Classical

theory vs.
Keynesiyan
theory
A comparison between the
two macroeconomic models.

Copyright @2020 Shreya

Contents
• What is Macroeconomics?
• Models of macroeconomics
y a
• Classical model
h re
0 S
• Keynesian model
0 2
@ 2
• How great depression
h y
was explained
t ha by

r i g
keynesian theory
sa
p y
Co
• conclusion
Macroeconomics

Copyright @2020 Shreya

What is macroeconomics?
• “A branch of economics that studies how an
overall economy behaves.”
y a
h
Macroeconomics studies economy-wide re
phenomena such as:
0 S
(a)Inflation 0 2
@ 2
(b) price levels
h t a y
(c) rate of economic
i g
rincome s a h
growth
(d) nationaly
pdomestic product (GDP)
(e)grosso
C in unemployment.
(f)changes
Contd..
Macroeconomics deals with the performance,
structure, and behaviour of the entire
y a
re
economy, in contrast to microeconomics, which
h
S
is more focused on the choices made by
0
2
individual actors in the economy ((like people,
0
2
households, industries, etc.).
@
h t a y
r i g a h
y s
C op
Contd..
Some of the key questions addressed by
macroeconomics include:
y a
re
(a) What causes unemployment?
(b)What causes inflation?
Sh
0
(c) What creates or stimulates economic growth?
2
2 0
t @ a y
i g
Macroeconomicsh a h
attempts to measure how
y r is s
p
well an economy performing, to understand
whatCoforces drive it, and to project how
performance can improve.
Macroeconomic
models

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What are models?
• A model is an abstraction that removes
unnecessary details to simplify understanding
of the situation.
y a
h
• economic models might be different re
depending on 0 S
0 2
•
@ 2
the structure and characteristics of the
t hay available;
economy; policyhinstruments
i g sa etc
institutionalrconstraints;
p y
Co
Classes of
macroeconomic models

models
y a
h re
Simple theoretic

0 S
0 2 Empirical
DSGE
classical
2
keynesian

@
forecasting
neoclassical IS-LM

h t a y
r i g a h
y s
C op
DSGE- dynamic stochastic general equilibrium models
Simple theoretical models
• They are based on a few equations involving a few
variables, which can often be explained with simple
diagrams
y a
•
h re
Most models are static. Only a few are dynamic
models.
0 S
The variables that appear in0 2
•
@ 2 these models often
represent macroeconomic
employment, etc.)ht y
aggregates(GDP, total
a
r i g a h
quantitativeyapplication sto forecasting, testing, or
•
o p
C
policy evaluation
substantially
is usually impossible without
augmenting the structure of the
model.
Classical
model

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Introduction
• The Classical Model was popular before the
Great Depression.(1929)
y a
re
• It says that the economy is very free-flowing,
h
and downs of demand over time.0 S
and prices and wages freely adjust to the ups

0 2
The major assumption 2
•
the economy is h
@
t at
of this model is that
a y employment,
r i g
always
a h full
meaning that
working p
s
everyone who wants to work is
y all resources are being fully used
C o and
to their capacity. 
What does the classical
model do?
The classical model is a model of the economy
a
that determines the real variables—real GDP,
y
re
employment and unemployment, the real wage
h
S
rate, consumption, saving, investment, and the
0
2
real interest rate—at full employment.
0
@ 2
h t
Most economists believe a
thatythe economy is
r i g a h
s
rarely at full employment but that the classical
y a benchmark against which to
o p
model provides
C
measure the actual state of the economy.
According to classical
theory:
• Economy is always in equilibrium
• No external forces are required
y a
• Market forces ensure equilibrium
hre
•
0 S
Full employment achieved due to flexible wages
and prices.
0 2
Unemployment is due @
2
•
h t ha y
to high wage rate
• i g semployment
If wage rate isrreduced, a
p y law of wages)
increases(Pigou’s
C o
• If demand = supply is not true, prices adjust and
restore equilibrium.
 Pigou’s law of wages
It is based on the following
assumptions:
(i) more labour will be offered for
higher real wage rates. y a
(ii) less labour will be hired for higher
h re
real wage rates and more at lower real
0 S
wage rates.
0 2
2
(iii) There are no imperfections or
@
t y
institutional rigidities in the labour
h a
r i g a h
market, i.e. labour is perfectly
mobile.
y s
C op
(iv) Aggregate demand (for goods and
services) remains constant and no
changes are anticipated.
(v) Population, tastes, technology, etc.
are given.
Limitations of the
classical theory
• Unable to explain why trade cycles occur
• Sometimes, the market fails to bring about
y a
re
equilibrium by itself. It needs an external
h
catalyst.
0 S
0 2
• Unrealistic assumption of full employment
@ 2
• Could not recognize
h t a y
the essential role that
the government
r i g a h
can play.
y s
• o p policies have little relevance for
Ideas and
C
under developed countries.
Keynesian
theory

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Introduction
• Keynesian Economics focuses on using active
government policy to manage aggregate
demand in order to address or prevent
economic recessions. y a
h re
S
• Keynes developed his theories in response to
02
the Great Depression, and was highly critical
0
2
of classical economic arguments that natural
@
t a y
economic forces and incentives would be
h
i g a h
sufficient to help the economy recover.
r
y s
• o
Activist pfiscal and monetary policy are the
C tools recommended by Keynesian
primary
economists to manage the economy
What keynes advocated?
• The theory states that during recessions,
structural rigidities and certain characteristics
of market economies would exacerbate
y a
economic weakness and cause aggregate
h re
demand to plunge further.
0 S
0 2
• Keynes advocated a countercyclical fiscal
@ 2
h t a y
policy in which, during periods of economic

r i a h
woe, the government should
g
y s
undertake deficit spending to make up for

C op
the decline in investment and boost consumer
spending in order to stabilize aggregate
demand. 
Assumptions of keynesian
theory
•  Keynes confines his analysis to the short-
period.
y a
• He assumes that there is perfect
h re
competition in the market.
0 S
0 2
• He carries out his analysis in the closed
@ 2
economy, ignoring the effect of foreign
h t a y
trade.
i g a h
r is a macro-economic
y s
•
i.e., C
p
His analysis
o with aggregates.
it deals
analysis,
Contd..
• The government is assumed to have no part
play either as taxer or a spender, i.e., the
fiscal operations of the government is
y a
not explicitly recognised.
hre
• He assumes that labour has 0 S
money
illusion. It means that a0 2 feels better
@ 2 worker
when his wages double
h
eveny
t hishreal
a
when prices also

r i g
double, thus leaving
sa wage
unchanged.
p y
Co
Limitations of keynesian
theory
• it does not provide a comprehensive
treatment of unemployment. It deals only
with cyclical unemployment
y a
h re
• there exists no direct and determinable
0 S
relationship between effective demand
0 2
2
and volume of employment. It all depends
@
h t a y
upon the relationship between wage rate,

r i g
prices and money supply.
a h
y s
assumespperfect competition which is not a
•
C o
very realistic assumption.
Contd..
• pays no attention in the long-run problems
of the dynamic economy.
y a
• Assumes a closed economy
h re
0 S
• Not applicable in underdeveloped
countries 0 2
@ 2
h t a y
r i g a h
y s
C op
How the great
depression
was explained
by keynesian
theory.

Copyright @2020 Shreya

The great depression
• in the wake of the great financial crash of 1929, as
the economy plunged into crisis, the business cycle
went down and did not come up again by itself.
y a
•
h e
The financial crash became generalizedreconomic
S
downturn, recession became depression.
0
• 0 2
The classical economists of the day could only
repeat old nostrums which2did little to solve the
t @ a y
i gh
problem of prolonged
h
depression.
a
• y r employment,
Wages fell with s but instead of
o
generatingpadjustment and recovery, the crisis
C
deepened.
• To understand why the downturn was not
followed by growth, we can begin by looking
at the relationship between wages and
y a
re
profits, between consumption and the
h
S
availability of surplus for investment.
0
0 2
2
• Keynesianism provided an answer to the
@
h t a y
question of how to generate growth via

r i g a h
surplus despite rising wages.
y s
C op
Keynesian explanation
• Keynes rejected arguments for trying to solve
the problems of the economic crisis through a
cut in wages.
y a
h re
• He said that workers would not submit to the
0
level of wage reductions required
S
0 2
•
@
he concluded, reductions 2 in costs and
h t a y
increases in sales
r i g
had
a h
to be sought through
other means, e.g., s
labour cooperation to raise
y lower interest rates and trade
o p
productivity,
C
protection.
Keynesian solution
• he pointed a way to a solution in which both wages
and profits could rise. 

y a
• That solution required the active intervention of the
re
state to stimulate a growth in productivity and output.
h
• S
0versus surplus
If the amount of production per hour is growing,
2
0the absolute amounts of
and if the proportions of consumed
output remain constant, then
@ 2
output going to wages
h t a y
and to profits can grow
simultaneously.
r i g a h
s
ythat wages had become "sticky
p
Co and could no longer be viewed as being
•  Keynes saw
downward"
purely negative
conclusion

Copyright @2020 Shreya

• We have now come a long way from the great
depression and multiple new as well as
dynamic theories are available to better
understand the macroeconomic conditions
prevalent in our world, which are employed
by government agencies and financial
y a
re
organizations to formulate policies and
h
evaluate growth.
0 S
0 2
2
• The classical and keynesian theories,
@
h t a y
however, stay the basis to evaluate any

r i g a h
economy. A wide number of theories and
y s
models are offshoots and improvements of
op
these two landmark models.
C
References
• https://
la.utexas.edu/users/hcleaver/304L/304Lrise.h
tml
y a
• http:// h re
0 S
www.microeconomicsnotes.com/employment/
0 2
keynesian-theory-of-employment/keynesian-t
2
heory-of-employment-introduction-features-s
@
t
ummary-and-criticisms/16011
h a y
r i g a h
•
y s
http://econ.ucsb.edu/~bohn/135/NoteClassica
l.pdf
o p
C
 Thank you.
Presented by,
Shreya sahay
1RV17CS200
CSE- 6B

Copyright @2020 Shreya