I.

assumptions

The new classical macroeconomics is based on three assumptions

(1) Markets Continuously Clear

(2) Rational Expectations

(3) Aggregate Supply Hypothesis

1. Markets Continuously Clear:

The new classical economists assume that all markets continuously clear in the
economy. The economy is in a state of continuous equilibrium both in the short-run
and long-run where all markets clear.
The new classical assume that markets clear instantaneously and there is no
disequilibrium even in the short run. Since price and wage adjustments are almost
instantaneous, all unemployment is equilibrium unemployment.

the new classical labour market equilibrium. Where SSL is the labour supply curve

which is vertical (or inelastic) at ONT labour force when wage rates are above the

competitive level. DDL is the labour demand curve. ONT is the total labour force in

the economy.

2. Rational Expectations:
One of the most important principles of the new classical macroeconomics is the
rational expectations hypothesis.

The new classical economists use Ratex to explain the Phillips curve in the inflation

theory. According to them, rational expectations are not based on past rates of

inflation but on the current state of the economy and policies being followed by the

government.
 The new classical short-run vertical Phillips curve PC at the natural unemployment

rate UN. If people under predict the rate of inflation (expected inflation rate is less

than the actual rate), they will believe that aggregate demand has increased.

 The new classical economists also explain the downward sloping short-run Phillips

curve. Such a curve arises when people are not able to correctly predict about real

wages. The new classical Phillips curve is vertical at the natural rate of

unemployment

3. Aggregate Supply Hypothesis:

The new classical macroeconomics incorporates the Lucas aggregate supply

hypothesis based on two assumptions:

 Rational decisions taken by workers and firms reflect their optimising
behaviour, and
 The supply of labour by workers and output by firms depend upon relative
prices. Thus the aggregate supply hypothesis is derived from optimising
behaviour of workers and firms about supply of labour and goods which depend
on relative prices only. We first study the labour market and then the goods
market to explain the aggregate supply hypothesis.

The new Keynesian school assumptions

 Keynes confines his analysis to the short-period.

 He assumes that there is perfect competition in the market.
  He carries out his analysis in the closed economy, ignoring the effect of foreign
trade.
 His analysis is a macro-economic analysis, i.e., it deals with aggregates.
 He assumes the operation of the law of diminishing returns or increasing costs.
 The government is assumed to have no part play either as taxer or a spender, i.e.,
the fiscal operations of the government is not explicitly recognised.
 He assumes that labour has money illusion. It means that a worker feels better
when his wages double even when prices also double, thus leaving his real wage
unchanged.

II. Regarding to their models

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

 Classical view of Long Run Aggregate Supply

The Classical view is that Long Run Aggregate Supply (LRAS) is inelastic. This has
important implications. The classical view suggests that real GDP is determined by supply-
side factors – the level of investment, the level of capital and the productivity of labour e.t.c.
Classical economists suggest that in the long-term, an increase in aggregate demand (faster
than growth in LRAS), will just cause inflation and will not increase real GDP>

 Keynesian view of Long Run Aggregate Supply

The Keynesian view of long-run aggregate supply is different. They argue that the economy
can be below full capacity in the long term. Keynesians argue output can be below full
capacity for various reasons:

 Wages are sticky downwards (labour markets don’t clear)

 Negative multiplier effect. Once there is a fall in aggregate demand, this causes
others to have less income and reduce their spending creating a negative knock-on
effect.
 A paradox of thrift. In a recession, people lose confidence and therefore save more.
By spending less this causes a further fall in demand.
Keynesians argue greater emphasis on the role of aggregate demand in causing and
overcoming a recession.

2. Demand deficient unemployment

Because of the different opinions about the shape of the aggregate supply and the role of
aggregate demand in influencing economic growth, there are different views about the
cause of unemployment

 Classical economists argue that unemployment is caused by supply side factors –

real wage unemployment, frictional unemployment and structural factors. They
downplay the role of demand deficient unemployment.
 Keynesians place a greater emphasis on demand deficient unemployment. For
example the current situation in Europe (2014), a Keynesian would say that this
unemployment is partly due to insufficient economic growth and low growth of
aggregate demand (AD)
3. Phillips Curve trade-off
A classical view would reject the long-run trade-off between unemployment, suggested by
the Phillips Curve.
  Classical economists say that in the short term, you might be able to reduce
unemployment below the natural rate by increasing AD. But, in the long-term, when
wages adjust, unemployment will return to the natural rate, and there will be higher
inflation. Therefore, there is no trade-off in the long-run.
 Keynesians support the idea that there can be a trade-off between unemployment
and inflation.

In a recession, increasing AD will lead to a fall in unemployment, though it may be at the

cost of higher inflation rate.

4. Flexibility of prices and wages

 In the classical model, there is an assumption that prices and wages are flexible, and
in the long-term markets will be efficient and clear. For example, suppose there was
a fall in aggregate demand, in the classical model this fall in demand for labour
would cause a fall in wages. This decline in wages would ensure that full
employment was maintained and markets ‘clear’.
A fall in demand for labour would cause wages to fall from W1 to We

 However, Keynesians argue that in the real world, wages are often inflexible. In
particular, wages are ‘sticky downwards’. Workers resist nominal wage cuts. For
example, if there were a fall in demand for labour, trade unions would reject
nominal wage cuts; therefore, in the Keynesian model, it is easier for labour markets
to have disequilibrium.Wages would stay at W1, and unemployment would result.

A Keynesian would argue in this situation the best solution is to increase aggregate
demand. In a recession, if the government did force lower wages, this might be counter-
productive because lower wages would lead to lower spending and a further fall in
aggregate demand.

5. Rationality and confidence

Another difference behind the theories is different beliefs about the rationality of people.

 Classical economics assumes that people are rational and not subject to large swings
in confidence.
 Keynesian economics suggests that in difficult times, the confidence of businessmen
and consumers can collapse – causing a much larger fall in demand and investment.
This fall in confidence can cause a rapid rise in saving and fall in investment, and it
can last a long time – without some change in policy.
III. Difference in policy recommendations

1. Government spending
 The classical model is often termed ‘laissez-faire’ because there is little need for the
government to intervene in managing the economy.
 The Keynesian model makes a case for greater levels of government intervention,
especially in a recession when there is a need for government spending to offset the
fall in private sector investment. (Keynesian economics is a justification for the ‘New
Deal’ programmers of the 1930s.)
2. Fiscal Policy
 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. (This is an argument to reject austerity policies of the 2008-13 recession.
3. Government borrowing
 A classical view will stress the importance of reducing government borrowing and
balancing the budget because there is no benefit from higher government spending.
Lower taxes will increase economic efficiency. (e.g. at the start of the 1930s, the
‘Treasury View‘ argued the UK needed to balance its budget by cutting
unemployment benefits.
 The Keynesian view suggests that government borrowing may be necessary because
it helps to increase overall aggregate demand.
4. Supply side policies
 The classical view suggests the most important thing is enabling the free market to
operate. This may involve reducing the power of trade unions to prevent wage
inflexibility. Classical economics is the parent of ‘supply side economics‘ – which
emphasises the role of supply-side policies in promoting long-term economic
growth.
 Keynesian don’t reject supply side policies. They just say they may not always be
enough. e.g. in a deep recession, supply side policies can’t deal with the fundamental
problem of a lack of demand.

Explanation:

a. gross domestic product

The GDP is $400 which is the money that Barry collects for haircut.

b. net national product

Net National Product:

= GDP – Depriciation

= $400 - $50
= $350

c. national income

The national income is the total income that the residents of the country earns and this will
be same as Net National Product which is $350

d. personal income

Personal income:

= National income – Retained earnings

= $350 - $100 - $30

= $220

e. disposable personal income

Disposable personal income:

= Personal income – Personal tax

= $220 - $70

= $150

Summary
 Classical economics emphasises the fact that free markets lead to an efficient
outcome and are self-regulating.
 In macroeconomics, classical economics assumes the long run aggregate supply
curve is inelastic; therefore any deviation from full employment will only be
temporary.
 The Classical model stresses the importance of limiting government intervention
and striving to keep markets free of potential barriers to their efficient operation.
 Keynesians argue that the economy can be below full capacity for a considerable
time due to imperfect markets.
 Keynesians place a greater role for expansionary fiscal policy (government
intervention) to overcome recession.