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Unit 4 - Class 2 - PPT - Classical & Keynesian Theory-1

Classical and Keynesian theories differ in their views of equilibrium and full employment. Under classical theory, equilibrium occurs at full employment when demand for labor equals supply. Unemployment is only temporary and wages adjust to clear the market. Keynesian theory sees equilibrium below full employment as possible, with demand determining output and employment rather than just wages. Government intervention may be needed to stimulate aggregate demand and achieve full employment.

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653 views14 pages

Unit 4 - Class 2 - PPT - Classical & Keynesian Theory-1

Classical and Keynesian theories differ in their views of equilibrium and full employment. Under classical theory, equilibrium occurs at full employment when demand for labor equals supply. Unemployment is only temporary and wages adjust to clear the market. Keynesian theory sees equilibrium below full employment as possible, with demand determining output and employment rather than just wages. Government intervention may be needed to stimulate aggregate demand and achieve full employment.

Uploaded by

shivam kumar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Unit 4

Classical vs Keynesian
Approach, Consumption
Function, Investment
Function, & Multiplier
Classical Approach vs Keynesian Approach

Classical Theory Keynesian theory


Equilibrium level of income and
employment is established at a point
Equilibrium level of income and
where AD = AS. But this need not be
employment is established only at
a full employment level since
the level of full employment.
equilibrium can be below the level
of full employment.
Full employment equilibrium is a Under-employment equilibrium is a
normal situation. There is no normal situation while full
possibility of under-employment employment equilibrium is an ideal
equilibrium in the long-run. and special situation.
Classical Approach vs Keynesian Approach

Classical Theory Keynesian theory


Supply by itself cannot create a
It is based on the belief that “supply
matching demand which generally
creates its own demand” which
results in overproduction &
implies that whole of output is
unemployment. On the contrary,
demanded and sold out.
“demand creates its own supply”.
In case of Temporary situation of Employment can be increased by
unemployment, a cut in money wage increasing effective demand (or AD)
increases employment. and not by money wage cut.
Variation in rate of interest Variation in income brings about
establishes equilibrium between equilibrium between saving and
saving and investment. investment.
Classical Approach vs Keynesian Approach

Classical Theory Keynesian theory


Economy by itself brings about full
Prices, wages and interest rates may
employment equilibrium through
not be flexible due to presence of
flexible system of interest rates,
monopolies and trade unions.
wages and prices.
Advocated policy of laissez faire and Advocated government intervention
opposed government intervention. to bring about equilibrium ..
The theory is based on the
The theory is meant for short period
assumption of long-run full
equilibrium of full employment.
employment equilibrium.
Detailing for the Classical Approach

To build up a classical macroeconomic model, we need to study


the framework that is composed of an aggregate production
function, the labour market, the money market, and the goods
market.
1. Employment-Output Determination: Labour
Market
 Labour market where we deal with production function in
which capital stock is fixed and labour is the variable input.

 Aggregate production function is: Y = f (K , L)


where K denotes a constant capital stock and L denotes
quantities of variable input, labour.

 In the classical model, equilibrium level of output is


determined by the employment of labour.
 The level of output and, hence, the level of employment is
established in the labour market by the demand for and
supply of labour.
1. Employment-Output Determination: Labour
Market
Demand for Labour
 Assuming a profit-maximising economy, Labour will be
demanded up to the point where the revenue earned from
selling the total product produced by the marginal unit of
labour is equal to the MC of labour.
i.e.
MRPL (Marginal Revenue Product for Labour) =MC
MR*MP=MC
P*MP=W
MP=W/P
1. Employment-Output Determination: Labour
Market
Demand for Labour
MP curve for labour indicates the firm’s demand for labour.
More labour is demanded at a lower wage. Thus, demand for
labour depends inversely on real wage.
1. Employment-Output Determination: Labour
Market
Supply for Labour
 Quantity of labour supplied (LS ) by households depends
upon the prevailing wage rate. If wage rate is too low certain
individuals may opt out of the market while at higher wage
rate individuals may put in more working hours.
 Thus there is a direct relationship between labour supply
and wage rate.
1. Employment-Output Determination: Labour
Market
 The relationships DL=SL together with the equilibrium
condition for the labour market determine output,
employment and real wage in the classical system.

 Equilibrium real wage rate and the equilibrium level of


employment are determined at that point where the negative
sloping labour demand curve cuts the positive sloping
labour supply curve.
1. Employment-Output Determination: Labour
Market
 In the lower panel, aggregate production function has been
shown. The intersection between DL and SL curves at point
E in the upper part of the figure determines the equilibrium
level of employment (LF) at the equilibrium real wage rate
(W/P)F.
1. Employment-Output Determination: Labour
Market
 The equilibrium of the classical labour market is one where
everyone willing to work at the real wage (W/P)F is able to
find work.

 This is the full employment position, denoted by LE = LF.

 The corresponding equilibrium level of output (at the


equilibrium level of employment) is YF.

 In the classical system, full employment is achieved


automatically due to wage-price flexibility.
1. Employment-
Output
Determination:
Labour Market

{
1. Employment-Output Determination: Labour
Market
 For instance, at a real wage (W/P)1 there exists a situation of
unemployment. Now, this excess supply of labour (AB) will
reduce the real wage rate until labour supply is equal to the
labour demand. Ultimately, real wage rate will decline to
(W/P)F where aggregate labour demand is exactly matched
by aggregate labour supply.

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