Question

Explain and compare how income is determined in the ‘Classical’ model as opposed to Keynes. Discuss how each of the two theories can explain the existence of unemployment.

Answer 1

Under the classical model, the income level is determined from the supply-side whereas in the keynesy model the income level is determined from the demand side. In classical model of income is equal to the full employment level. This is the level of income which corresponds to the full employment of resources whereas in the Keynesian model, the interaction between aggregate demand and aggressive supply determines the equilibrium level of income. Thus, In classical model, there is no participation of aggregate demand for determination of income as compared to that in Keynesian model where aggregate demand is integral to the determination problem of income in the Keynesian model.

Under classical model, the unemployment level depends on the real wage. If the real wage is higher than equilibrium level determined from the labour demand and labour supply curve because of minimum wage policies or unions ability to successfully bargain for a higher wage leads to unemployment. In the Keynesian model, unemployment is the result of shortage of aggregate demand. This shortage is the shortage in demand due to which the economy doesn't reach the full employment level of income.