Classical And Neo-Keynesian Models For Achieving Long-Term Economic Growth In The UK

Overview of Classical and Neo-Keynesian Models

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).

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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.

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 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).

Critical Evaluation of Classical and Neo-Keynesian Models

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:

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Figure 1: LRAS in the Classical Model

(Source: Benigno 2015)

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)

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 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.

Policy Implementation of Classical and Neo-Keynesian Models in the UK

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 of the countries to that of the presence of business cycle and the dynamics in the same (Lavoie 2014).

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.

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 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:

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).

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.

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).

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.

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 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.

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 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.

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

(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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