ROLE OF GOVERNMENT - Assignment Example

Treatment of recessionary gap in new classical approach: According to the new Classical approach, economists focus on the unemployment situation, which affects the economy owing to the continuous decline in the real output of the economy. In a recessionary gap situation, supply of resources in the labor market tends to increase substantially. Consequently, the wage rate declines to maintain the equilibrium position of the economy’s resources. Hence, this result in lowering wages and prices with a shift in short run Aggregate Supply (AS) curve causing recessionary gap.

Accordingly, the new classical theory suggests that the economy is self-regulatory, and can achieve equilibrium i.e. stability, full employment without government interference and can eliminate the gap in a “self-corrective mechanism” (Pearson Education, “Keynes and the Classical Economists: The Early Debate on Policy Activism”). Exhibit 1: Recessionary Gap AS movements as per the new classical theory (Jain, Jain, Ohri, Majhi and Ohri 193) Treatment of recessionary gap in Keynesian approach: In contrast to the new classical theory, the Keynesian theory asserts that recessionary gap is the shift in Aggregate Demand (AD) due to low spending in an economy.

Economists following the Keynesian approach suggest that the gap can be eliminated by spending more, that is by increase flow of money and capital resources within the economy, which will move the AD curve upwards (Pearson Education, “Keynes and the Classical Economists: The Early Debate on Policy Activism.”). Exhibit 2: Recessionary Gap AS movements as per the new classical theory (Jain, Jain, Ohri, Majhi and Ohri 193) The main difference between the new classical and the Keynesian theory persist in respect to their assumptions, which are directly associated with the AS-AD curve movements.

As can be observed from the above discussion, the new classical theory assumes that with the increase in the unemployment rate, which indicates a fall in the demand for labors in the economy, the wage will also shrink, causing the AS curve shift downwards. However, because the economy is assumed to function in a “self-corrective manner”, it is likely that the fall in the wage rate will increase the demand for the labors and thus fortify the situation to the equilibrium position. Contradictorily, the Keynesian economists shall assume that in a recessional gap situation, if the demand for employment falls, it shall have no effect on the price and also on the supply (in the short run).

It is under such circumstance that the government needs to intervene and increase demand for the resource to the equilibrium position (Baumol and Blinder 206-208). QUESTION 2 Two events supporting Classical theory: In the modern era, many economies practice the classical theory of microeconomics. Among these, China has been a significant illustration. China operates with minimum government intervention for better economic stability. For example, at the time of World War 2, China had to witness a steep fall in its employment rate, which had resulted in the downward shift of the wage rate and the AS curve.

The reason was likewise assumed to be the failure of the economic drivers to use the resources efficiently, as per the classical the