Classical Model and Keynesian Model: Study with Video Lessons, Practice Problems & Examples

The Keynesian model, developed by John Maynard Keynes during the Great Depression, contrasts with the classical model by emphasizing sticky prices and wages, which do not adjust quickly to market changes. Unlike the classical approach, which assumes self-correction and full employment, the Keynesian model acknowledges persistent unemployment and advocates for government intervention to stabilize the economy. In the aggregate demand and supply framework, the classical model adjusts immediately to equilibrium, while the Keynesian model experiences a time lag, highlighting the importance of fiscal policy in managing economic fluctuations.

Classical 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 classical model of economics. So this model had a flexible approach to prices and wages, okay? So everything 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 adjust to those conditions. So in a recession, right? The prices would fall. In an expansion, prices would rise along with wages. Everything would be moving. 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 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 laissez-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 going to compare the classical and Keynesian models with the metaphor. So imagine you're 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, 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.

Keynesian Model

Alright. So now, let's see some of the big differences here with the Keynesian Model. The Keynesian Model was introduced during the Great Depression. This is where they started to think, maybe the 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 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 there are sticky wages, that's like, let's say, a labor union where they sign a contract for what their wages are going to be for the next 3 years. Well, that's sticky. That can't really change because it's based on the contract. So if a recession happens or an expansion inflation, well, that wage is going to 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 model here. 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 utilized. However, in this model, we learned that some people who are looking for work cannot find work. And we learned about that when we studied unemployment, right? With frictional unemployment, structural unemployment, and cyclical unemployment during recessions, right? 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 recessions. 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 miles 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 highway is totally blocked and there's nothing nobody can move. The traffic will not clear up until someone, the government in this case, intervenes and helps 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. The government intervention is necessary to fight a recession or fight inflation. Okay? So that's the big difference: 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 going to look at these on the graph and notice what one of the key differences is between the two models on the graph.

Graphical Comparison of Classical Model and Keynesian Model

Alright. So now let's look at this aggregate demand aggregate supply model. Remember the aggregate demand aggregate supply model that we have? Well, 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, our short run equilibrium always adjusts straight back to the long run equilibrium. So what I mean by that is, let's say we go through 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 left here. So this is aggregate demand 1, and now we have a new aggregate demand out here, Aggregate demand 2. Well, the classical model 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 short run aggregate supply is automatically going to adjust right over here because remember how we said that in the classical model, everything's flexible. So prices and wages are going to adjust automatically. So instead of having this 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, 1 to 2 right there. It moves the equilibrium from 1 to 2 automatically. And 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, 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 Keynesian model will take time to correct. So we're going to 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 going to have our original equilibrium 1, and then we'll have the short run equilibrium 2. And then there's going to be time where it takes time for us to 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 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 going to adjust immediately back to the long run. But in the Keynesian view, well, it's going to 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.

Here’s what students ask on this topic:

What are the key differences between the Classical and Keynesian economic models?

The Classical and Keynesian economic models differ primarily in their assumptions about price and wage flexibility, self-correction, and government intervention. The Classical model, rooted in Adam Smith's ideas, assumes flexible prices and wages that adjust quickly to market conditions, leading to full employment and self-correction without government intervention. In contrast, the Keynesian model, developed by John Maynard Keynes during the Great Depression, posits that prices and wages are sticky and do not adjust quickly. This model acknowledges persistent unemployment and advocates for government intervention to stabilize the economy. In the aggregate demand and supply framework, the Classical model adjusts immediately to equilibrium, while the Keynesian model experiences a time lag, highlighting the importance of fiscal policy in managing economic fluctuations.

How does the Keynesian model explain unemployment during a recession?

The Keynesian model explains unemployment during a recession through the concept of sticky prices and wages. Unlike the Classical model, which assumes that wages and prices adjust quickly to restore full employment, the Keynesian model suggests that wages and prices are sticky and do not adjust immediately. For example, labor contracts or minimum wage laws can prevent wages from falling, leading to unemployment when demand for goods and services decreases. This stickiness means that the economy does not self-correct quickly, resulting in prolonged periods of unemployment. Keynesians advocate for government intervention, such as fiscal stimulus, to boost aggregate demand and reduce unemployment during recessions.

Why does the Classical model assume full employment?

The Classical model assumes full employment based on the idea that flexible prices and wages will always adjust to ensure that all resources, including labor, are fully utilized. According to this model, any deviations from full employment are temporary and self-correcting. For instance, if there is a surplus of labor (unemployment), wages will fall, making it cheaper for firms to hire workers, thereby restoring full employment. Similarly, if there is a shortage of labor, wages will rise, attracting more workers into the labor market. This self-correcting mechanism, often referred to as the 'invisible hand,' ensures that the economy operates at full employment without the need for government intervention.

How do the Classical and Keynesian models differ in their approach to aggregate demand and supply?

In the Classical model, aggregate demand and supply adjust quickly to reach long-run equilibrium. When aggregate demand falls, prices and wages adjust immediately, moving the economy back to its potential GDP without a prolonged short-run equilibrium. In contrast, the Keynesian model suggests that prices and wages are sticky, leading to a time lag in adjustment. When aggregate demand falls, the economy may experience a short-run equilibrium below its potential GDP, resulting in unemployment and underutilized resources. Government intervention, such as fiscal policy, is often necessary to boost aggregate demand and help the economy return to its long-run equilibrium. This difference highlights the Classical model's reliance on self-correction versus the Keynesian model's emphasis on active policy measures.

What role does government intervention play in the Keynesian model?

In the Keynesian model, government intervention plays a crucial role in stabilizing the economy, especially during periods of recession or inflation. Unlike the Classical model, which assumes that the economy is self-correcting, the Keynesian model acknowledges that prices and wages are sticky and do not adjust quickly. This can lead to prolonged periods of unemployment and economic instability. To address these issues, Keynesians advocate for fiscal policies such as increased government spending and tax cuts to boost aggregate demand. By doing so, the government can help reduce unemployment and stimulate economic growth, thereby shortening the time it takes for the economy to return to its long-run equilibrium.