Classical Model and Keynesian Model

throughout this course, we've been focusing on what's called the Keynesian model of economics based on the studies of john Maynard Keynes before that, they used the classical model of economics, let's learn some of the key differences and similarities between these models. So let's start here with the classical model. And this is basically the original foundation of economics and it was used primarily before the Great Depression. And this was developed generally first by we'll say Adam smith in the wealth of nations. This is where a lot of these ideas came from in the uh classical model of economics. So this model had a flexible approach to prices and wages. Okay, so everything was was flexible, wages can move up and down at any point in time, prices moved up and down based on the laws of supply and demand. Okay, so based on current financial conditions, prices and wages would quickly move to to adjust to those conditions. So in a recession, right, the prices would fall in, expansion, prices would rise along with wages, everything would be moving. Um And the economy was also assumed to be always at full employment, there was always full employment. Anyone who wanted a job could get a job and all resources were being used. Right? So this economy was said to be self correcting needing no intervention. This is the big thing about the classical model that they said that there was what we call the invisible hand. It's said to be the invisible hand of the market would fix any problems that the market had. You just you just let it run its course and all the problems would fix. If you're going through inflation. Well, the market would fix itself over time. If you're going through a recession, the market's gonna fix itself as well. This is said to be called what we say is lazy faire laissez faire economics. And this is just this no intervention policy allowing things to run their course without intervention. Okay. That's the big thing with the classical model, is those flexible prices and no intervention. Okay, so as a metaphor, we're gonna compare the classical and Keynesian models with the metaphor. So imagine your imagine there's a busy highway with a 60 mile per hour speed limit during rush hour, which we're gonna assume is a recession here during rush hour, the freeway is packed and no one can actually go the speed limit, right? We're going through a recession recession. But eventually as time passes, people leave the highway, it'll clear up again, right? And this is that self correcting after a while the highway clears up and everyone can go the speed limit again and everything's back to normal, right? So the recession happens. You don't intervene at all. Eventually it clears up and we move on. Okay, So that's the whole thing with the classical model. Remember there's no intervention and it's flexible prices and wages. Cool. Let's pause here and then let's talk about the keynesian model in the next video

Alright, so now let's see some of the big differences here with the Keynesian model. So the Keynesian model was introduced during the Great Depression. This is where they started to think maybe this classical model isn't working as we thought it would. And this was developed by john Maynard Keynes. And that's what we've been focused on mainly throughout this course when we've been studying um different graphs and different topics here. We've been focused here on Keynesian economics. So this model notes that instead of everything being flexible and adjusting to the market quickly, sometimes prices and wages may be sticky. Okay. And we call them sticky, which means they're not flexible, right? They're not able to change quickly. Okay. So when they're sticky wages uh that's like uh let's say like a labor union where they sign a contract for what their wage is going to be for the next three years. Well, that's sticky. That can't really change because it's based on the contract. So if if a recession happens or an expansion inflation, well that wage is gonna stay the same no matter what's happening in the market. So prices and wages do not always adjust quickly when we have this sticky uh sticky model here. And another key thing is that the economy is not always at full employment. So before the classical model assumed that anyone who wanted work could find work any resources we had were always being implemented. However, in this model, we learned that some people who are looking for work cannot find work, right? Looking for work but cannot find work. And we learned about that when we studied unemployment, right? With uh frictional unemployment, structural unemployment and cyclical unemployment during recessions. Right? So they don't think that the economy is self correcting in this model, the Keynesian model does not believe that the economy will always fix its own problems. Sometimes government intervention will help fight inflation or recession. So that's one of the big differences. The Keynesian model believes that government intervention is necessary to help fight recessions and inflation. So, let's think of that same metaphor here, imagine now the same busy highway, 60 mile per hour speed limit. And during rush hour the freeway is packed and no one can actually go the speed limit. However, the reason it's packed is that a semi truck has tipped over and is blocking all the lanes. Right? So now the highways totally blocked and there's nothing nobody nobody can move. The traffic will not clear up until someone, the government in this case, the government intervening and help remove the obstruction. Right? So once the government intervenes removes this obstruction in the economy, and we get back to normal, the speed limit is attained again. Right? So this is the difference here is that the government intervention is necessary to fight a recession or fight inflation. Okay, so that's the big difference is the flexible versus the sticky wages and prices. And then the government intervention here in the Keynesian model. Cool, let's pause real quick And then we're gonna look at these on the graph and notice what one of the key differences between the two models on the graph.

Alright. So now let's look at this aggregate demand, aggregate supply model, remember the aggregate demand aggregate supply model that we have, what we say that we've got our short run aggregate supply and our long run aggregate supply going straight up and down there with long run and then we've got our aggregate demand with the downward slope there. So in the classical model are short run equilibrium always adjust straight back to the long run equilibrium. So what I mean by that is, let's say we go through um a recession and aggregate demand has fallen. Okay, so if there's a situation where aggregate demand falls, let's say it goes to the to the left here. So this is aggregate demand one and now we have a new aggregate demand out here, aggregate demand to well, the classical model um believes that this will adjust immediately instead of having this short run equilibrium over here, this doesn't happen. We never have this short run equilibrium. The the short run aggregate supply is automatically going to adjust right over here because remember how we said that flexible the in the classical model, everything's flexible. So prices and wages are going to adjust automatically. So instead of having the short run equilibrium where we move to this recessionary phase below our potential GDP we immediately move back to a long run equilibrium there. So it basically goes from here, one, 22 right there, it moves the equilibrium from 1-2 automatically. And if you if you don't totally recall the aggregate demand aggregate supply model, go ahead and review that real quick if you're confused with this and then and then of course you can come back and review this video. But the main difference here is just showing that the classical model instantly corrects while the class the Keynesian model will take time to correct. So we're gonna have the same thing, our short run aggregate supply, our long run aggregate supply and our aggregate demand, and we go through a recession that shifts aggregate demand to the left. But now in this model, we're going to have a time lag in between. So we're gonna have our original well, we'll have our original equilibrium one and then we'll have this short run equilibrium to and then there's gonna be time where where it takes time for us to um reach our new equilibrium, our new long run equilibrium, when short run aggregate supply shifts to the right, okay, shifts to the right or government intervention helping uh push aggregate demand back to its levels. Right? So there is going to be the short run equilibrium where we're not at our long run potential GDP, right? The potential GDP being this spot right here where the long run aggregate supply is Okay, that's our potential GDP. So notice that in the classical view, it's gonna just immediately back to the long run, but in the Keynesian view, well, it's going to uh spend some time at a short run equilibrium. That's not at the long run equilibrium and then it'll adjust finally to the long run equilibrium, and that's because of those sticky wages. And then the government intervention can also help us fight this recession faster. Okay, so that's the big difference. There is. The classical view will instantly change, and the keynesian view has that stickiness. Alright, let's go ahead and pause here and move on to the next video.