Understanding Macroeconomic Theories: Classical vs. Keynesian Economics
Classical vs. Keynesian Economics
Core Principles
Classical Economics
Classical economists believe in flexible prices and that the price level adjusts to shifts in aggregate demand. They argue that government interventions have no effect on aggregate output.
Keynesian Economics
Keynesian economists believe in rigid, downward-sloping prices, leading to a flat aggregate supply curve. They argue that classical economics holds in the long run, but in the short run, the price level doesn’t adjust effectively.
Keynesian Concepts
Keynesian Cross
The Keynesian cross model equates aggregate demand (aggregate expenditure) with aggregate output (aggregate income). It shows how changes in consumption, investment, government spending, net exports, and autonomous consumption impact output.
Multiplier Effect
The multiplier effect suggests that an initial increase in government spending can lead to a larger increase in overall economic activity due to the ripple effect of increased spending.
Fiscal Policy
Keynesians advocate for using fiscal policy (government spending and taxes) to stabilize the economy. During recessions, they recommend expansionary fiscal policy (increased government spending and tax cuts) to stimulate demand and create jobs.
IS-LM Model
The IS-LM model illustrates the interaction between the goods market (IS curve) and the money market (LM curve) to determine equilibrium interest rates and output levels.
IS Curve
The IS curve shows the combinations of interest rates and output levels where the goods market is in equilibrium. It slopes downward because lower interest rates encourage borrowing and spending, leading to higher GDP.
LM Curve
The LM curve shows the relationship between interest rates and output levels where the money market is in equilibrium. It slopes upward because higher income levels lead to increased money demand, resulting in higher interest rates.
Liquidity Trap
A liquidity trap occurs when the LM curve is flat, rendering monetary policy ineffective. This is often due to very low interest rates and a flat money demand curve.
Exchange Rates and International Trade
Floating vs. Fixed Exchange Rates
Floating exchange rates allow for independent monetary policy but can lead to volatility. Fixed exchange rates provide stability but limit monetary policy flexibility.
Mundell-Fleming Model
The Mundell-Fleming model analyzes open economies with international trade by incorporating the balance of payments. It shows how policies in one country can impact other countries, particularly under fixed exchange rates.
Impossible Trinity
The impossible trinity states that a country cannot simultaneously have free capital flows, fixed exchange rates, and an independent monetary policy. It must choose two out of the three.
Critique of Keynesianism
Critics argue that Keynesian economics can lead to excessive government deficits and debt if fiscal stimulus is not used judiciously.