Question

Compare the effects of an expansionary fiscal policy action—an increase in government
spending financed by government bond sales to the public, for example—in the Keynesian
and classical models. Include in your answer the effects of this policy shift on the level of
real income, employment, the price level, and the rate of interest.

Answer 1

Classical model

There is an increase in government spending which is financed by government bond sales to the public. This will increase the aggregate demand and shift the AD curve to the right in goods market. At the current price, there is an excess demand for goods and services. Prices and wages are flexible and economy cannot produce more than what it produces at full employment so price level increases immediately. This eliminates all the excess demand and economy remains at its full employment level of output. There is no change in employment and output or real income. However, bonds are sold to public so bond prices are reduced and rate of interest is increased. There is a complete crowding out of private investment

Keynesian model

There is an increase in government spending which is financed by government bond sales to the public. This will increase the aggregate demand and shift the AD curve to the right in goods market. Prices and wages are rigid and economy can produce any amount of goods and services at the current price so price level remains unchanged and production is increased immediately. This implies that real income or output and employment both are increased. However, bonds are sold to public but price level is fixed and so the rate of interest is unchanged. There is a no crowding out of private investment