Answer to Question #115267 in Macroeconomics for Liu Ka Yee

Question

Explain, with aid of diagrams, the effects of an expansionary fiscal policy under the classical theory and
the Keynesian model. Compare and contrast the effects under the two models. How would these
differences affect their conclusion on the role of government?

Answer 1

Expansionary fiscal policy refers the government seeking to increase aggregate demand through higher government spending.

The Classical view is that Long Run Aggregate Supply LRAS is inelastic due to important implications. The classical view suggests that real GDP is determined by factors such as the investment and capital.

Classical theory suggest that in the long-term an increase in aggregate demand will cause inflation and will not increase real Gross Domestic Product.

Differences between classical theory and Keynesian theory.

In classical theory government borrowing increases more crowding out while in Keynesian theory no crowding out in recession.

The government should seeks aims at running a balanced economy while in Keynesian theory the government should borrow more.

In classical theory the government is only involved trades-off in the short run on the Phillips curve while in Keynesian theory the government trades off between inflation and unemployment on the Phillips curve.

In classical theory there is long term increase in output (Y) on the fiscal policy while on the Keynesian theory expansionary fiscal activity can stimulate more economic activity.

These differences would affect employment too much and the government may not conclude well on employment level. This is because the fall in aggregate demand which cause others to have less income and reduce their spending creating a negative effect.