Neo-classical vs Keynesian model

The neoclassical and Keynesian AD/AS models are two different economic models
that explain the relationship between aggregate demand (AD) and aggregate
supply (AS).

The neoclassical AD/AS model assumes that prices and wages are flexible, and
that the economy will naturally return to full employment in the long run.

The Keynesian AD/AS model assumes that prices and wages are sticky, and that
the economy may not return to full employment in the long run without
government intervention. In this model, the AD curve is also downward sloping,
but it is flatter than in the neoclassical model. This is because Keynesians
believe that changes in aggregate demand have a larger impact on output in the
short run than in the long run. The AS curve is also flatter in the Keynesian
model, reflecting the fact that producers are less willing to change their output
in response to changes in prices.

The main difference between the two models is their view of the role of
government in the economy.

Neoclassical economists believe that the government should play a limited role,
while Keynesian economists believe that the government can play a more active
role in stimulating the economy during recessions. Through subsidies and
grants.

Neoclassical AD/AS
Feature Keynesian AD/AS model
model

Assumptions
Prices and wages are Prices and wages are
about prices and
flexible. sticky.
wages

The economy will The economy may not

Assumptions
naturally return to return to full employment
about the long-
full employment in in the long run without
run equilibrium
the long run. government intervention.
 Downward sloping, but
Shape of the AD
Downward sloping. flatter than in the
curve
neoclassical model.

Upward sloping, but

Shape of the AS
Upward sloping. flatter than in the
curve
neoclassical model.

The government can play

The government
Role of a more active role in
should play a limited
government stimulating the economy
role.
during recessions.

In practice, most economists agree that the neoclassical and Keynesian AD/AS
models are both useful in understanding the economy. The neoclassical model is
better at explaining the economy in the long run, while the Keynesian model is
better at explaining the economy in the short run.

The two models can also be combined to create a more comprehensive model of
the economy. This is known as the new Keynesian synthesis. The new Keynesian
synthesis combines the insights of the neoclassical and Keynesian models to
explain how prices and wages adjust over time, and how government policy can
affect the economy.

Neoclassical model
Long run
In the long run, the neoclassical AD/AS
model assumes that prices and wages
are flexible and that the economy will
naturally return to full employment.
As a result, The long-run aggregate
supply curve (LRAS) is therefore
vertical, representing the economy's
potential output.
The aggregate demand curve can shift
in the long run due to changes in
factors such as government spending,
Short run
In the short run the neoclassical
AD/AS model assumes that prices and
wages are sticky. The short-run
aggregate supply curve (SRAS) is
therefore upward sloping, reflecting
the fact that producers are willing to
supply more output at higher prices.
investment, or net exports. However,
the long-run equilibrium of the
economy is always at the full
employment level of output.
The neoclassical AD/AS model is not without its critics. Some economists
argue that the assumption of fully flexible prices and wages is unrealistic.
They argue that prices and wages are sticky in the real world, and that this
can lead to prolonged periods of unemployment and output below potential.

Keynesian Model
Long run Short run
In the long run, the Keynesian AD/AS In the short run, however, prices and
model assumes that prices and wages wages are sticky and may not adjust
are flexible and will adjust to bring quickly enough to bring the economy
the economy to full employment. In to full employment. In this case, the
this case, the AS curve is vertical at AS curve is upward sloping, reflecting
the full employment level of output the fact that producers are willing to
supply more output at higher prices
Implications on government policy; in Implication on government policy; in
the long run, the government cannot the short run, fiscal policy can be
use fiscal policy to permanently used to increase output and
increase output. employment.

Neoclassical Keynessian
National Incomes:

In economics, national income is the total income earned by all the factors of
production in an economy during a given period. It is a measure of the economic
output of a country.

There are two main measures of national income:

1. Gross domestic product (GDP) is the total value of all goods and services
produced within a country's borders during a given period.
2. Gross national income (GNI) is the total income earned by a country's
residents, regardless of where they are located.

GNI = GDP + net income from abroad

Where net income from abroad is the difference between the income that
residents of a country earn abroad and the income that foreigners earn in the
country.

National income is an important measure of economic performance. It can be

used to;

-track the growth of an economy

- compare the economies of different countries

- assess the impact of economic policies

National income is a complex concept, and there are many ways to measure it.
The most used methods are the production approach, income approach and the
expenditure approach.

The income approach measures national income by adding up the incomes of all
the factors of production in an economy. The factors of production are land,
labour, capital, and entrepreneurship.

The production approach measures national income as the sum of the value
added at each stage of production.

= CP of primary sector + (SP of primary sector – CP of primary sector)

+ (SP of secondary sector – CP of secondary sector)

+ (SP of tertiary sector – CP of tertiary sector)

Where: SP = Selling price

 CP = Cost price

The objective of the production approach is to include only the market value of
final goods in GDP, also to avoid the double accounting of goods that are still in
production (intermediate goods).

The expenditure approach measures national income by adding up the

expenditures of all the economic agents in an economy. The economic agents
are households, businesses, and the government.

Both the income approach and the expenditure approach are valid ways to
measure national income. However, the income approach is more commonly
used because it is easier to calculate.

Real GNI per

Feature GDP GNI Real GDP capita

The value of all

goods and The total
services income The value of
produced within earned by a GDP The real GNI
a country's country's adjusted for divided by the
What it measures borders residents inflation population

Affected by
inflation Yes No No Yes

Used to compare
the economic
performance of
different countries Yes Yes Yes Yes
Business cycles:

A business cycle is a period of alternating expansion and contraction in

economic activity. It is measured by the changes in the Gross Domestic Product
(GDP).

The 4 phases of a business cycle are:

Expansion is the phase of the business cycle where economic activity is

increasing. This is characterized by rising GDP, employment, and income.

Peak is the point at which the expansion phase ends, and the contraction phase
begins. This is characterized by a slowdown in GDP growth, employment, and
income.

Contraction is the phase of the business cycle where economic activity is

decreasing. This is characterized by falling GDP, employment, and income.

Trough is the point at which the contraction phase ends, and the expansion
phase begins again. This is characterized by a low point in GDP, employment,
and income.

The length of a business cycle can vary from a few months to several years.

The causes of business cycles are complex and not fully understood. However,
some of the factors that can contribute to a business cycle include:

Changes in aggregate demand. Aggregate demand is the total amount of goods

and services that are demanded in an economy. Changes in aggregate demand
can be caused by changes in consumer spending, investment spending,
government spending, or net exports.

Changes in aggregate supply. Aggregate supply is the total amount of goods and
services that are supplied in an economy. Changes in aggregate supply can be
caused by changes in the price of inputs, such as labor and capital, or changes in
technology.

Financial shocks. Financial shocks are events that disrupt the financial system,
such as a stock market crash or a banking crisis. These shocks can have a
negative impact on economic activity.

Technological innovations. Technological innovations are inventions that alter

production methods and output. Significant changes in technology and the
adoption of these tools have an enduring impact on the capacity that a nation
has to produce.

Business cycles can have a significant impact on people's lives. During a

recession, people may lose their jobs, their homes, or their businesses. This can
lead to financial hardship and social unrest.
There are several policies that governments can use to try to smooth out
business cycles. These policies include:

Fiscal policy. Fiscal policy refers to the government's spending and tax policies.
The government can use fiscal policy to stimulate the economy during a
recession by increasing spending or cutting taxes.

Monetary policy. Monetary policy refers to the central bank's control of the
money supply. The central bank can use monetary policy to tighten or loosen
credit conditions in the economy.

Trade policy. Trade policy refers to the government's regulations on imports and
exports. The government can use trade policy to protect domestic industries
from foreign competition.

Grants and tenders are a form of government expenditure that tends to increase
economic output and are intended to establish an enduring benefit for the
economy. During recessionary periods, the government may establish incentives
on businesses to take certain initiatives such as employing youth, training
workers or acquiring equipment for production.

The effectiveness of these policies in smoothing out business cycles is a matter

of debate. However, there is evidence that they can be helpful in moderating the
severity of recessions and expansions.

Written by: Mphatso Manyamba