Classical and Keynesians View on Fiscal Policy for Recessionary Gap

Compare and contrast the role that fiscal policy plays in alleviating a recessionary (output) gap in both the classical and Keynesian models.

A recessionary gap exists if the existing level of aggregate production is less than what would be produced with the full employment of resources.

The Keynesians and classicalists both agree that an aggregate demand shock will cause output to fall in the short run but not in the long run and the economy’s level of output will eventually return from its recessionary level to its full employment level. However they both disagree on the time that it takes for the economy to reach the long run. According to the classicalists prices adjust quite rapidly to imbalances in quantities supplied and demanded so that the economy gets to its long-run equilibrium quickly. Because the adjustment takes place quickly, classical economists argue that little is gained by government actively trying to fight recessions. In contrast to the classical view, Keynesian economists argue that prices and wages do not adjust quickly in response to shocks. Hence the return of the economy to its long run equilibrium may be slow, taking perhaps years rather than months.(take example from Lecture). Because of these different views classical and Keynesians have contrasting views about the government policy in fighting recessions.

The belief fiscal policies can be used to influence macroeconomic performance is most closely associated with Keynes and his followers. The Keynesians due to their lack of confidence in the self-correcting powers of the economy tend to see an important role for the government in alleviating a recessionary gap unlike the classical who view that fiscal are unnecessary because there are market mechanisms—for example, the flexible adjustment of prices and wages—which serve to keep the economy at or near the natural level of real GDP at all times. Accordingly, classical economists believe that the government should run a balanced...