agram five determines the interest rate, r, which is expressed as a percentage per period and depends upon the interaction of the savings and investment functions. The investment function, I, shows that the lower the rate of interest, the higher the amount of investment. The savings function, S, shows that the higher the rate of interest, the more will be saved. Because of the Classical dichotomy, diagram five is basically to show the breakdown of the use of income, or the demand for output, between expenditure on consumption and new capital goods. Like the Classical model, the Keynes model can also be explained by using five diagrams that are shown in Appendix Two, Keynes model. This is about the only similarity between the two. In the Classical model, all markets cleared. This is not true for the Keynes model, where flexible wages and prices do not bring about simultaneous market clearing, which means its not inherently self-regulating. The labor market will not clear in the Keynes model, which can be seen in Diagram five that shows involuntary unemployment. Also, the arguments are not connected to wage and price rigidity as they are in the Classical model. On the subject of rigidities, Keynes also rejected Pigou's explanation for unemployment, which is basically the Classical models explanation. Keynes said that imperfections are not the source of unemployment, but other policy initiatives are required and not the removal of the imperfections. Keynes assumes there are only two assets households can hold, which are money and bonds. Bonds represent non-monetary options. Money has different effects on the economy in these models. Because of the Classical dichotomy, only the nominal sector is effected by money in the classical model. But in the Keynes model, many things are effected by money. First, the interest rate decreases, which causes an increase in bond prices. The decrease in interest rate causes an increase in investment and the...
