1. Classical vs. Keynesian
Adam Smith
John Maynard Keynes

2. 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

3. 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

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 doesn’t cause inflation AS
Price level AD Qf
Real domestic output, GDP 4

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
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

6. 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

7. The Ratchet Effect 7

8. 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

9. 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

10. 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

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

12. In general, there is an inverse relationship between unemployment and inflation12

13. 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

14. 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

15. 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

16. 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

17. 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

18. AD/AS and the Phillips Curve

19. 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

20. 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

21. 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

22. 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

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

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

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

26. AS AS2 LRPC LRAS Price Level Inflation PLe SRPC1 AD2 AD SRPC QY GDPRUY
Unemployment 26

27. Analyzing the Economy Graphically27

28. 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