# The Classical And The Keynesian Model Economics Essay

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

The behaviour of real wages in the business cycle has been studied increasing. Three models represent the way the real wage can be affected by a change in the output level, Y. These models are: The Classical Model, the Keynesian Model and the New Keynesian Model. The result for each varies in cyclic patterns; acyclical, counter-cyclic and pro-cyclic.

Each model is made up of graphs which include the variables: real output, employment, real and nominal wage and the price level.

The Classical Model

The Classical Model represents a closed economy and is made up for four graphs. Due to competitive exchange equilibrium, the classical model claims that where prices and quantities adjust perfectly, the labour market will never fail to clear.

Figure 1, graph (c), represents the change in the level of output as the level of employment increases by the production function,

Y=F(N). Where F'&gt;0, F''&lt;0,

As the level of employment increase, the level of output also increased, but at a decreasing rate.

Figure

When comparing figure 1 to figure 2, graph (b), a graph representing the labour market, with the same horizontal axis of the level of employment N. Ns represents the supply of labour and Nd represents the demand of labour. In the Classical Model, the supply of labour depends on the real-wage. As the real wage rises, more people are willing to work.

Figure

The Classical Model makes the real wage perfectly flexible. It allows it to adjust to the level that clears the labour market. By looking at figure 2 and obtaining the level of employment, the level of output can be determined, as shown in figure 5. This is known as the real sector.

The Classical Model's Classical aggregate demand curve is sown in figure 3, graph (d). For any change in the price level, P, the output, Y, of aggregate supply stays constant. The position of the real aggregate demand curve, representing the sum of the demands of output of all individuals in the economy, is controlled by the government or the central bank. They control the amount of money in circulation by controlling the price level and other nominal variables.

Figure

Figure 4, graph (a), shows the relationship between the price level and the real wage. According the Classical Model, the price level, P, alters according the nominal wage, W, keeping the real wage constant, W/P. Therefore, as there is no change in the real wage, output also stays the same.

Figure

Figure 5, shows the links between these four graphs described, and shows the Classical Model in completion. We can clearly see, due to the fixed aggregate supply, the output stays constant, for any change in the price level P. The real wage is rigid and remains fixed due to the relationship between the nominal wage and the price level.

Figure

We can see this in graph (a) and graph (b) in the figure; this is illustrated by the red dashed line in the figure. This can be described as Classical Dichotomy; which implies that the nominal variables do not influence real variables in the Classical Model. There is therefore, no relationship between output and real wage, and so can be described as being acyclical, where the real wage can be completely analyzed without considering the nominal

The Keynesian Model

Unlike the Classical Model, the Keynesian model is not self-regulating. The flexible wages and prices do not bring about market clearing, though relying on the help of the government or central banks to achieve this equilibrium. As opposed to the Classical dichotomy, there are no real wage rigidities in the Keynesian Model. Because of Classical dichotomy, only the nominal sector is affected my money in the Classical Model, however in the Keynesian model, many variables are affected.

Similarly to the Classical Model, 4 graphs are used. The first graph, Figure 6 shows the graph (c) of the Keynesian model, which also represents the production function,

Y=F(N). Where F'&gt;0, F''&lt;0,

Figure

Due to this, there is an effect on the real wages. Unlike the Classical Model, in the Keynesian Model, for any increase or decrease in the price level, the output, Y will be affected, due to the position of the aggregate supply curve, which has a positive gradient.

The labour market equilibrium is shown in figure7, in graph (b) of the Keynesian Model. An increase in employment will cause a decrease in real wages, which will cause involuntary unemployment to decrease, as shown in the figure by the dashed purple lines. The level of unemployment is represented by the distance between the supply and demand curves of employment at the same real wage level. It clearly shows that as the real wage decreases, the distance between the supply and demand curves of employment also decrease, signifying a resulting increase in unemployment.

Figure 7

Unlike graph (d) of the Classical Model's aggregate demand and aggregate supply curves, Figure 8, showing graph (d) of the Keynesian Model's aggregate demand and aggregate supply curves, does have a constant aggregate supply level. The aggregate supply curve has a positive gradient. This permits the increase and decrease of output, in the original production function.

Figure 8

The graph above shows the effects of monetary policy, shown in the movement from MS0 - MS1, or the fiscal policies from G0-G1 on equilibrium (P, Y1). This has an expansionary effect on output and the price level is also affected by this change, which we will see in figure 10.

Due to this, there is an effect on the real wages. Unlike the Classical Model, in the Keynesian Model, for any increase or decrease in the price level, the output, Y will be affected, due to the position of the aggregate supply curve, which has a positive gradient.

Figure 9, showing graph (a) of the Keynesian model, shows the real wage against the price level. The real wage decreases as the price level increases.

Figure 9

Figure 10 combines the four graphs described above, in which all graphs of the Keynesian Model can be compared. It can be used to study the effect on the real wage, according to the Keynesian Model, by a change in output. Figure 10 illustrates the effect of a increase and decrease in output, where the red dashed line represents an increase and the blue line represents a decrease.

P2

Y2

W0/P2

Figure 10

The effect of change in output shows the real wage is countercyclical. This means the real wage, W/P, moves in the opposite direction from the output, Y. This is shown from the red dashed line, representing an increase in output Y, resulting in an increased price level P, therefore resulting in a decreased real wage. However, when the output is decreased (as shown by the blue dashed line), the price level decreases and so the real wage is increased.

The New Keynesian Model

New Keynesians assume prices and wages are 'sticky', meaning that they do not adjust instantaneously to changes in the economy. The New Keynesian Model implies that the economy may fail to attain full employment. This is why similarly to the Keynesian Model; the model argues that stabilization may be attained by the help of the government or central banks, using fiscal or monetary policies.

Below shows the production function of the New Keynesian Model, as used in the other models described, also with the production function,

Y=F(N). Where F'&gt;0, F''&lt;0,

Figure 11

Below, figure 12 shows the labour market equilibrium. It shows effective demand, where the firms hire the quantity of labour needed to produce the amount of output demanded, YD.

Figure 12

Similarly to the Keynesian Model, figure 13 shows the effects of expansionary monetary policy, shown from Ms0 to Ms1, or fiscal policies from G0 to G1 at the equilibrium (P, Y). The graph shows expansionary effects on output but no effects on the price level, due to the sticky prices.

Figure 13

Figure 14 shows graph (a) of the New Keynesian Model. As price stays the same due to its stickiness, is it the nominal wage which alters, to increase or decrease the real wage, as shown in the graph.

Figure 14

The complete New Keynesian Model is shown in figure 15:

Figure 15

Studying the model, we can interpret the effect of output, Y, on the real wage, W/P. It is clear when comparing graphs (c) and (b) directly that an increase in output will cause an increase in the real wage, due to the increase in the level of employment. A decrease in output will cause a decrease in the real wage. This concludes that the real wage in this model is procyclical; moving in the same direction as the output. A simple example of this is the rise and fall of the real wage during recessions and recoveries, respectively.

Empirical Evidence

Many believe that real wage is procyclical, but often 'statistically insignificant' (Blanchard and Fisher (1989), Lectures on Macroeconomics, p.19)

However, recent evidence from longitudinal (panel) micro-date following the same workers over time suggests that the real wage is strongly procyclical.

There is the risk of bias as the composition of the workforce changes over the cycle. Low wage workers are more likely to get sacked in recessions, so the average wage automatically rises as output falls. This imparts a negative bias to the output-real wage relationship if measured using aggregate data. Using micro data we can control for occupation, thus removing the bias.

Devereux's (2001) analysis of men in the Panel Study of Income Dynamics (PSID) produced two findings: the first being that the real wages of salaried workers are noncyclical, and the second that wage cyclicality among hourly workers differs between two alternative wage measures. We conclude that job stayers' real average hourly earnings are substantially procyclical and that an important portion of that procyclicality probably is due to compensation beyond base wages.'

Authors: Shin, Donggyun1; Solon, Gary2

Source: Scottish Journal of Political Economy, Volume 54, Number 5, November 2007 , pp. 648-660(13)

Publisher: Blackwell Publishing

Barro, solon, barsky.

Compare aggregate and panel data

Look at empirical evidence and compare models and difference evidence and conclude.

Predictions

The real wage is procyclical