The Classical Theory
As we learned, “The father of economics”, Adams Smith’s explanations of national economic living standards became known as the Classical Theory. In the 18th and 19th century, economies have developed really fast. Besides of that, so many theories have been discussed to explain changing circumstance. Classical theory held the balance of power in economic circles, but it began to lose it at the time of the Great Depression of the 1930s. Classical theory had difficulty in explaining why the depression kept getting worse, and it pushed the birth of Keynesian Theory.
How to define the Classical Theory? What is the context of it? The term “Classical” ...view middle of the document...
Savings is equal by investment. If businesses need more money to invest, the interest rate will go up to encourage people save more. If businesses want few funds, the interest rates will go down. In addition, flexible wages and prices will maintain constant consumption. Classical theorists thought those cause-and-effect relationships could maintain price stability and full employment.
As the Depression continued in the 1930s, people began to question the Classical Theory. The Keynesian Theory was published by John Maynard Keynes. He believed that a depression would not automatically adjust to full employment.
He proposed that government must actively intervene to promote restoration to full employment. Keynesian economics recognized the many cause-and-effect interactions in our macro economy. This model emphasized the importance of aggregate demand. According to Keynes, savings, consumption and investment determine business cycles. Savings and investment were seldom equal, because they result from different motives. Furthermore, Keynes’s concern of monopoly power could prove that wages and prices were not totally flexible.
The relationship of Aggregate Demand which includes spending for consumption, business investment, government projects and exports to Aggregate Supply which includes employment, output and income determines economic...