Classical and Keynesian Macro Analyses Chapter 11 Classical and Keynesian Macro Analyses

Introduction Among the many factors influencing the rate of GDP growth is the volume of business regulation. Concerns about terrorism have multiplied the amount of documentation that must accompany cargo arriving in U.S. ports. How does this affect real GDP?

Learning Objectives Discuss the central assumptions of the classical model Describe the short-run determination of equilibrium GDP and the price level in the classical model Explain the circumstances under which the short-run aggregate supply curve may be either horizontal or upward-sloping

Learning Objectives Understand what factors cause shifts in the short-run and long-run aggregate supply curves Evaluate the effects of aggregate demand and supply shocks on equilibrium real output in the short run Determine the causes of short-run variations in the inflation rate

Chapter Outline The Classical Model Equilibrium in the Labor Market Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve Output Determination Using Aggregate Demand and Aggregate Supply

Chapter Outline Determinants of Aggregate Supply Effects of a Weaker Dollar

Did You Know That... Different approaches to economic analysis have different views of price flexibility? The Keynesian approach emphasizes the idea that prices of final goods and services may be slow to respond to higher input prices?

The Classical Model The classical model was the first attempt to explain fluctuations in: Inflation Output Income Employment Consumption Saving Investment

The Classical Model Assumptions of the classical model Pure competition exists Wages and prices are flexible People are motivated by self-interest People cannot be fooled by money illusion

The Classical Model Consequences of the assumptions Minimize the role of government in the economy If all prices and wages are flexible, any problems in the macroeconomy will be temporary The power of the market will keep the economy at full-employment in the long run

The Classical Model Say’s Law Supply creates its own demand. Producing goods and services generates the means and the willingness to purchase other goods and services.

Equating Desired Saving and Investment in the Classical Model 14 Desired Investment 12 10 8 Interest Rate (percent) 6 4 2 600 700 800 900 Investment and Saving per Year ($ billions) Figure 11-2

Equating Desired Saving and Investment in the Classical Model Summary Changes in saving and investment create a surplus or shortage in the short run. In the long run, this is offset by changes in the interest rate. This interest rate adjustment returns the market to equilibrium where S = I.

The Classical Model Question Answer Would unemployment be a problem in the classical model? Answer No, classical economists assumed that the wage would always adjust to the full employment level.

Example: Will Low Rates of Personal Saving Choke Off Investment Spending? Personal saving rates have fallen dramatically in the U.S. over the past decade. But rates of gross private domestic investment are steady. Firms have been able to access sources of financing other than personal saving, such as their own retained earnings and funds invested by foreigners.

The Classical Model of the Labor Market Figure 11-3

The Classical Model of the Labor Market Table 11-1

Classical Theory and Vertical Aggregate Supply In the classical model, long-term unemployment is impossible The long-term aggregate supply curve is the only one the matters. Rapid adjustment of prices and wages will move the economy to an equilibrium position on the long-run curve.

Classical Theory and Increases in Aggregate Demand LRAS Observations Increase in AD creates disequilibrium Quantity AD (Y1) > Quantity AS (Y0) AD2 AD1 Price Level A1 120 E1 Y1 Real GDP per Year Figure 11-4

Classical Theory and Increases in Aggregate Demand LRAS Observations Price level increases returning the economy to equilibrium P = 120, Real GDP = Y0 Only the price level changes Real GDP supply determined AD2 AD1 E2 130 Price Level A1 120 E1 Y1 Real GDP per Year Figure 11-4

Effect of a Decrease in Aggregate Demand in the Classical Model Figure 11-5

Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve Some assumptions Prices are not flexible Short-run approach

Demand-Determined Output Equilibrium AD1 Price Level Y1 P0 SRAS Real GDP per Year Figure 11-6

Demand-Determined Output Equilibrium With excess capacity, increases in AD increase equilibrium real national income, and the price level does not change. AD1 AD2 Price Level Y1 P0 SRAS Y2 Real GDP per Year Figure 11-6

Demand-Determined Output Equilibrium AD3 AD1 AD2 Price Level Y1 P0 SRAS Y3 Y2 Real GDP per Year Figure 11-6

Real GDP and the Price Level, 1934–1940 Figure 11-7

The Keynesian Short-Run Aggregate Supply Curve The Keynesian model Sources of price rigidities Union contracts Long-term contracts for raw materials, etc. AD determines equilibrium real GDP Capitalism may not be self-regulating

The Keynesian Short-Run Aggregate Supply Curve The impact of a change in AD differs depending on the shape of the SRAS. In the Keynesian model, the SRAS curve has one portion that is flat, and another portion that is upward-sloping.

Income Determination with Fixed versus Flexible Prices SRAS LRAS AD1 AD1 Price Level SRAS 120 12 120 12.0 Real GDP per Year ($ trillions) Real GDP per Year ($ trillions) Figure 11-8

Income Determination with Fixed versus Flexible Prices SRAS 12.0 LRAS AD2 AD2 AD1 AD1 130 12.5 Price Level SRAS 120 12 120 13 Real GDP per Year ($ trillions) Real GDP per Year ($ trillions) Figure 11-8

Income Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing Price Levels The Keynesian model Rigid prices Short-run view AD determines output The classical model Flexible prices Long-run view LRAS determines output

Shifts in Both Short- and Long-Run Aggregate Supply Figure 11-9

Shifts in SRAS Only Figure 11-10

Determinants of Aggregate Supply Changes that cause an increase in aggregate supply: Discoveries of new raw materials Increased competition A reduction in international trade barriers Fewer regulatory impediments to business An increase in labor supplied Increased training and education A decrease in marginal tax rates A reduction in input prices

Determinants of Aggregate Supply Changes that cause a decrease in aggregate supply: Depletion of raw materials Decreased competition An increase in international trade barriers More regulatory impediments to business A decrease in labor supplied Decreased training and education An increase in marginal tax rates An increase in input prices

Consequences of Changes in Aggregate Supply and Demand Aggregate Demand Shock Any shock that causes the aggregate demand curve to shift inward or outward Aggregate Supply Shock Any shock that causes the aggregate supply curve to shift inward or outward

The Short-Run Effects of Stable Aggregate Supply and a Decrease in Aggregate Demand: The Recessionary Gap Figure 11-11

The Short-Run Effects of Stable Aggregate Supply and an Increase in Aggregate Demand: The Inflationary Gap Figure 11-12

The Effects of Stable Aggregate Demand and a Decrease in Aggregate Supply: Cost-Push Inflation Figure 11-14

International Example: Korea Experiences Cost-Push Inflation Winds and flooding from Typhoon Maemi in September 2003 caused significant damage to Korea’s infrastructure and productive capacity. We depict this as a leftward shift of short-run aggregate supply, with a corresponding temporary decline in real GDP.

International Example: Korea Experiences Cost-Push Inflation Figure 11-15

The Effects of a Weaker Dollar Decrease in the value of the dollar raises the cost of imported inputs. SRAS decreases With AD constant, the price level rises GDP decreases Figure 11-16, Panel (a)

The Effects of a Weaker Dollar Decrease in the value of the dollar makes net exports rise. AD increases With SRAS constant, the price level rises along with GDP Figure 11-16, Panel (b)

Issues and Applications: An Aggregate Supply Shock in Cargo Measures contained within the 2002 Trade Act require transportation companies to give prior notice to U.S. government officials of shipments arriving internationally. The costs of complying with this regulation have caused an aggregate supply shock.

Summary Discussion of Learning Objectives The four assumptions of the classical model are: Pure competition Completely flexible wages and prices People are motivated by self-interest No money illusion

Summary Discussion of Learning Objectives Both the short-run and long-run aggregate supply curves are vertical at the full employment level of output. If output prices and wages and input prices are “sticky,” the short-run aggregate supply curve can be horizontal.

Summary Discussion of Learning Objectives Both the long-run and short-run aggregate supply curves will shift due to changes in resource endowments and technology. Changes in resource prices cause the SRAS curve to shift. Aggregate demand and supply shocks change the equilibrium level of real output in the short-run.

Summary Discussion of Learning Objectives Causes of short-run variations in the inflation rate: An increase in aggregate demand A decrease in short-run aggregate supply

Classical and Keynesian Macro Analyses End of Chapter 11 Classical and Keynesian Macro Analyses