The Keynesian Model and the Classical Model of the Economy

The Keynesian Model and the Classical Model of the Economy
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Lesson Transcript
Instructor: Jon Nash

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

Economists use two basic models to describe economic growth. In this lesson, you'll find out more about each one of these models using real-world examples. So buckle up your seatbelts!

The Keynesian Model and the Classical Model of the Economy

We're talking about two models that economists use to describe the economy. Let's take a look at each one and the important assumptions behind them. Then we can look at them visually, using the laws of supply and demand.

Economic Output: The Long and Short of It

I want you to imagine that you're in the town of Ceelo, where Bob the business owner is taking the day off. He's decided to drive to Green Meadows, which is the next town over. To get there, Bob takes the expressway. It has three lanes on each side, and it's a very busy expressway. So just imagine that Bob enters the expressway.

Now imagine you're inside of a helicopter far above the expressway, looking at it from a bird's-eye view. You can see the progress of every car on it, and you can see the movement on the expressway, like it's a big machine with moving parts. As you watch the traffic from above, you notice that the cars are going an average of 55 miles per hour. Why 55? Because there's a speed limit sign posted that says 55. If you're on this expressway, 55 is your potential speed. From time to time, however, the cars slow down. Let's look at two scenarios that would cause a slowdown.

Imagine that traffic is slowing down on the expressway right now. Why is it slowing down? Because there are too many cars trying to get on at the same time. There's an influx of cars trying to merge on to the expressway ahead. What happens next? The average speed of the cars goes below 55 miles per hour as all of the cars behind slow down for a few minutes. This machine made up of individual cars goes below its potential. Eventually, though, this situation resolves itself when the extra cars get on to the expressway. The cars begin moving faster again, and traffic returns to its potential of 55 miles per hour. Nothing is required to help the cars, they simply slow down for a little bit.

Now let's look at another scenario. Imagine there's an accident between Ceelo and Green Meadows. A big business truck carrying products and services flips on its side and blocks the road. Fortunately, the driver is okay, and he gets out of the truck. However, the truck is blocking everyone from moving through. When this happens, it takes a long time before traffic is traveling at its potential speed again. In fact, traffic stops completely until the police arrive on the scene and tow trucks come and clear the accident from the road. Finally, even after a bad accident like this, traffic will start up again and it will reach its potential speed of 55 miles per hour. But there's no telling how long it would have taken to clear the accident without the help of the police and the tow trucks.

Over the years, economists came up with two basic models of the economy. There are other variations of this, but these are the basic concepts. The first one's called the Classical Model.

Guess when that started? A long time ago, in a galaxy far, far away. When you hear the words 'Classical Model' you can also think of Beethoven wearing that really weird wig. It's an old model, very old. The other model is called the Keynesian Model, named after the famous economist John Maynard Keynes. This is a newer model. When you hear the word 'Keynesian' just think of the Great Depression, because this model came about as a result of the Great Depression.

Economist John Maynard Keynes
John Keynes

The Classical Model

The Classical Model was popular before the Great Depression. It says that the economy is very free-flowing, and 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 toward full employment, or what economists call potential output - just like the expressway at an average speed of 55 miles per hour. Remember what happened when traffic slowed down because there were too many cars? After a few minutes, everything went back to normal. 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

A second model is called the Keynesian Model. As I said before, 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.

Think back to the expressway that Bob was driving on. Picture Bob behind the wheel, when the business truck fell on to its side and traffic came to a complete standstill for a long time. It was stuck until the police and the tow truck came. When economist 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 the government and monetary leaders should do something to help the economy along in the short run, or the long run may never come. In fact, he is quoted as saying 'In the long run, we are all dead.'

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