Question

Imagine that the U.S. economy falls into depression. Explain the recommendations of a Keynesian economist to correct the problem. Would a Classical economist agree? Why or why not? What would they suggest?

Answer 1

During economic depression, aggregate demand falls. Keynesians will advise government intervention by increasing government spending and/or decrease in tax, or central bank intervention of increasing money supply, to boost aggregate demand. But Classical economists will disagree, since Classical economics believes in the self-correcting mechanism. They would argue that in absence of intervention, lower price level (due to lower aggregate demand) will reduce input costs for firms and firms will increase output. Eventually, new long run equilibrium will be established at a higher real GDP and output at a further lower price level.