Supply and Demand Curves in the Classical Model and Keynesian Model

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  • 0:04 Two Models for Economic Growth
  • 0:52 The Classical Model
  • 1:50 The Keynesian Model
  • 3:09 Differences Between the Models
  • 6:17 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

See how economists illustrate aggregate supply and aggregate demand in the long-term and short-term using the Classical and Keynesian models. This lesson emphasizes the differences in the shape of the aggregate supply curve using these two models.

Two Models for Economic Growth

The aggregate demand and aggregate supply curves intersect at the macroequilibrium point
Macroequilibrium Point

When economists describe economic growth, there are two main models that they use. One is called the Classical model, and the other is called the Keynesian model - named after, guess who? If you said John Maynard Keynes, you'd be correct. While there are other variations, these are the two basic models. The distinctions between these two models are important because one model describes how the economy works in the short-term, while the other describes long-term economic growth. Both of them serve as the foundation for other topics in macroeconomics - so the ideas that each model are based on will surface again down the road. Let's take a quick look at each of them and then explore how each model illustrates supply and demand differently.

The Classical Model

The Classical model was popular before the Great Depression. It says that the economy is very free flowing and that prices and wages freely adjust to the ups and downs of demand over time. In other words, when times are good, wages and prices quickly go up, and when times are bad wages and prices freely adjust downward.

The major assumption of this model is that the economy is always at full employment, meaning that everyone who wants to work is working and all resources are being fully used to their capacity. The thinking goes something like this: if competition is allowed to work, the economy will automatically gravitate towards full employment or what economists call 'potential output.' Classical economists believe that the economy is self-correcting, which means that when a recession occurs, it needs no help from anyone. So that's the Classical model.

The Keynesian Model

The aggregate supply curve is shown vertically in the classical model
Classical Model Graph

A second model is called the Keynesian model. This model came about as a result of the Great Depression. Economist John Maynard Keynes observed that the economy is not always at full employment. In other words, the economy can be below or above its potential. During the Great Depression, unemployment was widespread, many businesses failed and the economy was operating at much less than its potential.

When John Maynard Keynes was observing the Great Depression, he realized that the economy could be well below its potential for a long time and that something was causing it to get stuck. It may be self-correcting like the Classical economists were saying, but it was taking way too long. In the meantime, people were losing jobs and were suffering. Keynes believed that government and monetary leaders should do something to help the economy along in the short run, or the long run may never come.

The Classical model does a great job of describing the economy in the long run - where resources are fully employed and everyone is working. The Keynesian model, on the other hand, does a great job of describing what happens in the short run when there's a recession and people are out of work or when the economy is temporarily overheating and a shortage of workers takes place.

Differences Between the Models

Let's look at this visually on a very basic level and see how economists illustrate the differences between these two models representing what the economy looks like in the short run and also in the long run. Both models illustrate economic growth using a chart showing the relationship between economic output (which is real GDP) and prices. Since the economy operates according to the laws of supply and demand, we have two types of curves in this model, one representing supply and the other representing demand.

Economists call this supply curve aggregate supply, which simply means total supply. This supply represents all the firms in the economy, including Bob's lawn business, Margie's cake business and many others. When you see an aggregate supply curve, just think of all the businesses, their products and services and all their workers - each of which earns wages.

The aggregate supply curve is upward sloping based on the Keynesian model
Keynesian Model Graph

Economists call this demand curve aggregate demand, which means total demand in the economy. When you hear the words aggregate demand, just think of consumers, businesses, the government and foreigners - all of whom want products and services.

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