The fundamental differences of classical and Keynesian theories

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The fundamental differences of classical and Keynesian theories

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Keynesian economics is the view of the economy where in the short-run, especially during recessions the economic output is strongly influenced by total spending of the economy, also known as aggregate demand. Classical economics on the other hand is defined to be, the study of market dynamics; describes the way markets and market economies work. Classical economics is concerned with changes in economic growth and it stresses economic freedom and promoted free competition within markets and laissez-faire markets (Palley, 22).

The fundamental differences of classical and Keynesian theories are:

Classical economics based their theory that the market was perfect and could stand on its own (self sustaining) and that no government mediation was required. Classical economists believe that too much government spending takes away valuable resources needed by businesses for investment. While the Keynesian economics describes that the market is imperfect and requires intervention from the government and that it is not self sustaining. Keynes argues that government spending improves the economy and can replace absence of consumer spending.

Classical economist show that price level varies in response to changes in the quantity of money. Quantity theory of money seeks t o explain the value of money in terms of transformation in its amount. Keynesian economists discard the quantity theory of money; according to them under-utilization of resources and recession in the economy leads to substantial increase in real output and employment without affectively price level.

Classical economics tends to resolve and give long-term solutions to the economic problems. Regulation of the government, effects of inflation and taxes plays an important role in the providence of solutions to the economic problems in the long term. Keynesian economies focus on the providence of short term solutions to the economy problems; how economic policies can make instant corrections to a country (Miller, 45).

The multiplier effect can be described as the expansion of a country’s money supply due to banks ability to lend money. The percentage of bank deposits known as bank reserves influence the multiplier effect. It is money used to create more money and is calculated by dividing total bank deposits by the reserve needs. The multiplier effect can also be described by the fact that one individual’s spending becomes someone else’s income and the second individual’s income is subsequently spent, becomes the income of other persons (third person) and the chain builds on.

Wealth effect is described as the changes in aggregate demand caused by change in the value of assets such as stocks, property and bonds. Increase in the market value of assets induces the feeling of being wealthier and often tends to stimulate spending and use of savings. Value of stock rises due to escalating stock prices; investors feel more comfortable causing them to spend more. A positive wealth effects arises when an increase in wealth gives rise to an individual spending more than they had planned or if the marginal yield on gaining assets is diminishing or penalty cost is increasing (Miller, 96).

What are the five factors that lead to the increase or the decrease of aggregate demand?

Exchange rates: when the exchange rate of a country increases, people will tend to export products less hence aggregate expenditure lowers leading to the decrease in the aggregate demand; however a decrease in the exchange rate increases the level of exporting of products in a country hence leading to an increase in the level of spending increasing the aggregate demand.

Income distribution: this is in direct conjunction with the wages and salaries of individuals in a country, when the people in a nation are receiving high level of income, they tend to spend more hence leading to an increase in the level of aggregate demand. However, if the level of salaries and wages in a country are low, the level of spending is low leading to a decrease in the level of aggregate demand.

Expectations of the future: when investors perceive that the future economy will be better, they tend to save leading to a decrease in the level of spending hence a decrease in the aggregate demand. However, if the investors and consumers perceive a decrease in the economy people tend to spend more hence leading to an increase in the aggregate demand.

Foreign income: an increase in foreign income in a country leads to the increase in the level of exports in a country, the level of spending increases hence leading to an increase in the aggregate demand. While low level of foreign currency in a country leads to less exporting of products leading to low level of expenditure leading to decrease of low aggregate demand.

Monetary and fiscal policies: the government may decide to control how consumers spend their money by increasing the level of taxes. A favourable tax policy will lead to increase in the level of spending among consumers, leading to the increase in the aggregate demand, while high level of taxes leads to less spending hence leading to the decrease in the aggregate demand (Leung, 34).

The attributes of good money:

It must be durable: money as a medium of exchange must be able to withstand the wear and tear due the constant exchanging. It should take a form that is able to stand the test of time.

It must be portable: as a medium of exchange and one that is constantly on the move from one person to another should be easily transferrable from one owner to another; this is mostly dependent on the size and weight.

It must be divisible and consistent: money must be easily separated into smaller forms without altering its fundamental characteristics. On the other hand it should also be easy to integrate it to form a larger amount without also having to alter its form.

It must have intrinsic value: this mostly focuses on the value and worth of money. The quality and the worth money carries should be agreeable by all and that its value does not change and it does not derive its worth from anything else.

It must have a long history of acceptance, the form or material that makes money should have be acceptable or agreed upon between nations and within a nation for a long period of time. This is common to gold and silver for it has been acceptable over the years.

Should be malleable, should be able to be changed or remoulded into another new form or can be remade to create new money (Leung, 77).

Contrary to famous belief that money is created by government printing. Banks actually create money through deposits and making of loans. Banks create money through the issuing of loans, when a bank issues out money to a person, the bank is able to create more money through giving out of deposited money at a higher rate to someone who wants the loan. Through interest earned from loans offered to the government through treasury bonds and bills.

The bank may also make money through floating of shares to the public; through the sale of company shares the bank is able to make money.

Through interest it gains from loans. When a bank lends out money to an interested party, it sets a certain percentage rate at which the principle amount gains value within a given period of time. Through this interest earned on loans the bank is able to create money.

Banks can also make or create money through investments. Banks may decide to buy shares from other companies. Through the dividends earned through the shares the bank is also to create money. Banks may also decide to invest through real estates, the bank through building estates and selling them, the company gets to get money through selling these houses.

Government bonds- one can buy government bonds which are offered by the government as a way to take out of circulation some of the money in the economy. They have a permanent rate of interest and thus their interest rate is not affected by inflation. This also makes it possible to estimate the amount that one should get at the end of the period. Government bonds can have a maturity period of even 50 years thus can be invested for any period above one year.

Real estate-one can invest in real estate especially in terms of land. This is effective especially if one buys freehold land which has no time limit of holding the property and in most cases no rates is charged on holding the property. This can later be sold at a profit. This is because land is one of the few factors that keep on appreciating every other time. It is therefore safe to assume that it will be an assured profit maker.

Fixed accounts- this is a product offered by commercial banks. One can deposit into a fixed account for a period agreed upon by both the bank and the customer. The interest rate on this deposits changes very slightly in the course of that period. This assures the customer of a somewhat predictable amount at the end of the period agreed upon. The periods can be very long but the account holder is given the option of withdrawing before the period ends be it without the interest to be accrued at the end of the agreed period.

By definition the difference between fiscal policy and monetary policy is that: a fiscal policy involves the change in tax rates by the government and the level of government expenditure and their influence on aggregate demand. While monetary policy involves the changing in the interest rates and its influence on the money supply.

In fiscal policy the government uses the following tools: increase its spending, this has the effect of increasing demand on labour resulting to low unemployment levels. Through cutting the level of taxes, through this the government is able to create demand for goods when the economy takes a turn for the worse. With more money in the pocket, consumers are able to spend more hence increasing the aggregate demand.

While on the other hand, involves manipulation of the available money supply within the economy, higher interest rates increases borrowing costs and reduces consumer spending and investment, leading to lower aggregate demand. Fiscal policy is usually used to increase the aggregate demand while the monetary policy is used to reduce inflation. Monetary policy on the other hand is used to decrease the rate of inflation and reduce the level of unemployment in a country. This in other words is called reduction of stagflation.


Leung, Man Por. Macroeconomics. Hong Kong: Hung Fung Book Co., 1990.Print.

Miller, Roger Leroy. The Economics of macro issues. 2d ed. San Francisco: Canfiled Press, 1978. Print

Palley, Thomas I.. Post Keynesian economics: debt, distribution, and the macro economy. Houndmills, Basingstoke, Hampshire: Macmillan Press ;, 1996. Print.

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