Classical and Neo Keynesian Models for Achieving Long Term Growth

This assignment analyses the Classical and Neo Keynesian Models of economic growth and their policy implications for achieving long term growth. It discusses the macroeconomic objectives of governments and how supply side policies under the Classical framework and demand side policies under the Neo Keynesian framework can be used for long term growth. The assignment emphasizes on the government of the United Kingdom and its policy frameworks.

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Business Economics
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Introduction
The two of the primary macroeconomic models, having immense implications on the
economic dynamics, growth and economic policy making aspects across the globe have been
the Classical and the Neo Keynesian Models (Agénor and Montiel 2015). The former model
is mainly a supply side model of growth, trying to explain the long term economic growth of
a country with the help of supply side variables and activities. On the other hand, the latter
model is more of a demand side growth model, evolving from the criticisms of the Classical
Model and trying to explain the economic growth and dynamics of a country from the
demand side perceptions and behaviours of the economic agents (Heijdra 2017).
Both of the Classical as well as the Neo Keynesian Models, with their inherent
differences, have been of immense importance, particularly in the aspects of planning and
developing policies on parts of the government of different countries, to achieve economic
growth and stability and both of these models have shown positive as well as negative results
at different points of time (Mankiw 2014). Keeping this into consideration, the concerned
assignment tries to analyse the ways in which the Classical as well as the Neo Keynesian
policies can be used for the purpose of achieving long term growth. To study the same, the
assignment particularly emphasizes on the government of the United Kingdom and the policy
frameworks of the same.
Classical Model: Assumptions and Implications
As discussed above, the Classical Model of Growth, being one of the primary school
of thoughts in macroeconomics, is evidently a supply side economic framework. One of the
primary assumptions of this model is that supply creates its own demand (Say’s Law) and
that with the increase in the supply side activities, long term growth of real output as well as
the productive capacity of the economy increase (Skousen 2015). That, is, according to the

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Classical Model, the market forces adjust themselves, by mutual interactions, to bring the
economy in equilibrium. This notion evolved from the notion of the “invisible hand”,
proposed by Adam Smith, one of the founding fathers of this particular school of thought
(Hollander 2012). Another crucial assumption in the Classical Model is that the prices in the
economy are flexible which in turn implies that the markets adjust quickly to equilibrium, in
case of any deviation from the same. The model also assumes that the savings of the
household sector in an economy equates the level of investment expenditures in the same
(Meade 2013).
Another important assumption of the Classical Model is that of an inelastic Long Run
Aggregate Supply, which comes from the notion of full employment level of output in the
domain of Classical Theory, which represents the situation of potential output which can be
produced when the economy operates in the full-capacity level (Benassy 2014). Keeping this
into consideration, the Classical Model assumes that in the long run, at the full-employment
level, the supply curve is perfectly inelastic, which can be shown as follows:
Figure 1: LRAS in the Classical Model
(Source: Benigno 2015)

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Thus, in the Classical Model, in the long run, with the supply remaining inelastic, the
increase in demand leads to increase in the price levels in the economy and vice versa, as can
be shown with the help of the following figure:
Figure 2: Increase in demand in the long run in Classical Model
(Source: Benigno 2015)
Neo Keynesian Model: Assumptions and Implications
The Classical theory, being one of the primary school of thoughts of economic
growth, was however, criticised heavily, especially in the times of the Great Depression,
when the concept of “invisible hand” did not work to bring the economy back to a steady
equilibrium and growth path (Galí, Smets and Wouters 2012). This led to the evolution of the
Keynesian Economic Model. As per the assumptions of the model, unlike that of the
Classical Model, prices and wages are inflexible, particularly in the downwards direction as
producers and workers are not easily convinced to accept lower prices or wages.
The Model also negates the assumption of the Classical Model that supply creates its
own demand and growth in the economy. On the contrary, the Neo Keynesian model
emphasises on the demand side activities as one of the crucial components of growth of the
economies (Gabaix 2016). The model also negates the saving-investment equality
assumption, by proposing that due to the presence of sticky or non-flexible prices, the

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equilibrium in the financial markets is not always reaches, which in turn implies that it is not
necessary for the savings and investments of a country to be same always.
Unlike that of the Classical Model, the LRAS in the Neo Keynesian framework, can
be shown as follows:
Figure 3: LRAS in the Neo Keynesian Model
(Source: Rotheim 2013)
As per the assertions of the concerned model, in the first phase, the LRAS is perfectly
elastic due to the presence of spare capacity in terms of easy availability of the factors of
production, which can be used without any increase in the cost of production. However, after
a certain point, with the factors becoming scarce, the cost of production increases (Rotheim
2013). The final phase of the LRAS in this model, is perfectly inelastic, resembling that of
the LRAS curve in the Classical Model, due to the attainment of full capacity by the
economy.
Unlike the Classical Model, the Keynesian Model of economic growth reconciles both
the paradigms of short run fluctuations in the economies and the long run stable growth
trends in the economy. The model attributed the short run fluctuations in the economic trends

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of the countries to that of the presence of business cycle and the dynamics in the same
(Lavoie 2014).
Macroeconomic objectives of the governments of different countries
The governments of different countries, in general, aims to take their countries on the
path of long and sustained economic growth and all-round development. In doing so, the
governments usually have several macroeconomic objectives, which primarily includes that
of reduction of inflation, unemployment, increase in the economic growth trends (both short
term as well as long term) and also of that of achieving Balance of Payments. However, in
doing so, the governments and policy makers often face different trade-offs between the
macroeconomic variables and outcomes (Argy 2013). Keeping this into consideration, the
following sections of the assignment, try to discuss the policy implications of both the
models.
Policy implications of the Classical Growth Model
Being primarily a supply-side model of growth, the primary assertion of the Classical
Model, is that long run stable growth trends in an economy cannot be achieved by
implementing demand-side policies as in the long run, according to the concerned model, due
the presence of inelastic LRAS curve, the policies of increasing and stimulating demand
would lead to creation of inflationary pressures on the economies (Canto, Joines and Laffer
2014). Thus, the model implies that to enhance the growth in an economy in the long run, the
governments should employ supply side policies.
According to the notions of the Classical Model, the supply side policies can include
those of implementation of training programmes for the purpose of skill developments the
workers, increase in the level of both private and public investments in the aspects of
technological and infrastructural developments, attracting investments in the industrial

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sectors in the economy (Fernández-Villaverde, Guerrón-Quintana and Rubio-Ramírez 2014).
These supply side policies can lead to the increase in the long run aggregate supply, by
increasing the full employment or full capacity thereby shifting the vertical LRAS curve
towards the right, the effects of which can be seen as follows:
Figure 4: Effects of supply side policies in positively influencing growth in the economy
(Source: Open.lib.umn.edu 2018)
As is evident from the above figure, with the implementation of the growth enhancing
supply side policies, on part of the government of a country, the supply curve shifts to the
right and leads to an increase in demand, which in turn increases the Real GDP of the
country, without exerting considerable upward pressures on the price levels (Copeland and
Taylor 2013).
Keeping this notion of usage of supply side policies into consideration, the different
macroeconomic objectives of the government can be achieved in the following manners:
For reduction of inflation

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Higher level of inflation affects the consumption behaviour of the population of a
country adversely, thereby having negative implications on the overall economic health of the
concerned country, thereby making reduction of inflation levels one of the primary objectives
of the government of the country.
Under the Classical theoretical framework, this can be achieved by increasing the
productivity of a nation, by encouraging the industries to become cost and resource efficient,
attaining economies of scale (Copeland and Taylor 2013). This can lead to the increase in the
LRAS, which in turn, can help in reduction of the price levels in the economy, as shown
below:
Figure 5: Increase in productivity leading to fall in price
(Source: Open.lib.umn.edu 2018)
This in turn indicates that the implementation of supply and productivity increasing
policies can help the economies to avert cost-push inflation. However, this policy may take
long time for increasing the long run supply and this policy framework does not take into
account the possibilities of demand-pull inflation in the economy (Kalecki 2013).
For reduction of unemployment

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The Classical theory suggests that with the implementation of expansionary supply
side policies, leading to high productive activities, more job scopes can be created, thereby
decreasing the problems of unemployment in the country. However, the concerned model
does not take into account the unemployment problems which occur during periods of
abnormal economic stagnations and recessions, thereby making the policy generic to a
considerable extent.
For stabilising BOP
The supply side economics asserts that rise in productivity, brought by the supply side
policies can lead to higher competencies and efficiencies among the production entities of the
country, thereby increasing the demand for their cost efficient and quality products in the
international scenario, which may help the governments of the concerned countries to
increase and stabilise their balance of payments (Kalecki 2013).
Policy Implications of Neo Keynesian Model
The policy framework of Keynesian Model is based on the assumptions of the
fluctuations of the business cycles which are assumed to have considerable influences on the
productivity, consumption and investment levels in the economy. This model helps in
studying the interactions between the monetary policies and productivity growth in the
economy.
Stabilisation Policies and Long Run Growth
In this framework, the consumption demand patterns of households depend on their
future income expectations and stagnation of growth can be a fallout of weak aggregate
demand in the country. Taking this into consideration, this model recommends demand
boosting policies, at least to a certain extent, in order to stimulate the growth in the economy
(Arestis 2012). In the situations of low or medium economic activities (horizontal and

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positive LRAS region) if the government facilitates increase in demand by expansionary
policies, then the growth in the economy can be facilitated, as can be seen with the help of the
following figure:
Figure 6: Demand enhancing policies in Neo Keynesian Framework
(Source: Arestis 2012)
The Neo Keynesian growth model, thus emphasizes on the business cycles and the
importance of monetary policies on the productivity, investment and overall economic
growth of the countries.
Neo Keynesian and Classical Supply Side Policies for long-term growth
From the above discussion, it can be asserted that the government of the concerned
country can implement supply side (AS-targeted) policies under the Classical framework or
demand side (AD-targeted) policies in the Neo Keynesian framework. The Classical supply
side policies may include those of free market policies like trade liberalisation, privatisations,
deregulations and policies of tax cuts and others. The free market supply side policies, in the
domain of Classical Growth Model, also includes the aspects of trade unions (Fitoussi and
Saraceno 2013). The decrease in the dominance of the trade unions can help in facilitating

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free market dynamics, which in turn help in increasing the efficiencies and productivity in the
labour markets of the countries and also in keeping the wage in the equilibrium level, thereby
facilitating higher employments and job creations.
On the other hand, they may also include interventionist supply side policies like that
of training and education programmes, building of infrastructural aspects and similar policies.
These policies may also include investment on part of the governments to improve the
aspects of healthcare in the economy as much of the skill development and productivity
aspects of the workers depend on their overall health conditions. All these policies can in turn
help in facilitating the economic growth of a country (Keynes 2018).
On the other hand, the Neo Keynesian framework can also be used by the
governments to employ demand side policies which may involve fiscal policies like that of
reduction of taxes, increasing government expenditure as well as monetary policies like that
of reduction of rate of interests, in order to ensure the growth in the concerned economies.
The monetary policies, under the domain of Neo Keynesian framework, are generally used as
common tools, especially to facilitate economic growths in situations of negative output and
the same can be done by reduce interest rate thereby influencing the AD positively (Keynes
2018). On the other hand, lowering the tax levels with the help of fiscal policies can help in
increasing the disposable income of the population of the country, thereby increasing the AD
in the country, which in turn by influencing the aggregate supply can lead to growth of the
productivity in the economy.
However, these expansionary policies have the threats of inflationary pressures and
also the chances of the government sector borrowing crowding out the growth of the private
sector as in most cases the government of the countries borrow from the private sectors.
Examples of Neo Keynesian and Classical Policies in the UK Government Policy Framework

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The contemporary economy of the United Kingdom and the government policies in
this domain show the evidences of the presence of both the Neo Keynesian and Classical
aspects, which can be shown with the help of the following instances:
Instances of expansionary fiscal policies- After the recessionary situation arising from the
Global Financial Crisis, the government of the country could be seen to implement
expansionary fiscal policies in the form of increased government expenditures, which in turn
led to an increase in the government borrowing, which in turn was considerably acquired
from the private sector (King 2016).
Free market policies- The government of the UK, can also be seen to be employing free
market policies in the labour market in order to bring more flexibilities in the market, thereby
making it easier for the firms to hire workers and keep the wages in the equilibrium levels,
thereby leading to higher economic growth in the long run.
Figure 7: Unemployment dynamics in UK over the years

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(Source: Theconversation.com 2018)
Expansionary monetary policies- The UK government can also be seen to be lowering rate of
interest in 2009-2010, in order to come out of the recessionary situation. However, this did
not prove to be an effective policy for long term growth of the economy (Joyce et al. 2012).
Supply enhancing policies- UK government can also be seen to be emphasizing on improving
the relationships with the unions in order to increase the workers productivity as well as wage
scenarios in the country, thereby aiming to improve the economic growth of the country.
Conclusion
The above discussion makes it evident that the Neo Keynesian as well as Classical
policies, differing in terms of characteristics and focus on the demand and supply side, have
considerable implications on the economic scenario of the world and also influences the real
policy making scenarios of the governments considerably. Both of these policy frameworks
have their inherent advantages as well as limitations and judicious implementation of their
different components can help in attaining long-term growth rate. This can also be seen in the
economic scenarios of the UK, as can be seen from the different policies taken by the
government of the country at different points of time, especially in the recessionary and
financial crisis period in order to facilitate higher economic growth in the concerned country.

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