Classical Economics
Let's look at classical economy and what that entails. Start with an economy in a recession, which is identified by price level one and quantity level one. According to a classical economist, with the unemployment in the economy, eventually wages – how much workers make – and prices of resources will decrease. Supply can then increase, because producers do not have to pay workers as much and because the cost of inputs is now less. The aggregate supply curve will shift to the right and achieve equilibrium again at a lower price and a higher output, with yf representing this higher output, therefore the recessionary gap is closed.
The principle of classical economics can also be illustrated when the economy is doing well. This graph represents the idea of a classical economists in a boom time. A booming economy and high inflation is represented by Price level one and quantity one. According to classical economist, with low unemployment and a higher price level, eventually the cost of wages and resources will increase. Why? Because workers are more scarce; therefore they can demand more money. With the cost of input also increasing, the aggregate supply curve will shift to the left and achieve a new equilibrium at a higher price level and a lower output.
Keynesian Economics
We will now look at another theory of economics called Keynesian economics. Once again, we will start the economy in a recession which is identified as price level one and quantity level one. According to Keynes, with unemployment in the economy, Government needs to increase aggregate demand by lowering taxes and increasing spending. By lowering taxes consumers have more disposable income, which means they will have more income to spend on different products; therefore, their consumption will increase. A new equilibrium will be achieved with higher price levels and greater output.
If we start with the economy experiencing high inflation, once again identified by price level one and quantity one, according to Keynes inflation is the biggest problem in the economy, and the government needs to decrease aggregate demands by increasing tax levels and decreasing government spending. By increasing taxes, consumers will have less disposable income, which means their consumption will decrease. A new equilibrium will be achieved with a lower price level and a smaller output.
Monetary Policy
We will now look at monetary policy. We will start with the economy in a recession which is identified by price level one in quantity one. The Federal Reserve, which is the government entity that controls much of monetary policy, is faced with a stagnant economy with high unemployment. Therefore, they would use an expansionary money policy which would help to correct the situation. By increasing the money supply and decreasing the interest rate businesses and consumers would be able to borrow more money. By increasing consumption and investment aggregate demand would shift to the right. The economy would achieve a new equilibrium at a higher price level and a higher output.
Let's now start the economy which is experiencing high inflation which is once again identified as price level one and quantity one. The Federal Reserve, when it is faced with high inflation, would use a contractionary monetary policy to take money out of the economy to correct the situation. By decreasing the money supply, and increasing interest rates, it will cost businesses and consumers more to borrow money. By decreasing consumption and investment, aggregate demand would shift to the left. The economy would achieve a new equilibrium at a lower price level and a lower output.
