Essay Classical vs. Keynes

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Classical vs. Keynes

The Classical model of the economy says that all markets always clear. The labor market failing to clear does not exist in the Classical model because of competitive exchange equilibrium in which prices and quantities always adjust perfectly. The Classical model is of a closed economy and the variables are real output, employment, real and nominal wages, the price level, and the rate of interest. It is easier to understand the classical model using five diagrams that are numbered one through five in Appendix One, The Classical Model. These diagrams represent the separate parts of the model that together illustrate, for the most part, the entire Classical model. Diagram one represents the production function,
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The separate treatment of the monetary sector and real sector is known as the 'Classical dichotomy.' To complete the model, diagrams three, four, and five are needed. Diagram three represents the Classical aggregate demand curve, which shows the relationship between real aggregate demand for output, y, on the horizontal axis, and the price level P, on the vertical axis. Real aggregate demand represents the sum of the demands for output of all the individuals in the economy. The Classical aggregate demand curve, AD, illustrates the level of aggregate demand for a given price level. Since the government or the central bank can control the quantity of money in circulation, it also controls the position of the Classical aggregate demand curve. But it can only control the price level and other nominal variables because it is independent of the monetary sector. The full understanding of the classical model comes with diagrams four and five, which consider money-wage determination and interest rate determination respectively. In diagram four, the real wage, w, is defined as the money wage, W, divided by the price level, P. For this reason there is a relationship between money wages and the price level which results in a straight line through the origin that corresponds to the real wage. The higher the price level, the higher the money wage must be to maintain any given real wage. Diagram five determines

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