Question

1.

a. Why did the classical macroeconomic school of thought lose its credibility during the 1930s?

b. Explain today’s consensus of the school of thought behind the macroeconomic theory.

Answer 1

1.

a.

Classical Theory is based on the idea of "Laissez-Faire". It says the economy is self-adjsuting and is capable of reaching at natural level of output on its own through supply-demand interactions. The theory discourages the role of the Government in solving macroeconomic issues. They assumed full wage and price flexibility.

During the Great Depression, many firms went bankrupt due to sudden fall in the stock prices. Consumer confidence, therefore, turned negative about the future outlook of the economy. Consumers started spending less and save more money. The demand for money in the hands of the public increased manifold. On the production side, lower consumer spending lead to fall in aggregate demand. Lower AD discouraged the producers to produce more. As a result, output fall and the wages of the workers started showing negative trend. But during this time, both prices and wages becomes rigid so much so that the imbalance between demand and supply created huge unemployment. The old classical theory suggestions failed as the equilibrium between demand and supply could not be maintained.

Due to these reasons, the Classical theory lost its credibility during 1930s.

b.

Today's consensus has been synthesis of New Classical and New Keynesian Macroeconomics. This is called New Neoclassical Synthesis. Both gives micro-foundations to the old Classical and Keynesian systems.

New Classicals, on one hand, assumes that markets clear themselves and the short-run disruptions in the technology leads to the emergence of Real Business Cycles.

New Keynesians, on the other hand, shows that price and wages are not flexible and does not adjust quickly. Such rigidities lead to involuntary unemployment