Difference Between Classical And Keynesian Economics Pdf


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Keynesian economics Classical follow the basic assumption that 1. Difference between Classical and Keynesian economics Keynesian follow the basic assumptions that 1. The economists who generally oppose government intervention in the functioning of aggregate economy are named as classical economists.

Differences Between Classical & Keynesian Economics

New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics. Two main assumptions define the New Keynesian approach to macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis usually assumes that households and firms have rational expectations.

However, the two schools differ in that New Keynesian analysis usually assumes a variety of market failures. In particular, New Keynesians assume that there is imperfect competition [1] in price and wage setting to help explain why prices and wages can become " sticky ", which means they do not adjust instantaneously to changes in economic conditions. Wage and price stickiness, and the other market failures present in New Keynesian models , imply that the economy may fail to attain full employment.

Therefore, New Keynesians argue that macroeconomic stabilization by the government using fiscal policy and the central bank using monetary policy can lead to a more efficient macroeconomic outcome than a laissez faire policy would. New Keynesianism became a part of the new neoclassical synthesis , which incorporated parts of both it and new classical macroeconomics and forms the theoretical basis of much of mainstream economics today.

The first wave of New Keynesian economics developed in the late s. Suppose that there are two unions in the economy, who take turns to choose wages.

When it is a union's turn, it chooses the wages it will set for the next two periods. This contrasts with John B. Taylor 's model where the nominal wage is constant over the contract life, as was subsequently developed in his two articles, one in "Staggered wage setting in a macro model'.

The Taylor model had sticky nominal wages in addition to the sticky information: nominal wages had to be constant over the length of the contract two periods. These early new Keynesian theories were based on the basic idea that, given fixed nominal wages, a monetary authority central bank can control the employment rate.

Since wages are fixed at a nominal rate, the monetary authority can control the real wage wage values adjusted for inflation by changing the money supply and thus affect the employment rate. In the s the key concept of using menu costs in a framework of imperfect competition to explain price stickiness was developed. George Akerlof and Janet Yellen put forward the idea that due to bounded rationality firms will not want to change their price unless the benefit is more than a small amount.

Gregory Mankiw took the menu-cost idea and focused on the welfare effects of changes in output resulting from sticky prices.

While some studies suggested that menu costs are too small to have much of an aggregate impact, Laurence Ball and David Romer showed in that real rigidities could interact with nominal rigidities to create significant disequilibrium.

For example, a firm can face real rigidities if it has market power or if its costs for inputs and wages are locked-in by a contract. The expense created by real rigidities combined with the menu cost of changing prices makes it less likely that firm will cut prices to a market clearing level.

Even if prices are perfectly flexible, imperfect competition can affect the influence of fiscal policy in terms of the multiplier. Huw Dixon and Gregory Mankiw developed independently simple general equilibrium models showing that the fiscal multiplier could be increasing with the degree of imperfect competition in the output market.

When government spending is increased, the corresponding increase in lump-sum taxation causes both leisure and consumption to decrease assuming that they are both a normal good.

The greater the degree of imperfect competition in the output market, the lower the real wage and hence the more the reduction falls on leisure i. Hence the fiscal multiplier is less than one, but increasing in the degree of imperfect competition in the output market. The Calvo model has become the most common way to model nominal rigidity in new Keynesian models. There is a probability that the firm can reset its price in any one period h the hazard rate , or equivalently the probability 1-h that the price will remain unchanged in that period the survival rate.

The probability h is sometimes called the "Calvo probability" in this context. In the Calvo model the crucial feature is that the price-setter does not know how long the nominal price will remain in place, in contrast to the Taylor model where the length of contract is known ex ante.

Coordination failure was another important new Keynesian concept developed as another potential explanation for recessions and unemployment. In such a scenario, economic downturns appear to be the result of coordination failure: The invisible hand fails to coordinate the usual, optimal, flow of production and consumption. The increase in possible trading partners increases the likelihood of a given producer finding someone to trade with.

As in other cases of coordination failure, Diamond's model has multiple equilibria, and the welfare of one agent is dependent on the decisions of others. If a firm anticipates a fall in demand, they might cut back on hiring. A lack of job vacancies might worry workers who then cut back on their consumption. This fall in demand meets the firm's expectations, but it is entirely due to the firm's own actions. New Keynesians offered explanations for the failure of the labor market to clear.

In a Walrasian market, unemployed workers bid down wages until the demand for workers meets the supply. In efficiency wage models, workers are paid at levels that maximize productivity instead of clearing the market.

Shirking models were particularly influential. Since each firm pays more than market clearing wages, the aggregated labor market fails to clear. This creates a pool of unemployed laborers and adds to the expense of getting fired. Workers not only risk a lower wage, they risk being stuck in the pool of unemployed.

Keeping wages above market clearing levels creates a serious disincentive to shirk that makes workers more efficient even though it leaves some willing workers unemployed. In the early s, economists began to combine the elements of new Keynesian economics developed in the s and earlier with Real Business Cycle Theory.

RBC models were dynamic but assumed perfect competition; new Keynesian models were primarily static but based on imperfect competition. The New neoclassical synthesis essentially combined the dynamic aspects of RBC with imperfect competition and nominal rigidities of new Keynesian models.

Tack Yun was one of the first to do this, in a model that used the Calvo pricing model. Inflation has negative welfare effects. It is important for central banks to maintain credibility through rules based policy like inflation targeting. In , [46] John B Taylor formulated the idea of a Taylor rule , which is a reduced form approximation of the responsiveness of the nominal interest rate , as set by the central bank , to changes in inflation , output , or other economic conditions.

In particular, the rule describes how, for each one-percent increase in inflation, the central bank tends raise the nominal interest rate by more than one percentage point. This aspect of the rule is often called the Taylor principle. Although such rules provide concise, descriptive proxies for central bank policy, they are not, in practice, explicitly proscriptively considered by central banks when setting nominal rates.

Taylor's original version of the rule describes how the nominal interest rate responds to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product GDP from potential GDP:. The curve is derived from the dynamic Calvo model of pricing and in mathematical terms is:.

The ideas developed in the s were put together to develop the new Keynesian Dynamic stochastic general equilibrium used to analyze monetary policy.

These three equations formed a relatively simple model which could be used for the theoretical analysis of policy issues. However, the model was oversimplified in some respects for example, there is no capital or investment. Also, it does not perform well empirically. Whilst the models of the s focused on sticky prices in the output market, in Christopher Erceg, Dale Henderson and Andrew Levin adopted the Blanchard and Kiyotaki model of unionized labor markets by combining it with the Calvo pricing approach and introduced it into a new Keynesian DSGE model.

In order to have models that worked well with the data and could be used for policy simulations, quite complicated new Keynesian models were developed with several features. Mankiw and Reis found that the model of sticky information provided a good way of explaining inflation persistence. Sticky information models do not have nominal rigidity: firms or unions are free to choose different prices or wages for each period.

It is the information that is sticky, not the prices. Thus when a firm gets lucky and can re-plan its current and future prices, it will choose a trajectory of what it believes will be the optimal prices now and in the future. In general, this will involve setting a different price every period covered by the plan.

This is at odds with the empirical evidence on prices. These studies all show that whilst there are some sectors where prices change frequently, there are also other sectors where prices remain fixed over time.

The lack of sticky prices in the sticky information model is inconsistent with the behavior of prices in most of the economy. This has led to attempts to formulate a "dual stickiness" model that combines sticky information with sticky prices. In addition to sticky prices, a typical HANK model features uninsurable idiosyncratic labor income risk which gives rise to a non-degenerate wealth distribution.

The name "HANK model" was coined by Greg Kaplan , Benjamin Moll and Gianluca Violante in a [65] paper that additionally models households as accumulating two types of assets, one liquid the other illiquid. This translates into rich heterogeneity in portfolio composition across households.

Consistent with empirical evidence, [66] about two-thirds of these households hold non-trivial amounts of illiquid wealth, despite holding little liquid wealth. These households are known as wealthy hand-to-mouth households, a term introduced in a study of fiscal stimulus policies by Kaplan and Violante.

The existence of wealthy hand-to-mouth households in New Keynesian models matters for the effects of monetary policy, because the consumption behavior of those households is strongly sensitive to changes in disposable income, rather than variations in the interest rate i.

The direct corollary is that monetary policy is mostly transmitted via general equilibrium effects that work through the household labor income, rather than through intertemporal substitution, which is the main transmission channel in Representative Agent New Keynesian RANK models. There are two main implications for monetary policy. First, monetary policy interacts strongly with fiscal policy, because of the failure of Ricardian Equivalence due to the presence of hand-to-mouth households.

Second, aggregate monetary shocks are not distributional neutral since they affect the return on capital, which affects households with different levels of wealth and assets differently. New Keynesian economists agree with New Classical economists that in the long run, the classical dichotomy holds: changes in the money supply are neutral.

However, because prices are sticky in the New Keynesian model, an increase in the money supply or equivalently, a decrease in the interest rate does increase output and lower unemployment in the short run. Furthermore, some New Keynesian models confirm the non-neutrality of money under several conditions. Nonetheless, New Keynesian economists do not advocate using expansive monetary policy for short run gains in output and employment, as it would raise inflationary expectations and thus store up problems for the future.

Instead, they advocate using monetary policy for stabilization. That is, suddenly increasing the money supply just to produce a temporary economic boom is not recommended as eliminating the increased inflationary expectations will be impossible without producing a recession. However, when the economy is hit by some unexpected external shock, it may be a good idea to offset the macroeconomic effects of the shock with monetary policy.

This is especially true if the unexpected shock is one like a fall in consumer confidence which tends to lower both output and inflation; in that case, expanding the money supply lowering interest rates helps by increasing output while stabilizing inflation and inflationary expectations. Studies of optimal monetary policy in New Keynesian DSGE models have focused on interest rate rules especially ' Taylor rules ' , specifying how the central bank should adjust the nominal interest rate in response to changes in inflation and output.

More precisely, optimal rules usually react to changes in the output gap , rather than changes in output per se. In some simple New Keynesian DSGE models, it turns out that stabilizing inflation suffices, because maintaining perfectly stable inflation also stabilizes output and employment to the maximum degree desirable.

However, they also show that in models with more than one market imperfection for example, frictions in adjusting the employment level, as well as sticky prices , there is no longer a 'divine coincidence', and instead there is a tradeoff between stabilizing inflation and stabilizing employment. Recently [ when? At any other desired target for the inflation rate, there is an endogenous trade-off, even under the absence real imperfections such as sticky wages, and the divine coincidence no longer holds.

Over the years, a sequence of 'new' macroeconomic theories related to or opposed to Keynesianism have been influential.

New Keynesian economics

Some of the main differences between new classical and new Keynesian macroeconomics are as follows:. New classical economists argued that Keynesian economics was theoretically inadequate because it was not based on microeconomic foundations. According to them, macroeconomic models should be based on firm microeconomic foundations. New Keynesians agree on this but they differ how markets work. New classical economists base their models on perfectly competitive consumer, producer and labour markets.

Edgar O. Introduction, Keynes's treatment of labor supply, Sketches of classical and Keynesian employment theories, A graphical formulation of aggregate demand and supply, ; the aggregate supply curve, ; the aggregate demand curve, ; the aggregate diagram, The classical theory amended, The Keynesian diagram amended,


Classical Theory believes that full-employment is the employment level the economy will return to, and tends to remain at in the long run. Graphically, the pure.


Keynesian Economics

K eynesian economics is a theory of total spending in the economy called aggregate demand and its effects on output and inflation. Although the term has been used and abused to describe many things over the years, six principal tenets seem central to Keynesianism. The first three describe how the economy works. A Keynesian believes that aggregate demand is influenced by a host of economic decisions—both public and private—and sometimes behaves erratically.

Keynesian Economics Vs. Classical Economics: Similarities And Differences

Keynesian economics is an economic theory developed during the great depression.

Keynesian and Monetarist Economics: How Do They Differ?

New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics. Two main assumptions define the New Keynesian approach to macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis usually assumes that households and firms have rational expectations.

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The following points highlight the six main points of differences between Classical and Keynes Theory. The differences are: 1. Assumption of Full Employment 2.


Further Reading

Keynesian economic theory comes from British economist John Maynard Keynes, and arose from his analysis of the Great Depression in the s. The differences between Keynesian theory and classical economy theory affect government policies, among other things. One side believes government should play an active role in controlling the economy, while the other school thinks the economy is better left alone to regulate itself. The implications of both also have consequences for small business owners when trying to make strategic decisions to develop their companies. Keynesian advocates believe capitalism is a good system, but that it sometimes needs help. When times are good, people work, earn money and spend it on things they want.

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5 Comments

Lutero C.
14.05.2021 at 05:03 - Reply

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Aqoljepan
15.05.2021 at 21:37 - Reply

A distinction between the Keynesian and classical view of macroeconomics can be illustrated looking at the long run aggregate supply LRAS.

Jesse L.
18.05.2021 at 00:03 - Reply

Classical economists do not like government spending, and they especially detest more government debt. Keynesians are okay with government borrowing, because they are convinced that government spending increases aggregate demand in the economy.

Norman S.
20.05.2021 at 23:31 - Reply

Real business cycle theory explains the business cycle via the classical model. An exogenous change in the economic fundamentals changes the general.

Heather B.
22.05.2021 at 08:12 - Reply

Classical economics places little emphasis on the use of fiscal policy to manage aggregate demand. Classical theory is the basis for Monetarism, which only concentrates on managing the money supply, through monetary policy. Keynesian economics suggests governments need to use fiscal policy, especially in a recession.

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