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1.3 School of Thoughts

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37 views26 pages

1.3 School of Thoughts

notes

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06.anishasingh
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Economics-II: Macro Economic Analysis

UNIT-1
Overview of Macroeconomics
TOPIC: 1.3
SCHOOL OF THOUGHTS
CLASSICALS AND KEYNESIAN

Vishal Vyas
Assistant Professor
DME Law School
v.vyas@dme.ac.in
TEXTBOOKS
1. D.N. Dwivedi, Macroeconomics, Tata Mc
Graw-Hill, Delhi (Latest Edn.)
2. E. Shapiro, Macroeconomic Analysis, Tata
Mc Graw-Hill, Delhi, 1996
3. M.L. Seth. Money, Banking, International
Trade and Public Finance, Lakshmi Narian
Agarwal Educational Publishers, India
(8thEdn.)
School of thoughts

•Classical Economics
•Keynesian Economics
Classical Economics

• Known as the English School of Economic Thought


• Originated during the late 18th century in Britain
• Main Idea: “Invisible Hand”
• The most effective market system is the market without government
intervention.
Assumptions

Full
Employment

Self adjusting Laissez-faire

Aggregate
Free trade
Supply

Wages are
Flexible
Classical Aggregate Supply curve

• LRAS is vertical.
• Increase in Aggregate Demand results in increase in
prices only.
Say’s Law of Market

“Supply creates its own demand”

Production creates demand for goods


Price Level in the economy depends on the supply of money
Saving investment equality
Rate of interest as determinant factor
support the laissez-faire belief that a capitalist economy will
naturally tend toward full employment and prosperity
without government intervention
Wage Price Flexibility

• Decrease in demand for labor results in decrease in


wage rates.
No tradeoff

• No Tradeoff Between Unemployment and Inflation


• Classical economists say that in the short term, you might be able to reduce
unemployment below the natural rate by increasing AD.
• But, in the long-term, when wages adjust, unemployment will return to the
natural rate, and there will be higher inflation. Therefore, there is no trade off in
the long-run.
Full employment
• Full employment refers to that situation in which at a given
level of real wage demand of labour is equal to the available
supply of labour.
• All those people get employment who are willing to work at
prevailing wage rate
Demand of labour = Supply of labour
Implications of Classical Economics
• Money supply changes has not effect on current output,
only affect price.

• Changes in government expenditure has no effect on current


output.

• Changes in the overall level of taxation do not affect current


output.

• Policy tools will not affect output and employment but add
instability.

• Let market work properly is the best thing the government


can do.
Criticism to Classical School
• The main critic of the classical school of thought was John Maynard
Keynes.

• In his book, “General Theory of Employment, Interest and Money”,


he out rightly rejected the Say’s law of market that supply creates its
own demand.

• In addition, in his view, the idea of full employment in the economy is


unrealistic.
John Maynard Keynes

• During the Great Depression of


the 1930s, existing economic
theory was unable either to
explain the causes of the severe
worldwide economic collapse or
to provide an adequate public
policy solution to remove
unemployment.
Assumptions
Govt
Intervention

Under-
Short Run employment
equilibrium

Money
Trade Off
Illusion

Wages are
Inflexible
Aggregate Supply Curve

• The Keynesian view of long run aggregate supply is different. They argue
that the economy can be below full capacity in the long term. Therefore, a
Keynesian plays greater emphasis on the role of aggregate demand in
causing and overcoming a recession.
Aggregate demand
• Effective demand refers to that level of aggregate demand where it is equal
to aggregate supply.

• He therefore suggested that unemployment could be removed by increasing


the effective demand.

• According to him aggregate demand comprised of demand for two types of


goods: Demand for consumption good and Demand for investment goods

C + I = AD
• to remove unemployment and to achieve full employment, government
interference is necessary
Wages inflexible
• Wages are ‘sticky downwards’.
• Workers resist nominal wage cuts.
• For example, if there was a fall in demand for labour, trade unions would reject
nominal wage cuts, therefore, in the Keynesian model it is easier for labour markets
to have disequilibrium. Wages would stay at W1, and unemployment would result.

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