Basic principles underlying both the Classical and the Keynesian schools of thought within Economics. Work I produced whilst studying Monetary Economics in my second year of study at the University of Brighton. Ryan Reardon Finance and Investment student.

1. Ryan Reardon,WalterHeering,GroupG, Monetary Economicsandpolicy,Studentno:13818702,
EC284
Classical vs Keynesiantheory ofEconomics
There are twowidelyacceptedschoolsof thoughtwithinEconomics. ClassicalandKeynesiantheory.
KeynesiantheorywascreatedbyEconomistJohnMaynardKeynesandthe ideologiesof this
approach differvastlyfrom thatof Classical theory developedbyMiltonFriedman andFriedrich
Hayek.In thisessayIwill compare andcontrast the two opposingtheoriesandtheirstance of fiscal
and monetarypolicyandinterventionintoafree capitalistmarket.
AD = C+I+G+ (I-E)
C= Consumptionof goods and services
I=Investment
G=Governmentspending
(I-E) = Netimports/exports
Firstly,Classical theoryisbasedonthe ideathatthe free marketisbestlefttoitself. Accordingto
Flanders(2012), Hayekisstronglyopposedtoall governmenteconomic planning;he believesthe
free marketandprivate firmswill provideall goodsandservicesthatare demandedby consumers.
Classical theory statesthatthe economy isself-correcting(Nash,2003).This meansthatwagesand
pricesof goodswill adjustimmediatelyafterafall in aggregate demand(AD) because of automatic
stabilisers.Classical theoryentailsthe ideathatoutputissupplydetermined(Collie,2014).
Classical theorybelievesthatthe economyisalwaysoperatingatfull productive potential atall
times,thismeans all resources(land,labour,capital andentrepreneurship)are utilisedattheir
maximumcapacity. Thismeansthatthere isno spare capacity inthe economyto produce more
goodsand servicesforconsumptionbythe public. (Collie,2014)
Diagram showingthe difference betweenKeynesianandNeo-classical supplycurve.(Welker2011)
Y3
P3

2. Ryan Reardon,WalterHeering,GroupG, Monetary Economicsandpolicy,Studentno:13818702,
EC284
The diagram showsthatin the Classical model the LRAScurve isvertical because there isfull
employmentwithinthe economy.Classical theoryassumesanatural rate of unemploymentof
around5%. Unemploymentinthe Classicalmodel onlyassumesbothstructural (mismatchof skillsof
workers) andfrictional unemployment(movementof workersgoingintodifferenttrades).The
contractioninAD has meantan inwardmovementonthe demandcurve anda shiftfromAD1 to
AD2 and a fall inthe level of inflation (Collie2014).However,the supplycurve hasremainedata
constantpositionassumingthatthe fall indemanddoesnot leadtolay-offsforstaff.Insteaditleads
to lowerwagesforemployees andlowerpricesof goodsinthe economy. Keypointinthe Classical
model isthatthe purchasingpowerof goodsremainsthe same. The Classical model therefore
believesthatthe fall indemandleadstoarapid adjustmentinthe price of goodsandservicesand
that employeesare willingtoworkat the new prevailingwage rate ratherthanface unemployment.
The Keynesianmodelpicturinghere onthe leftportraysacompletelydifferentideologyin
comparison. A slopingsupplycurve meansthatafall inAD isrepresentedby atrade-off between
inflationandunemployment(Phillipscurve).Keynesiantheorytakesintoaccountdelaysthatfirms
may experience whentryingtoreduce average total costs(ATC) aftera negative demandshock.For
instance, contractsare notnegotiated daily.Keynesiantheoryalsoassumesthatfirmsdonotlookto
lowertheiremployees’wagesinsteadtheylooktomake redundancies.Thisinducesthe movement
of a newequilibriumatpointp2, y2 where the fall inADis tangentwiththe new supplycurve. Thisis
a pointwithloweroutputandlowerinflation. Keynesalsosuggestedamovementof p3,y3 a state of
disequilibriuminthe economy.
Accordingto Collie (2014) Keynesianeconomistsrefer towagesas “stickydown”whichmeans
workersare reluctantto acceptlowerwages.Keynesarguesthatthe Classical modelisoutdated
because trade unionshave more powerthantheydidwhenthe Classical modelwasdeveloped.Also,
the minimumwage actand contracts has stoppedfirmsbeingable toreduce wagestoacertain
extentmeaningthatwagesare fixedinthe short-runandnoreadjustmentof priceslike the Classical
model suggests.Furthermore,thereare more lawsprotectingworkersandcollectivelyworkershave
more bargainingpowerthantheydidinthe 1900’s.
Keynesianeconomistswouldlooktointervene inthe marketwiththe manipulationof expansionary
monetaryand/orfiscal policyinordertocreate a positive demandshock andreduce unemployment.
KeynesiantheorybelievesthatcreatingADis the bestway to pursue economicgrowth anda rise in
GDP and actual livingstandards.AccordingtoRiley(2011) Keynesianeconomistsbelieve thatthe
economyisnotself-correctinglike Classical economistsassume.Therefore,aneconomycannotrely
on automaticstabilisersandnewinventionstopull aneconomyoutof recession.
Stimulatingdemandiscrucial tocreatinga positive multipliereffect inKeynesiantheory wherebyan
increase inADand consumerspendingleadstoamore than proportional injectionof cashin the
circularflowof income creatinga largerfinal impactonoutputand unemploymentlevels.Gordon
Brownusedexpansionaryfiscal policyreducingtaxesinordertoinduce more consumerspending
and create a fiscal stimulusinthe economy afterthe 2008 recession. (Riley,2011)

3. Ryan Reardon,WalterHeering,GroupG, Monetary Economicsandpolicy,Studentno:13818702,
EC284
Diagram showingnegative output gaps experiencedbyGermany,UKand the US after 2007. (Collie
2014)
The expansionaryfiscal policyincorporatedlarge levelsof borrowingbythe UKgovernment;thishas
meanta huge governmentbudgetdeficitnow facedbyUKtax payers. AccordingtoAnderson(2014)
the UK hasborrowedover£1trillionmostof whichhasbeenspentonthe publicsectorin orderto
reduce unemploymentlevels andboostAD.
The diagramshowsthat the UK has experiencedanegative outputgapsince 2008 meaning thatthe
economyisoperatingbelowits “potential output”(Nash,2003).The UK experiencedunemployment
levelsof 8%in2008 (Camposetal, 2010). Keynesianeconomistsbelievethatthe interventioninthe
marketand governmentpolicyisjustifiedasthe rate of unemployment decreased by3% pre-
recessionlevels.
Fiscal austeritymeasuresare nowbeingputtingintoplace inordertolowerthe UK’slarge and
growingdebtlevels.Thisinvolvescuttinggovernmentspendingandraisingtaxes. Thisinitself can
cause a negative multipliereffectandleadthe economyintoadeeprecessionasitisusually
associatedwithafall inAD.
Output gaps 1998-2010 (%)
-7.0
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
1998 2000 2002 2004 2006 2008 2010
Germany United Kingdom United States

4. Ryan Reardon,WalterHeering,GroupG, Monetary Economicsandpolicy,Studentno:13818702,
EC284
Accordingto Weller(2011) Classical theoristssuchasHayek wouldwidelycriticise the ideaof
governmentinterventioninthe market.Forinstance,the presence of the minimumwage acthas
meantthat pricescannotadjustin a recessionliketheywouldhave before.
Furthermore,the Classical model showsthatanincrease inADdoesnotaffectthe level of output.
But, itcan only leadto demand-pull inflationasclassical theoryassumesthe economyisworkingat
itsfull productive potential. Atequilibriumpoint“e”the economyisworkingatitstarget level of
inflationwhichwe assumetobe around2%. Thisis a desirable levelof inflationforaneconomyasit
isstable and controllableandimportantlynottoohigh(hyperinflation) andnotnegative(deflation).
A 2% level of inflationisseenasabenchmarkthateconomiesshouldstrivefor(Garay,2014).
The Bank of Englandcoulduse contractionarymonetarypolicyof increasingnominal interestrates
to targetthe level of inflation.Increasingthe nominal interestrate will leadtoreal interestrates
increasinganda reductioninthe moneysupply (availabilityof loansrelativelymore expensive).This
will meanthatthe UK’s exportsare relativelymore expensive incomparisonwithcountrieswith
lowerinterestrates.Higherinterestratesalsomeanthatimportsare cheaper.Therefore,intheory
importswill increase andexports willdecrease whichwillleadtoafall inAD (ceterisparibus).
Moreover,higherinterestrateswill meanthere isanincrease inthe marginal propensitytosave as
the rewardfor savingbecomesmore attractive.Thiswill alsoreducethe consumptionelement
withinADandit shouldleadtoAD movinginwardsbackto point“e”at a lowerandmore desirable
level of inflation. Foreignandlocal companieswillalsosee the UKas a lessattractive investmentif
consumerspendinglevelsare lowthisshouldinturnreduce the IcomponentwithinAD. The
manipulationof interestratesisusedinbothmodels intargetingasuitable level of inflation.The
Taylorrule indicatesif inflationoroutputisabove targetitis a signal to increase interestratesand

5. Ryan Reardon,WalterHeering,GroupG, Monetary Economicsandpolicy,Studentno:13818702,
EC284
reduce the moneysupplyasmentionedbyCollie(2014).In the Keynesianmodel itisalsousedto
stimulate ADina downturnreducingunemploymentbutincreasinginflationarypressures.
Classical economistsbelieve thatoutputissupplydetermined;therefore the onlygovernmental
interventioninthe marketwould be the implementationof supply-sidepolicies.
Diagram showingand outward shiftin AS curve Collie (2014)
The implementationof supply-side policiessuchasincreasedspendingoneducationcanleadto an
outwardshiftinthe AS curve and a movementtoAS1over the years as mentionedbyWhite (2014).
The target level of inflationhasremainedontargetdespite atemporaryfall inthe price of goods
representedhereat equilibriumpointB.Thusthe pursuitof economicgrowthandrisingaverage
livingstandardscome aboutthroughimprovementsinthe efficientlyinproducinggoods.Thisis
achieved throughinnovationandimprovementsinthe size andqualityof the laboursupply,not
simplyanincrease indemand.
In conclusion, itseemsasthoughthe Classical theoryof economicsissomewhatoutdatedandthe
UK has adopted the Keynesianapproachformanyyears inpolitics introducingthe minimumwage
act and safetyregulationstoprotectworkers.Itisacceptedthatthere isa level of unemploymentin
the economywhichisabove the natural rate whichcontradictsClassical theory.The governmenthas
persistentlyusedexpansionarymonetaryandfiscal policyinorderto;correctthe negative output
gap, reduce unemploymentandstimulatelow levelsof AD experiencedbythe UK ina downturn.
The evidence showsthatthe Keynesianapproachisfarmore relevanttothe UK as government
policy.

6. Ryan Reardon,WalterHeering,GroupG, Monetary Economicsandpolicy,Studentno:13818702,
EC284
References
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Garay, S. (2014). Overview of the inflation report. Available:
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continues/. Last accessed 30th November 2014.