Classical and Neo Keynesian Models for Achieving Long Term Growth

Running head: BUSINESS ECONOMICS
Business Economics
Name of the Student
Name of the University
Author Note

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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