Classical vs Keynesian Economic Model

Emmalee Wagner

Economics 2020

December 2nd, 2018

 The Classical theory of economics was proposed by renowned economists such

as Adam Smith, David Ricardo, and John Stuart Mill. In this theory, the economy is

always running at full potential, meaning it is producing the maximum amount it can at

all times. Since the economy is always producing at full potential, this means the real

Gross Domestic Product (GDP) will always remain the same. As illustrated with Graph

A1&2, the Long Run Aggregate Supply (LRAS) will be a vertical line and remain on the

same x-value. The theory proposes, in the long run, only aggregate demand (AD) will

change and short lived effects on demand will not affect GDP or supply in the long run.

When the aggregate demand increases (shown by upward movement on LRAS), the

prices increase as well; this is inflation (Miler, 2017). Conversely, if aggregate demand

decreases (downward movement on LRAS), deflation occurs. In classical economics,

the only way prices change is through inflation or deflation. When the demand goes up,

the prices increase and the purchasing power of consumers decreases. In turn, workers

ask for higher salaries and when granted, consumption will rise again, as will prices. As

prices continue to increase, the cost of goods and service become too high, limiting any

consumption increase (Miler, 2017). Once the market reaches this point, and

consumption lowers, companies do not need as many workers, also leading to a fall in

aggregate demand. As the demand slows, the prices drop, actually giving more

purchasing power back to consumers since the prices are affordable again. The

process is inversed when deflation occurs (Graph A2); this can happen eventually, and

the market will correct itself. The classical theory states periods of inflation and

recessions are purely short-term and do not require outside intervention to correct the
market. The inside forces in a market, or “invisible hand” as coined by Adam Smith, is

enough to restore the price level in an economy (Khan Academy).

Graph A1 Graph A2

The economist Jean-Baptiste Say developed an economic law explaining all the

supply in a market creating all the demand as well. His law states people are producing

goods and services solely because they are in need of other goods and services. In this

case, there should technically be no overproduction. However, Say’s law allowed for

surplus or deficient supply in a given market. If this is the case, the excess of a product

would lower prices, a shortage of products would, therefore, increase prices. Either

case would eventually restore price equilibrium (Khan Academy).

During the economic crisis of the Great Depression, John Maynard Keynes

proposed that outside forces or government intervention may be necessary to restore

equilibrium price levels. His theory became known as the Keynesian theory, and while

he agreed with the classical theory on some aspects, especially in the long term, it was

his belief that in times of severe economic recession, the economy is actually

performing under potential and not reaching maximum real GDP. The three stages or

ranges are depicted in Graph B. Each AD curve in Graph C represents the stages of an

economy according to Keynesian theory. At AD1 the economy is along the LRAS vertical
line, experiencing full employment, and producing at its maximum capacity, so real GDP

is at maximum potential as well. If the AD curve begins to shift to the left, due to the

shortage of money in circulation or job security decreasing, for instance, the economy

moves to the intermediate stage. The equilibrium of AD2 and the AS curve decreased

the real GDP and prices. AD is in the Keynesian range (AD3), when AS is horizontal,

price levels are stagnant or sticky. This is an important part of the Keynesian theory

because if the economy reaches this level of recession, the inner market forces cannot

correct itself no matter the level of aggregate demand (Miler, 2017). The economy is

experiencing high levels of unemployment. Consumers do not want to buy products, as

they have little to no purchasing power and expect prices to continue to drop.

Companies will not lower their prices, fearing a loss of revenue and potentially letting off

workers or having to shut down operations altogether. Workers, on the other hand,

refuse to allow their wages to be lowered, but companies can not justify raising their

wages either. The price is stagnant but consumption decreases, causing aggregate

demand to decline as well. As demand falls, the real GDP falls too. In order to address

this issue, the government would ideally stimulate the demand in the market. This could

be by lowering taxes, reducing government spending for a short time, or providing

works programs as the U.S. did during the Great Depression (Miler, 2017). By

increasing the purchasing power of consumers, demand begins to increase and the real

GDP follows. While it may take months or even years to leave the Keynesian range,

eventually the real GDP reaches the intermediary range of the aggregate supply curve

and by this point, the inside forces of the market begin to fix itself again and prices

begin to increase as the real GDP reaches its maximum potential (this can be seen in

Graph B). Without outside intervention, the economy could potentially collapse on itself.
Greece experienced ecnomomic crisis in 2008. Greece’s GDP dropped by 28% but the

EU stepped in and bailed out Greece with fiscal policies. Since 2008, last year Greece

saw it’s first increase in GDP (1.4%) (Greece Emerges from Eurozone Bailout

Programme, 2018). With intervention and outside stimulation, an economy is able to

recover and correct, relying on just inside forces once out of the Keynesian range.

Graph B
Graph B demonstrates Phillip’s curve,
created in the 1950s. It shows the three
stages of the AS curve as seen by Keynesian
economics.

Graph C

For markets and economies, in the long run, the classical approach makes the

most sense. The world exists in an equilibrium, so the markets will always readjust

themselves. Also, based on the influence the government has on the economy like price

ceilings and floors, government influence, or any outside influence on the economy can
lead to negative consequences, either for the producer or consumer. Limiting outside

forces and allowing inside forces like employment, wages, market prices, and interest

rates to fluctuate as demand permits them.

However as Keynesian economics proves, in times of severe economic

recession, outside intervention may be the best tactic in the short term. Once an

economy has contracted to a certain level, it is difficult or impossible for it to correct

itself. Once demand has dropped too low, wages will not decrease any lower nor will

prices. In this instance, stimulation is necessary to increase the purchasing power of

consumers and end the stagnate levels. The U.S. federal government created work

programs during the Great Depression which aided in decreasing unemployment and in

the economic crisis of 2008, the Federal Reserve lowered interest rates, and the federal

government increased spending on infrastructure. These policies increased trust and

allowed people to start investing in the economy again, which increased aggregate

demand in the economy and move the curve to the right, out of recession.

Works Cited

Greece Emerges from Eurozone Bailout Programme. BBC News. 20 August, 2018.

Khan Academy. Keynes’ Law and Say’s Law in the AD/AS model.

Miller, Roger. Economics Today: The Macro View. London: Pearson. 2017.