Theories, Models, and The Fundamental Macro Debate zOur first venture into theories and models in macroeconomics. zTheory -- An assertion about the causes of observed behavior, in order to predict outcomes. zModel -- A formalization of a theory, done to make concise predictions.

Classical Versus Keynesian Macroeconomic Theories -- The Fundamental Debate

Classical Thought -- The Economy (Adam Smith) zClassical Macroeconomics -- Because the nominal wage rate (W), prices (P), and interest rates (i) are flexible, the economy will automatically correct itself without need of policy.

Classical Response to a Sluggish Economy (Y < Y N ) zW   labor more attractive to hire zP   goods and services cheaper to purchase zi   cheaper cost of borrowing, prompting more durable goods consumption and investment

Keynesian Thought -- The Economy (1936) zKeynesian Macroeconomics -- Because the nominal wage rate (W), prices (P), or interest rates (i) are inflexible, the economy will not automatically correct itself, and therefore needs overt policy.

Possible Reasons for Inflexibility or Stickiness zW  long-term labor contracts zP  costly for firms to change prices for goods and services they produce zi  Federal Reserve target variable for monetary policy

Practical Thoughts -- Classical Vs Keynesian zThere are several Keynesian models, all based upon inflexibility. zWas the Great Depression an aberration? zWhat better represents the macroeconomy? zHow long is the short-run?