Classical vs. Keynesian Adam Smith 1723-1790 John Maynard Keynes 1883-1946

Debates Over Aggregate Supply Classical Theory A change in AD will not change output even in the short run because prices of resources (wages) are very flexible. AS is vertical so AD can’t increase without causing inflation. AS Price level AD Qf Real domestic output, GDP

Debates Over Aggregate Supply Classical Theory A change in AD will not change output even in the short run because prices of resources (wages) are very flexible. AS is vertical so AD can’t increase without causing inflation. AS Recessions caused by a fall in AD are temporary. Price level Price level will fall and economy will fix itself. No Government Involvement Required AD AD1 Qf Real domestic output, GDP 3

Debates Over Aggregate Supply Keynesian Theory A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession doesn’t cause inflation AS Price level AD Qf Real domestic output, GDP 4

Debates Over Aggregate Supply Keynesian Theory A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession puts no pressure on prices AS Price level “Sticky Wages” prevents wages to fall. The government should increase spending to close the gap AD AD1 Q1 Qf Real domestic output, GDP 5

Debates Over Aggregate Supply Keynesian Theory A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession puts no pressure on prices AS When there is high unemployment, an increase in AD doesn’t lead to higher prices until you get close to full employment Price level AD3 AD1 AD2 Q1 Qf Real domestic output, GDP 6

The Ratchet Effect 7

The Ratchet Effect A ratchet (socket wrench) permits one to crank a tool forward but not backward. Like a ratchet, prices can easily move up but not down! 8

Does deflation (falling prices) often occur? Not as often as inflation. Why? If prices were to fall, the cost of resources must fall or firms would go out of business. The cost of resources (especially labor) rarely fall because: Labor Contracts (Unions) Wage decrease results in poor worker morale. Firms must pay to change prices (ex: re-pricing items in inventory, advertising new prices to consumers, etc.) 9

Three Ranges of Aggregate Supply 1. Keynesian Range- Horizontal at low output 2. Intermediate Range- Upward sloping 3. Classical Range- Vertical at Physical Capacity AS Price level Classical Range Keynesian Range Intermediate Range Qf Real domestic output, GDP 10

The Phillips Curve Shows tradeoff between inflation and unemployment. What happens to inflation and unemployment when AD increase?

In general, there is an inverse relationship between unemployment and inflation 12

Short Run Phillips Curve When the economy is overheating, there is low unemployment but high inflation Inflation When there is a recession, unemployment is high but inflation is low 5% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% SRPC 2% 9% Unemployment 13

Short Run Phillips Curve What happens when AS falls causing stagflation? Increase in unemployment and inflation Inflation 5% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment SRPC1 1% SRPC 2% 9% Unemployment 14

Short Run vs. Long Run What happens when AD increases? What happens in the long run? Long Run Phillips Curve Inflation In the long run, wages and resource prices increase. AS falls. SRPC shifts right. 5% 3% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment SRPC1 1% SRPC 2% 5% 9% Unemployment 15

Short Run vs. Long Run Long Run Phillips Curve In the long run there is no tradeoff between inflation and unemployment Long Run Phillips Curve Inflation 5% The LRPC is vertical at the Natural Rate of Unemployment 3% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% 2% 5% 9% Unemployment 16

What happens when AD falls? What happens in the long run? Short Run vs. Long Run What happens when AD falls? What happens in the long run? Long Run Phillips Curve Inflation 5% In the long run wages fall and there is no tradeoff between inflation and unemployment 3% Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% SRPC SRPC1 2% 5% 9% Unemployment 17

AD/AS and the Phillips Curve

AD/AS and the Phillips Curve Show what happens on both graphs if AD increase LRPC Price Level LRAS Inflation AS PLe AD1 AD SRPC QY GDPR UY Unemployment 19

AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC with the recessionary gap. What happens when AD falls? Price Level LRAS LRPC Inflation AS PLe AD SRPC AD1 QY GDPR UY Unemployment 20

AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC at full employment. What happens when AS falls? Price Level LRAS LRPC Inflation AS1 AS PLe SRPC1 AD SRPC QY GDPR UY Unemployment 21

AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC with an recessionary gap. What happens when AS goes up? Price Level LRAS LRPC Inflation AS AS1 PLe SRPC AD SRPC1 QY GDPR UY Unemployment 22

SRAS LRPC LRAS Price Level Inflation SRPC QY GDPR UY Unemployment 23

SRAS LRPC LRAS Price Level Inflation PLe AD2 AD SRPC AD3 QY GDPR UY Unemployment 24

AS1 SRAS LRPC LRAS Price Level Inflation AS2 PLe SRPC1 AD SRPC2 SRPC QY GDPR UY Unemployment 25

AS AS2 LRPC LRAS Price Level Inflation PLe SRPC1 AD2 AD SRPC QY GDPR UY Unemployment 26

Analyzing the Economy Graphically 27

PPC Business Cycle AD/AS Phillips Curve Use the following models to show full employment, a recessionary gap, and an inflationary gap. PPC Business Cycle AD/AS Phillips Curve 28