Macroeconomics models are ways of predicting the behavior of the economy. Two models dominate modern thinking: the classical model and the Keynesian model.
The classical model was popular before the Great Depression, a time of serious economic downturn in the 1930s. In this model, the economy is self-adjusting: in good times, wages and prices rise, while in bad times, wages and prices fall. Prior to the Great Depression, this model seemed to hold true, because small fluctuations occurred in the business cycle, an interval of expansion and contraction in the economy. The business cycle is normal for a healthy economy and tends to follow the economy's overall economic growth.
The Great Depression, however, represented a major failure of the classical model. The economy did not self-adjust, and the effects were severe and widespread. In response, the Keynesian model was developed, which posits that the economy does not self-adjust. The Keynesian model relies on governments to implement fiscal policies in order to stabilize economic fluctuations.
The classical economic theory, based on the ideas of Adam Smith, focuses on a long-run approach to achieving economic growth. Adam smith was a Scottish philosopher and economist who lived in the 18th century. The classical theory holds the economy will fluctuate around full-employment gross domestic product (GDP) and a rate of natural unemployment. Gross domestic product (GDP) is a measurement of a country's total economic output. Two assertions are made by the classical theory. First, the main focus is on economic growth or producing more output, which is determined at the full-employment level of GDP. Second, advocates of the classical theory assert that wages and prices are flexible and will adjust back to full-employment GDP in the long run. Therefore, intervention by the government to assist in economic downturns is not supported by the classical theory. In addition, the government should focus less on short-term fluctuations in GDP or on the business cycle and focus more on growing full-employment GDP, because the economy rebounds and returns back to full-employment GDP. If this is the case, then policy should focus on long-term growth in national productivity, which will lead to an increase in full-employment GDP. To help foster growth in national productivity, tax rates should be kept low, and an emphasis should be put on allowing businesses to make optimal investment decisions by increasing competition and removing monopolies. The classical theory strongly favors supply-side policies that help to increase and shift the long-run aggregate supply curve, thus increasing real GDP and keeping price levels low. Other policies the classical theory supports to achieve long-run economic growth are savings and investment, education, technology, and research and development. This model essentially translates to letting markets take the lead, and having an emphasis on long-run aggregate supply.
A tangential point to this idea is Say's law, which is the theory that supply creates its own demand. According to Say's law, when an individual produces a product or service, they get paid for that work, and are then able to use that income to demand other goods and services. The classical theory also views the Phillips curve as vertical, which implies that there is no negative relationship between unemployment and inflation in the long run. The argument is that the natural rate of unemployment is also vertical, and fluctuations in unemployment vary around this natural rate. Per the classical theory, an economy without the assistance from government adjusts back to its long-run potential output. The policy implication is that the government should instead keep inflation rates low.
While in the long run there is an upward trend toward the full-employment level of of GDP, the reality is that certain phases of the business cycles (recessions, troughs, contractionary phases) have a negative impact on lives. Unemployment affects families—the Great Depression is an example of the despair that can be caused by downturns. The return to full-employment GDP may take a long period of time. The Keynesian theory, initially proposed by John Maynard Keynes, a British economist in the 19th and early 20th centuries, argues that something should be done to smooth out business cycles (maintain a constant and positive GDP growth rate) to keep employment levels consistent and close to a rate of full employment and to keep inflation at a low, consistent rate.
Keynesian models focus on short-run fluctuations in the business cycle instead of solely focusing on long-term growth. The Keynesian view argues two points. First, aggregate demand (the overall demand for goods and services) is a key aspect with respect to production, because it provides incentives to hire labor and bring production closer to full-employment GDP. Second, in the short run, wages and prices are sticky (or rigid) as opposed to flexible. If prices and wages are sticky, they do not respond to increases or decreases in aggregate demand, and an excess of supply is created. The evidence for these proposals came directly from analyzing the Great Depression. During this era, production capacity did not change and there were no major supply shocks, yet there was a large-scale contraction in the economy. This would be a contradiction to Say's law, which would suggest that supply should have created the demand. It did not. Under the Keynesian view, the government should implement an expansionary fiscal policy (increase spending and reduce taxes) in cases of recessionary gaps and should implement a contractionary fiscal policy (reduce spending and increase taxes) in times of inflationary gaps. These policies focus on shifting aggregate demand to hopefully smooth out short-run fluctuations in business cycles.