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_Classical VS Kayenes _
By: Jaoge
Classical vs. Keynes By: Jorge Zanga E-mail: j_z_2@hotmail.com The Classical
model of the economy says that all markets always clear. The labor market
failing to clear does not exist in the Classical model because of competitive
exchange equilibrium in which prices and quantities always adjust perfectly.
The Classical model is of a closed economy and the variables are real output,
employment, real and nominal wages, the price level, and the rate of interest.
It is easier to understand the classical model using five diagrams that are
numbered one through five in Appendix One, The Classical Model. These diagrams
represent the separate parts of the model that together illustrate, for the
most part, the entire Classical model. Diagram one represents the production
function, which shows the assumption that real output, y, is determined by the
level of employment, N. So y is a function of N and from the slope of the
function we can see that output rises as employment is increased. But there is
a diminishing marginal productivity of labor, which means that each time
employment increases, the increase in output will get smaller and smaller.
Diagram one illustrates the relationship between output and employment in the
short run, but does not determine the level of output or the level of
employment. But when used together with other diagrams of the model, diagram
one can be used to figure these things out. Diagram two is the labor market
with the real wage, w, on the vertical axis and employment, N, on the
horizontal axis. In the classical model, the supply of labor depends upon the
real-wage level because as the real wage rises, more people are willing to
work. The line SN represents the labor supply function and the line DN
represents the demand for labor. As the real wage increases so does the labor
supply function, but as the labor supply function increases, the demand for
labor decreases. Because the Classical model makes real wages perfectly
flexible and allows it to adjust to the level that clears the labor market,
the real wage and the level of employment can be figured out by using diagram
two. Once given the level of employment determined from diagram two, it is
possible to use diagram one to figure out the level of output. So diagrams one
and two, also know as the real sector, can be used to determine employment,
real output, and the real wage without any knowledge of the monetary sector of
the classical model. The monetary sector, given the level of real output,
determines only the monetary or nominal variables such as the price level and
the money wage. The separate treatment of the monetary sector and real sector
is known as the 'Classical dichotomy.' To complete the model, diagrams three,
four, and five are needed. Diagram three represents the Classical aggregate
demand curve, which shows the relationship between real aggregate demand for
output, y, on the horizontal axis, and the price level P, on the vertical
axis. Real aggregate demand represents the sum of the demands for output of
all the individuals in the economy. The Classical aggregate demand curve, AD,
illustrates the level of aggregate demand for a given price level. Since the
government or the central bank can control the quantity of money in
circulation, it also controls the position of the Classical aggregate demand
curve. But it can only control the price level and other nominal variables
because it is independent of the monetary sector. The full understanding of
the classical model comes with diagrams four and five, which consider
money-wage determination and interest rate determination respectively. In
diagram four, the real wage, w, is defined as the money wage, W, divided by
the price level, P. For this reason there is a relationship between money
wages and the price level which results in a straight line through the origin
that corresponds to the real wage. The higher the price level, the higher the
money wage must be to maintain any given real wage. Diagram five determines
the interest rate, r, which is expressed as a percentage per period and
depends upon the interaction of the savings and investment functions. The
investment function, I, shows that the lower the rate of interest, the higher
the amount of investment. The savings function, S, shows that the higher the
rate of interest, the more will be saved. Because of the Classical dichotomy,
diagram five is basically to show the breakdown of the use of income, or the
demand for output, between expenditure on consumption and new capital goods.
Like the Classical model, the Keynes model can also be explained by using five
diagrams that are shown in Appendix Two, Keynes model. This is about the only
similarity between the two. In the Classical model, all markets cleared. This
is not true for the Keynes model, where flexible wages and prices do not bring
about simultaneous market clearing, which means its not inherently
self-regulating. The labor market will not clear in the Keynes model, which
can be seen in Diagram five that shows involuntary unemployment. Also, the
arguments are not connected to wage and price rigidity as they are in the
Classical model. On the subject of rigidities, Keynes also rejected Pigou's
explanation for unemployment, which is basically the Classical models
explanation. Keynes said that imperfections are not the source of
unemployment, but other policy initiatives are required and not the removal of
the imperfections. Keynes assumes there are only two assets households can
hold, which are money and bonds. Bonds represent non-monetary options. Money
has different effects on the economy in these models. Because of the Classical
dichotomy, only the nominal sector is effected by money in the classical
model. But in the Keynes model, many things are effected by money. First, the
interest rate decreases, which causes an increase in bond prices. The decrease
in interest rate causes an increase in investment and then this causes an
increase in aggregate demand, which then causes income and employment to
increase. This can be seen in diagram four, and then because of the increase
in income, going back to graph three, we can see that this would cause an
increase in consumption. From diagram five, we can see because of the increase
in employment that this would cause a decrease in real wages. The decrease in
real wages would then cause involuntary unemployment to decrease. Because of
the different effects that money has on the economy in these models, they
arrive at different conclusions. The Classical economy seems to be in favor of
no policy since everything works itself out and ends up in equilibrium since
all the markets clear. The opposite is true for the Keynes model, where they
are in favor of government intervention since it is not inherently
self-regulating and the markets do not clear. The Keynes model needs a little
help from the government, or the central bank, to achieve equilibrium, where
as the Classical model, assuming all assumptions were realistic, is
self-regulating and all markets clear. Word Count: 1167
Word Count: 1177
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