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Economics - Classical and Keynesian Theories Output, Employment

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Study GuideEconomics–Classical and Keynesian Theories: Output,Employment1. The Classical Theory1.1Basic Idea of the Classical TheoryTheclassical theoryis built on one main idea:The economy is self-regulating.Classical economists believed that the economy naturally moves toward itsnatural level of realGDP.This natural level meansfull employment, where all available workers and resources are being usedefficiently.Sometimes the economy may producemore or lessthan this natural level.However, classical economists believed thatmarket forces automatically correct these problemsand bring the economy back to normal—without government help.This belief is based ontwo key ideas:1.Say’s Law2.Flexible prices, wages, and interest rates1.2Say’s Law: “Supply Creates Its Own Demand”According toSay’s Law, when goods and services are produced,enough income is created to buythem.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 supplyBecause of this, classical economists believed the economy can always reach thenatural level ofreal GDP.

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Study Guide1.3The Problem of Saving (And Why It’s Not a Problem)In real life, people donot spend all their income.Some income issaved, 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 levelAt first, this looks like a weakness in Say’s Law.Classical Answer to the Saving ProblemClassical economists argued:•Savings do not disappear•Savings areborrowed by investors•Investment spending increases production and incomeSo, saving doesnot reduce real GDPin the long run.1.4When Saving Is Greater Than InvestmentIf people savemore than firms want to invest, real GDP may temporarily fall below its natural level.This situation is explained using theloanable funds (money market) diagram.

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Study GuideExplanation of the Diagram•S (Saving curve)slopes upwardoHigher interest rate → more saving•I (Investment curve)slopes downwardoHigher interest rate → less investmentInitially:•Saving = Investment at interest rateiIf saving increases:•Saving curve shifts right toS′•At interest ratei, saving > investment•Agapappears•Real GDP falls below its natural level

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Study Guide1.5Role of Flexible Interest RatesClassical economists believed thatinterest rates are flexible.What happens next?•Excess saving pushesinterest rates down•Lower interest rates encourage more investment•Investment rises until it equals saving againAt the new interest ratei′:•Saving = Investment•Real GDP returns to itsnatural levelThis flexibility keeps themoney market in balanceand prevents long-term unemployment.1.6Flexible Wages and Full EmploymentJust like interest rates,wages are also flexible.If there are too many workers:•Wages fall•Firms hire more workers•Full employment is restoredClassical economists believed that:•Any unemployment isvoluntary•Workers are unemployed because theyrefuse lower wages
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Document Details

University
Texas A&M University
Course
Economics
Subject
Economics

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