The Classical View: S W Demand Shock

Introduction to Economics –ECO401 VU
Lesson 26
INTRODUCTION TO MACROECONOMICS (CONTINUED)
DIFFERENCES BETWEEN CLASSICAL AND KEYNESIAN ECONOMICS

We can see the major differences between classical and Keynesian economics in three ways:
1. Labor market
2. Market for loanable funds
3. Aggregate demand and supply
1- (A) LABOR MARKET: THE CLASSICAL VIEW

If there is excess supply of labor in the labor market, then market mechanism will cause the
price of labor (wages) to fall and labor demand is increased by the firms and clears the market.
Demand The Classical

W View
Shock
SL
W*
W’
D L* Full
Employment
D L’ Level
L’ L* L
A negative demand shock decreases the labor demand and shifts the labor demand curve
downward. If market mechanism works freely then wages would fall to W’ and demand for
labor will rise and shifts back again to DL*, and equilibrium is reestablished again at full
employment level. But classical economists face the problem that wages do not fall in
accordance with the labor demand. The reason why the wage rate do not fall much is that
wages are sticky downwards. Wages get stuck to a level and do not fall below certain level.
(B) LABOR MARKET: THE KEYNESIAN VIEW

Keynes said once there is an excess supply of labor in the labor market and there is the
pressure of wage rate to fall then firms look at the pressure of wage rate falling in a negative
way. They think people are becoming poorer due to lower wages and they will not buy our
products. So firms have no incentives to invest in the production of new goods.
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The Keynesian
W View
SL
W’’
DL
DL’
DL’’
L’’ L L
If demand for labor falls to DL’, then this would require wage rate to fall but once the wages fall
then what would be the impact of this on the firms? Wages of consumers are used as the
consumer spending. So when firms saw that people are becoming poorer they will have less
incentive to produce more goods. So, investment falls and demand for labor also falls and
further shifts downward to DL’’. Wages would also decrease further. This will continue and
increase unemployment. This is how Keynes explains the reasons of high unemployment in
the period of great depression.
In summary, Keynes believed that an economy could settle at equilibrium below the full
employment level, he advocated demand-side policies to lift the economy out of that
equilibrium towards full employment. He suggested the government spend itself and
encourage consumption spending. This would cause demand and prices of goods to rise,
generating firms’ interest in producing more. This would in turn require hiring to go up, which
would cause labour incomes to go up which would lead to further higher demand for goods
and hence a reinforcement of the virtuous circle. Only such a circle could, according to
Keynes, change agents’ pessimistic view of the future and take the economy out of
Depression.
2- (A) MARKET FOR LOANABLE FUNDS: THE CLASSICAL VIEW

This is the market of money. Depositors provide the supply of loanable funds and
business/firms borrow the money generating the demand for loanable funds.
The market for loanable funds

Interest
rate
Supply = Savings
(Households)
E
r*
Demand =
Investment
(Firms)
QLF Amount of loanable

funds
According to classicals, firms were not investing during great depression because of higher
interest rate. Interest rate is the cost of borrowing the funds for the firms. When firms borrow
funds, it has to pay the interest rate, that’s why firm’s investment was declined. According to
them, if we lowered the interest rate then we can encourage the firms for investment. So
individuals should save more, provide more and more money to the banks so that the supply
of funds increase and interest rate fall.

Interest So
rate S1
E
r*
r1

funds
(B) MARKET FOR LOANABLE FUNDS: THE KEYNESIAN VIEW
Keynes said if you increase the supply of loanable funds the savings increase and
consumption of consumers falls. This means that firms demand for new investment will fall and
its curve shifts downward. Because they see that they would not be able sell their goods. So
the new market clearing interest rate would be r2. Thus increased savings would cause
investment demand to fall.
Interest So
rate S1
E
r*
r1
r2 D0
D1

funds
AGGREGATE DEMAND
Aggregate demand (AD) is the total planned or desired spending (expenditure) in the economy
during a given period. AD is the sum of consumption, investment, government spending and net
exports (i.e. exports minus imports), and is inversely related to the aggregate price level through
the wealth, interest rate and international purchasing power effects.
AD curve slopes downward for both Keynes and classicals.
Aggregate
Demand
Curve

WHY AD CURVE SLOPES DOWNWARD

AD curve slopes downward due to the following three effects.
1. The interest rate effect of a price level increase on AD is negative as it causes a fall in
investment demand. Higher prices cause the nominal interest rate to rise discouraging
firm investment.
2. The wealth effect of a price level increase on AD is negative and works through the
reduction in the purchasing power of consumers’ income and wealth (real asset values).
These cause a reduction in consumption demand.
3. The international purchasing power (or competitiveness) effect of a price level increase
on AD is also negative as it reduces the net foreign demand for domestic goods and
services. As the price level of a certain country increases the demand for its exports falls
because they become expensive (less competitive) in international markets.
FACTORS THAT SHIFTS AGGREGATE DEMAND

AD shifts to the right when any component of AD increases autonomously; e.g., if
a) Consumers become more willing to spend at every price level;
b) There are autonomous increases in investment due to better business prospects;
c) The government spends more, or reduces taxes;
d) Net exports rise at all prices (due to say an increase in the quality of domestic goods
relative to foreign goods).

The Classical View: S W Demand Shock

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Introduction to Economics –ECO401 VU

INTRODUCTION TO MACROECONOMICS (CONTINUED)

DIFFERENCES BETWEEN CLASSICAL AND KEYNESIAN ECONOMICS

1- (A) LABOR MARKET: THE CLASSICAL VIEW

Demand The Classical

(B) LABOR MARKET: THE KEYNESIAN VIEW

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2- (A) MARKET FOR LOANABLE FUNDS: THE CLASSICAL VIEW

The market for loanable funds

QLF Amount of loanable

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QLF Amount of loanable

QLF Amount of loanable

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WHY AD CURVE SLOPES DOWNWARD

FACTORS THAT SHIFTS AGGREGATE DEMAND

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