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Economics - Classical and Keynesian Theories Output, Employment

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    Study Guide Economics – Classical and Keynesian Theories: Output, Employment 1. The Classical Theory 1.1 Basic Idea of the Classical Theory The classical theory is built on one main idea: The economy is self - regulating. Classical economists believed that the economy naturally moves toward its natural level of real GDP . This natural level means full employment , where all available workers and resources are being used efficiently. Sometimes the economy may produce more or less than this natural level. However, classical economists believed that market forces automatically correct these problems and bring the economy back to normal — without government help. This belief is based on two key ideas : 1. Say’s Law 2. Flexible prices, wages, and interest rates 1.2 Say’s Law: “Supply Creates Its Own Demand” According to Say’s Law , when goods and services are produced, enough income is created to buy them . In simple words: • Producing output = paying wages, rent, interest, and profits • This income is then spent to buy the output • So, total demand equals total supply Because of this, classical economists believed the economy can always reach the natural level of real GDP .

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    Study Guide 1.3 The Problem of Saving (And Why It’s Not a Problem) In real life, people do not spend all their income . Some income is saved , not spent on goods and services. This can cause a problem: • Less spending → lower demand • Firms reduce production • Employment falls • Real GDP drops below its natural level At first, this looks like a weakness in Say’s Law. Classical Answer to the Saving Problem Classical economists argued: • Savings do not disappear • Savings are borrowed by investors • Investment spending increases production and income So, saving does not reduce real GDP in the long run. 1.4 When Saving Is Greater Than Investment If people save more than firms want to invest , real GDP may temporarily fall below its natural level. This situation is explained using the loanable funds (money market) diagram .

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    Study Guide Explanation of the Diagram • S (Saving curve) slopes upward o Higher interest rate → more saving • I (Investment curve) slopes downward o Higher interest rate → less investment Initially: • Saving = Investment at interest rate i If saving increases: • Saving curve shifts right to S′ • At interest rate i , saving > investment • A gap appears • Real GDP falls below its natural level

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    Study Guide 1.5 Role of Flexible Interest Rates Classical economists believed that interest rates are flexible . What happens next? • Excess saving pushes interest rates down • Lower interest rates encourage more investment • Investment rises until it equals saving again At the new interest rate i′ : • Saving = Investment • Real GDP returns to its natural level This flexibility keeps the money market in balance and prevents long - term unemployment. 1.6 Flexible Wages and Full Employment Just like interest rates, wages are also flexible . If there are too many workers: • Wages fall • Firms hire more workers • Full employment is restored Classical economists believed that: • Any unemployment is voluntary • Workers are unemployed because they refuse lower wages

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