Keynesian Economics vs. Classical Economics

3 March 2017

In economics, there are two main theories: Keynesian economics and Classical economics. Each approach to economics has a different take on monetary policy, consumer behavior, and last but not least, government spending. Let us first look into classical economics. The basis of the Classical Theory of Economics is self-regulation. Supporters believe that the economy is able to maintain its-self and is always capable of achieving the natural level of real GDP.

While circumstances do occasionally arise that effect the economy, causing it to fall above or below the natural GDP level, self-adjusting mechanisms are believed to exist. The belief that prices, wages, and interest rates are flexible and Say’s Law are two of the classical economists most firmly held beliefs. Say’s law basically states that the economy is always capable of demanding all of the output that its workers and firms choose to produce. Hence, government intervention is not needed.

Keynesian Economics vs. Classical Economics Essay Example

Generally, political liberals would side with Classical economics. Keynesian Theory rejects Say’s Law of self-regulation and suggests that the relationship between aggregate income and expenditure is key. Keynesian believers agree that government should step in and implement policies that will regulate the economy more efficiently. Typically political conservatives would agree with the Keynesian Theory. Were I a policy maker receiving conflicting advice, I would consider all aspects of the issue including equilibrium real GDP, employment, and prices.

Money is measured in different ways, mainly focusing on the liquidity, or how easily and quickly it can turn into a spendable form (Ayer & Colligne, Pg. 328). There are three main measurements; M1, M2 and M3. M1 represents the most liquid form of money and consists of the sum of currency and coins in the hands of the public, demand deposits, checkable deposits, and travelers checks. M2 is the sum of M1 plus the balances in savings deposits and balances deposited into money market mutual funds.

Lastly, M3 is the summation of M2 plus large time deposits (greater then 100k), and several other near monies Ayer & Colligne, Pg. 328-329). Expansionary monetary policies are fiscal policies that encourage economic growth. The deposit multiplier is a value representing the ratio of bank reserves to bank deposits. If bank reserves increase, bank deposits may increase by the amount of the increase times the deposit multiplier (Ayer & Colligne, pg 257-328).

Balance of payments accounts are an account of all transactions (monetary) between a country and the rest of the world. The BOP includes two sub accounts: the current account and the capital and financial account. The current account is adjusted for international incomes and transfers and records the monetaty value of imports and exports (both goods and services). The capital and financial accounts records the monetary value of capital inflows and outflows, and any financial investments (purchasing of stocks or bonds).

The BOP must have a balance that equals zero (Ayers & Collinge, pgs 378-380). The balance of payment accounts is very important to economic growth because it encourages international trade and hold each country accountable for fiscal policy. International commerce can increase the country’s consumption, however not all share in the gains. The majority of the economy benefits from international trade, but some people will end up losing due to job opportunities lost, migration, and eventual inflation/deflation, or market uneasiness.

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