Answer to Question #225833 in Macroeconomics for Nawabii

Question

Do as you are being directed.

1. Assume that our economy is in deep recession now due to Corona virus pandemic. What government 

should to help economy revive according to:

a. Classical model

b. Keynesian model

c. Monetarist model

d. New classical model

Use graphs to elaborate your answers.

Answer 1

Classic (basic) macroeconomic model

Economists call this model basic because it focuses on the behavior of two basic, key variables for macroeconomic processes - aggregate production and price levels. It is called classical because its origins were the classics of economic science A. Smith and D. Ricardo, J.St. Mill and J. B. Say.

The outlined model assumes three conditions: first, the goal of the owner of income is not to receive money as such, but to acquire various material goods on it, i.e. the income received is spent in full. With this approach, money plays a purely technical role as an intermediary in circulation. Secondly, only own funds are spent. Thirdly, society consists of the same producers who are also consumers.

However, a legitimate doubt arises: what are such assumptions based on? First, it is quite reasonable to assume that some part of the income received will not be spent and will take the form of savings. This assumption jeopardizes the validity of Say's law, since the withdrawal of part of the funds from income will necessarily lead to underconsumption, and, consequently, to the disruption of the existing equilibrium between the aggregate supply and the aggregate demand it creates.

Secondly, the producer carries out part of the costs not from his own funds, but through loans (credits), which increases the size of the supply and also upsets the equilibrium. Finally, thirdly, persons who save part of their income and persons who invest through loans are different participants in the economy (they coincide only in a natural or totally state-owned economy).

Understanding the validity of the assumptions made, representatives of the classical direction went further and developed a fairly coherent theory of general economic equilibrium, which does not contradict Say's law. Its main provisions are as follows:

1. The market system ensures the full use of resources in the economy. Violations can occur for individual product groups due to any external reasons, and not due to imperfection of the economic mechanism itself. These imbalances are resolved through the automatic self-regulation of the market.

2. Aggregate supply generates exactly the same aggregate demand, which means there is no reason to fear overproduction. An increase in the aggregate supply, i.e. an increase in the volume of goods and services produced is at the same time an increase in income, and, consequently, an increase in demand. If a society completely spends the national income, then an equilibrium is automatically established between aggregate demand and aggregate supply.

3. Part of the income really goes into savings, but if money can bring interest, then reasonable people will not keep it in liquid form, but put their savings in banks or securities. Interest money is usually a source of investment. If the volume of investment is equal to the volume of savings, then the balance between aggregate demand and supply will not be disturbed.

4. Savings and investment decisions are indeed made by different people, whose goals and actions may not coincide. However, there is a mechanism in the money market that helps to achieve a balance between savings and investment. It is based on interest rate fluctuations, which are flexible. Equilibrium interest is a payment for borrowing savings that is acceptable to both savers and investors.

5. Fluctuations in prices that maintain equilibrium in the economy occur not only in the commodity and money markets, but also in the resource markets and, above all, in the labor market. Falling commodity prices lead to lower wages or, if they remain the same, to unemployment. Then the supply of labor will exceed the demand.

6. Workers will begin to accept lower wages, and entrepreneurs will find it profitable to hire anyone willing to work for that money. In other words, market forces and flexible wages act towards equilibrium in the labor market, which leads to full employment of the labor force.

7. An increase in the money supply in circulation does not change anything in the real flow of goods and services. This only affects nominal values, so long-term inflation is not possible.

8. If the market has regulators capable of ensuring the full use of available resources, then government intervention is unnecessary.

9. The state should refrain from influencing economic entities operating in a competitive environment and adhere to the laissez-faire policy (translated from French - “let everyone go their own way.” English version of this expression: let it be - let everything go as goes), i.e. non-interference in the economy.