Fiscal and Monetary Policy in the Classical and Keynesian Models

The classical and Keynesian approaches to macroeconomic policy are different. Disagreements relate to the causes of instability in aggregate demand; factors that determine aggregate supply; the relationship between inflation and unemployment; fiscal and monetary policy instruments.

The general methodological approach of Keynesians is the concept of an active macroeconomic policy of the state, which is carried out to stabilize the internally unstable economy. Internal instability is largely due to the lack of flexibility of the labor market, the “rigidity” of wages and the inelasticity of prices downwards.

In the classical model, the macroeconomic policy of the state is always passive, since the economy is internally stable and automatically comes to a state of long-term equilibrium on the basis of the market mechanism of self-regulation. The instruments of “self-regulation” are flexible wages, prices and interest rates. State intervention in the economy, according to the classics, on the contrary, increases economic instability and therefore should be minimized.

In the Keynesian model, the basic equation of macroeconomic identity is the well-known equation of total expenditure:

Y = C + i + G + Xn,

which determines the value of the nominal GNP.

In the classical model, the main equilibrium equation of the economy is the equation of exchange:


where the value of the MV represents the total expenses of the buyers, and the PY represents the total income (revenue) of the sellers, which also determines the nominal GNP.

Obviously, both equations describe the circulation of income and expenditure in the economy and are therefore interrelated.

In the Keynesian model, fiscal policy is considered as the most effective means of macroeconomic stabilization, since government spending has a direct impact on the amount of aggregate demand and a strong multiplicative impact on consumer spending. At the same time, taxes have a fairly effective effect on consumption and investment.

In the classical model, fiscal policy is given a secondary role compared to monetary policy, since fiscal measures cause a crowding out effect and contribute to an increase in the level of inflation, which significantly reduces their stimulating effect.

In the Keynesian model, monetary policy is considered as secondary to fiscal policy, since monetary policy has a very complex transfer mechanism: a change in the money supply leads to a change in GNP through a mechanism for changing investment expenditures that respond to interest rate dynamics.

In the classical model, it is assumed that a change in the money supply directly affects aggregate demand and, consequently, nominal GNP.

In neoclassical concepts, such as the theory of rational expectations (TRO), prices and wages are seen as completely flexible. Therefore, the market mechanism can automatically maintain the economy in a state of equilibrium without any intervention of the government or the Central (National) Bank. Stabilization policies can be effective only if the government and the central bank are better informed about aggregate supply and demand shocks than ordinary economic agents. If this advantage is not in the information, then fiscal or monetary policy will not be able to improve the economic situation.