Keynesian and Classical Approaches to Solving a Current Macroeconomic Problem - Essay Example

Unemployment and inflation are some of the macroeconomic problems that every government together with its economists has to solve repeatedly. There have been considerable debates over the years among economist on the best approaches to solving some of the macroeconomic issues like unemployment and inflation. The two major perspectives that will be considered in the paper will be the Keynesian and the classical models, with a focus on the Keynesian in solving macroeconomic problems.

Comparison of the models

The classical models can be traced back to David Ricardo, a British economist. The models tend to focus on the long terms and the forces that are deemed essential in the growth of an economy. According to the classical economists, supply is responsible for the creation of its own demand. The Say’s law is used to describe the phenomenon. According to that perspective, business creates income that is enough for all the output that they are responsible for producing. In other words, the balance between potential output and the natural level of employment in the course of production are not the problem in an economy (Smith, 1937). The economy possesses the ability to create such a balance. However, classical economists also acknowledge that having such a balance requires a process that would take time. Looking at the problem from a long-term perspective allows the process to unfold successfully.

The classical theory of macroeconomics was accepted worldwide until the 1929 worldwide recession. The massive and prolonged unemployment that characterized the then industrial world led to a disproval of the predictions made by the classical model. The initial stages of the depression had unemployment rate stand at about 3.2 percent in 1929. Four years later, the rate of unemployment had risen to about 25 percent, while the economic output dropped by almost the same percentage. Ten years following the depression, the rate of unemployment was still high, about 17 percent. The fact that time was unable to resolve the macroeconomic problem of unemployment led to some economist like John Keynes, a British to question the classical model predictions (Jespersen, 2011). The arguments of Keynes led to the Keynesian economist. These economists argue that the changes that exist in aggregate demand are responsible for the creation of gaps between the potential and actual output levels in an economy. The demand gaps can also be prolonged according to the Keynesian model. Fiscal and monetary policies are seen as the most important elements in closing the demand gap and bringing about balance in an economy.

Keynesian model in solving macroeconomic problems

The Keynesian system has a fundamental equation: aggregate income= aggregate expenditure. That means that people only receive money, as income, when others elsewhere spend the same amount. As such, every monetary income is a result of an act of expenditure elsewhere. Aggregate expenditure in the Keynesian system is seen as final expenditure on services and goods, consumption, or expenditure incurred in the production process, investment. The system considers the relationship between aggregate consumption and income stable. The consumption function dictates that the aggregate consumption, and by extension savings, are stable ad a function on income passively. Therefore, the level of national income determines the consumption expenditures. However, the effects on investment expenditure are independent of national income (Rothbard, 2008).For example, if consumption equals 90 percent of income, then savings equal 10 percent of income.

Therefore:

Income = passive consumption expenditure + independent expenditure (government deficit +private investment)

Applying the example above of consumption function, income would be= 90 percent of income + independent expenditure. That would mean that income equals 10 times the independent expenditures. That would further mean that a decrease in the independent expenditure would decrease the income by 10 fold. This is called the multiplier effect, and is applicable to all types of independent expenditures, whether government deficit or private investment. The savings/consumption function remains constant throughout, according to the Keynesian system, while the constancy of investment is only for the time before equilibrium is reached. It means that a volume of employment that is definite results for each level of national income. The volume of employment is directly related to the national level of income until a “full employment” state is reached. After the “full employment state: a rise in national income only translates to price rise without any employment or physical output rise (Ailenei, Mosora, & others, 2011).

Variables associated with the problem

The most distinctive variable between the Keynesian and the classical models in macroeconomics is the long-run aggregate supply (LRAS).

The LRAS according to the classical model is inelastic. As shown below in the graph:

The implication for the view is that supply side factors like labor productivity, capital level, and investment level determine the Real GDP. The classical economist argues that increasing aggregate demand in the long term only leads to inflation. On the other hand, the Keynesian view on LRAS suggests that an economy could be below the optimal capacity in the long term. The implication is that Keynesians place emphasis on the aggregate demand in dealing with or causing a recession. The graph below illustrates it (Friedman, 2009).

The difference in the shapes of the two graphs above lead to a difference in causes that each model suggests leads to unemployment. The classical economists blame supply side factors for unemployment. Classical economists downplay Unemployment due to demand deficit. On the other hand, Keynesian economists see demand deficit as the key to employment. Low aggregate demand growth together with economic growth that is insufficient is seen as the cause of unemployment. Another variable regards the Philips curves below.

Classical economist argues that decreasing the aggregate demand only serves to reduce unemployment in the short term, as the long term bring wage adjustment leading to a restoration of unemployment returning to its natural rate. As such, tradeoffs do not occur in the long-term, according to the classical model. On the other hand, a trade-off occurs between inflation and unemployment according to the Keynesian economists (Hein, Truger, & van Treeck, 2012).

Finally, the two models differ in terms of perception on wages and prices flexibility. The Classical model assumes that wages and prices are flexible in the long term. Aggregate demand fall, for example, would lead to a fall in wages from W1 to W2 as shown in the graph below.

The wages decline would then ensure that full employment remains in the market. On the other hand, Keynesians assert that wages are normally inflexible in the real world, as workers resist the wage cuts. For example, a fall in aggregate demand would lead to workers union resisting pay cuts, leading to inflexible wages, at W1, and higher unemployment as a result (Jespersen, 2011).

Alternative solutions that reflect Keynesian as opposed to classical economic theory

The Keynesian model advocates for more government involvement and spending as a means to intervene in a recession. Government spending deals with the rigidity of prices in causing output fluctuation. The spending is seen as a way to offset the investment fall by the private sector. Keynesian economists advocate for more fiscal policies in offsetting recession by the government. The fiscal policies aid in increasing the economic growth rate together with increasing the aggregate demand. The Keynesians also advocate for government borrowing as a necessity in increasing the aggregate demand that affects the rate of unemployment (Smith, 1937).

Evaluate impact of each suggested action

Government spending: if all other types of spending remain constant as government sending increases, Keynesians believe that there will be an increase in output. The implication is that any government spending causes an increase in output, as long as the multiplier is more than zero, which increases the aggregate demand for labor hence dealing with unemployment. Unfortunately, the government spending cannot be used to fine-tune the rate of unemployment as the lag between the times the macroeconomic problem is discovered and when the actions are taken might be too long to cause any real impact (Chair of the Council of Economic Advisers, 2016).

Fiscal policies: if the government uses fiscal policies to increase both aggregate demand and economic growth rate, the implications arising will include an increase in spending by the government and reduction in taxation. Lower taxation increases the level of disposable income that allows for a higher aggregate demand. However, other factors like a high confidence and the longevity of the policy determine the reaction of the market. For example, if the policies will be reversed soon, people would prefer to save than spend.

Government borrowing: higher government borrowing pushes the bonds interest rates reducing the quantity of private sector investment. A rise in government borrowing causes a decrease in private debt and savings, leading to more money for the government to spend. However, there is a possibility of crowding out, if the rate of borrowing is so high in the short run.

Recommended actions

The application of counter-cyclical demand management on the Keynesian model would increase the aggregate demand in the economy. Such a management system would foster more government spending to increase the rate of growth motivating the private sector to invest further. It would complement the private sector investment increasing aggregate demand and lowing unemployment (Chair of the Council of Economic Advisers, 2016).

The government can also implement counter-inflation policy while spending and borrowing can be a reserve of a certain time in the cycle of the economy, the Philips curve suggests that the government has an option of making a tradeoff between inflation and unemployment in its expenditure and borrowing patterns. It should prioritize unemployment in the trade off.

Assess the effects of the actions on national and global economy and conclusion

The above actions are mostly government related. According to Milton Friedman in Capitalism and Freedom, real exchange if ideas hardly exist especially when the means of production are regulated by the government. The involvement of the government has a likelihood of reducing the level of economic freedom, where free market forces provide a mutually beneficial ground for parties involved. The ability and control of the government of money and the fiscal policies, although necessary in maintaining order and regulating certain conditions like inflation, might limit the private sectors’ ability to contribute to economic growth.