1. Classical and Keynesian Theory
Unit Three:
Classical and Keynesian Theory

2. Goals
Explain the differences between Classical and Keynesian economic theory and how each developed.
Illustrate how Classical and Keynesian theory operates through a simple circular flow diagram.
Explain the development of neo-classical schools and new Keynesian theory.

3. I. Classical vs. Keynesian Economic Theory
Laissez- faire/ non-activists
Say’s Law – “Supply creates its own demand.”
Dominant school of economic thought until the Great Depression.
Keynesian
Government intervention needed/ activists
John Maynard Keyes– Demand creates supply.
Emerged in the 1930’s and remains fairly prominent.
Classical Economics: when AS equals AD we are at full employment; nonactivists
Keynesian: activists

4. I. Classical vs. Keynesian Economic Theory
Classical Model:
Say’s Law: In the process of producing output, businesses also create enough income to ensure that all the output will be sold.
Saving = Investment
Unemployment occurs because of rigid wages, not deficiency in total spending.
Recessions caused by external shocks and rigid wages.

5. I. Classical vs. Keynesian Economic Theory
Keynesian Model:
Demand to supply: For Keynesians, businesses base their production decisions on the level of expected demand, or expected total spending.
Savings = investments, unless there are changes in expectations among consumers and producers.
Many markets are not very competitive, so producers would rather decrease output than lower prices and fight rigid wages to reduce costs.
“Sticky wages” causes unemployment and a deficiency in spending causes recessions.

6. II. Other Economic Schools
Rational Expectations Theory
People are rational.
Therefore, they will predict the impacts of Fiscal policy, rendering it useless.
Supply-Side Economics (Reaganomics)
Return to a more classical outlook on Macroeconomic theory.
Economic growth will be most effective when investing in capital and lowering production costs.
The Chicago School
Neoclassical school of thought, attributed with the University of Chicago.
Based on the theory of rational expectations.
Stemmed from the Austrian School.

7. III. Practice
1) Keynesians are considered_________ economists, whereas the classical economists are considered__________ economists.
Nonactivist, activist
Laissez-faire, activist
Activist, nonactivist
Nonactivist, laissez-faire C

8. III. Practice 2) According to classical economists,
Unemployment is caused by too little spending.
The interest rate will ensure that the amount households plan to save will equal the amount businesses desire to invest.
Increasing government spending is the most reliable method of restoring full employment.
The amount households plan to save is determined primarily by their income. B.

9. III. Practice
3) Keynes would suggest that during a period of unemployment, government should
Do nothing.
Reduce its spending to stimulate the economy.
Increase its spending to stimulate the economy.
Take legal action against unions in order to make wages more flexible. C

10. III.
4) According to the classical model, even, when all saving is not invented, full employment will be maintained because
The government will step in and stimulate spending.
The equilibrium wage rate will rise to stimulate spending.
Wages and prices will fall to permit businesses to continue hiring everyone who wants to work.
The government will establish special work programs. C.

11. III. Practice
5) Which of the following is an example of the fiscal policy Keynes would find appropriate for a period of unemployment?
Decrease government spending
Increase the money supply
Reduce personal income taxes
Reduce the money supply C