresses many of these issues.
  • The Keynesian Theory is different from Classical theory in the following ways:
    1. Unemployment: Keynesian Theory accepts the fact that there is unemployment, the economy cannot function always on Full Employment Mode, it is just possible for a short period.
    2. Role of Government: Keynesian Theory accepts the fact that sometimes it is required for the Government to step in and control/regulate the economy.
    3. The Keynesian Theory does not follow Say’s Law, rather it accepts that Demands Creates its Own Supply i.e. Demand will determine the levels of supply.
    4. The Keynesian Theory does not believe in flexible prices and self-correcting mechanism. As per the theory, it is difficult to change prices and wages frequently due to various rigidities.
  • Keynesian Theory is based on grounds that in the short run, there are price and wage rigidities so the wage and price cannot be reduced when there is a decrease in demand.
  • As per the Keynesian Theory, the Aggregate Supply curve is horizontal in the short run and becomes vertical in the long run when the output is fixed, this is due to the reason that there are price and wage rigidities, the following graph explains the concept.
  • In the above graph, the supply curve AS is initially horizontal and becomes vertical in the long run. In initial changes in demand level (AD1AD2 and AD3) has a very low impact on price level as compared to the classical theory. To maintain the equilibrium the output is reduced from Q3 to Q1. If there will be a further decrease in the demand levels, the output will become very low, this will create a situation of recession in the economy.
  • In the long run, the output is fixed at level, which is the minimum acceptable level of output, and then the price is reduced to maintain the Equilibrium. Hence, the Classical Model explains the long run, whereas the Keynesian model explains the short run.

Output vs Employment (Classical vs Keynesian Theory)

Classical Theory Keynesian Theory
Output The output is fixed at a certain level and the Price is changed to attain Equilibrium when aggregate demand changes. The price level is fixed due to various rigidities and Output is changed to attain Equilibrium when aggregate demand changes.
Employment The economy works on Full Employment that assumes that no one is unemployed. The economy has an unemployed population and it does not work on Full Employment.
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