The basic difference between classical model and the Keynesian model lies in the assumption of :

Question

Accepted Answer

The correct option is 1:

The fundamental difference between the Classical model and the Keynesian model, which revolutionized macroeconomics, hinges primarily on the assumption regarding money wages (nominal wages). The Classical economists believed in perfect market flexibility, assuming that money wages were perfectly flexible downwards. If unemployment existed, wages would fall until the labor market cleared and full employment was automatically restored. This flexibility ensures that the economy operates at full employment in the long run. In stark contrast, John Maynard Keynes argued that in reality, money wages are **rigid** (or sticky), especially downwards, due to factors like labor contracts, unions, efficiency wage theory, and psychological resistance among workers to wage cuts. This downward rigidity prevents the labor market from clearing quickly, meaning involuntary unemployment can persist indefinitely, justifying government intervention through fiscal policy to restore demand.

The incorrect option is 2: Rigid money supply
Both the Classical and the Keynesian models generally treat the money supply as an exogenously determined policy variable, meaning the central bank can change it. The difference between the two models does not fundamentally lie in the rigidity or flexibility of the money supply itself.

The incorrect option is 3: Demand for money
While Keynes introduced a revolutionary theory of money demand (Liquidity Preference Theory, including speculative demand), which differs significantly from the Classical quantity theory, this is a consequence of their differing views on the labor market and price/wage flexibility, not the foundational difference.

The incorrect option is 4: Real interest rate
Both models incorporate the real interest rate into their frameworks, though they differ on how it is determined. Classical economists believed the real interest rate is determined by saving and investment in the loanable funds market, whereas Keynes linked investment more to expected profits and the interest rate itself to monetary factors (though the real interest rate remains an important variable). The core distinguishing assumption remains wage flexibility.