2 Classical Theory Review All resources fully usedNo unused capacityFull employment/ Supplied determinedEconomy is flexible- Prices, wages, savings, investment, resources, labor, etc., all moving towards equilibrium based on market forces (supply/demand)Shift of AD only changes price level not output (GDP)No short run equilibrium - Recessions are temporary and economy always adjusting back to LRAS
3 Classical vs. Keynesian The Classical ModelFlexible pricesLong-run viewLRAS determines outputThe Keynesian ModelRigid pricesShort-run viewAD determines output
4 Keynesian Foundations Post WWI- Europe in economic declineGreat Depression- 1930’sBasis for John Maynard Keynes and his theories.If classical approach was correct then,economy would have corrected itself-BUT IT DIDN’T!
5 Classical Theory and a Decrease in Aggregate Demand Q0LRASAccording to KeynesPrice level will not decrease back to LRAS when AD decreasesCLASSICAL THEORY IS WRONG SAYS KEYNES!AD1AD2110E1Q1100E2Price LevelReal GDP per Year
6 Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve Some Different Assumptions1) Short-run approach to the macroeconomy2) Concentrated on reasons for continuing recessions3) Horizontal portion of AS curve is called the Keynesian short-run AS.
7 Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve 4) Prices are not flexible/demand shocks will not raise or lower prices- it will only affect output (Real GDP)5) Level of output is “demand determined” and the price level is constant6)The SRAS curve assumes high unemployment and unused capacity
8 Demand Determined Income Equilibrium With excess capacityincreases in ADincreases equilibriumreal national incomeand the price level doesnot changeQ3AD3SRASAD1Q2AD2Price LevelQ1P3With prices stickydownward decreasesin AD will decreasereal national incomeand the price leveldoes not changeReal GDP per Year
9 Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve Big Question is WHY the SRAS is Horizontal,and prices are constant and not flexible?“Sticky” wages make involuntary unemployment possibleTherefore since wages will not be cut to employ all workers- wages will remain the same for some while others will remain unemployedThus the “classical” view of full employment no longer holds true- economy is not self-regulatingPrice of wages are “sticky” downwardLabor unions and long term contracts make downward inflexibility of the nominal wage not possibleAlso employers unwilling to cut wages because they feel workers would not work as hard—loss of productivity
10 Keynesian Analysis of the Great Depression 1929 unemployment -- 3%End of 1929 unemployment -- 9%1933 unemployment -- 25%1929 Real GDP not reached until 1937Real GDP fell from $1 trillion to $700 billion1933 economy operated at 30% below potential
11 Keynesian Analysis of the Great Depression LRASAD1933AD1929SRAS100E11.0E20.7Price LevelAFollowing the decreasein AD the price levelwould have had to dropto point A to avoidUnemployment as Classical theorists support--it did not!Real GDP per Year($ trillions)
13 Final Thoughts on Keynes So in situations of excess capacity and large amounts of unemployment—the price level will NOT fall. Instead what occurs is continued unemployment and reduced GDPGeneral economy wide equilibrium can occur and endure even if there is excess capacityCapitalism is NOT a self-regulating system sustaining full employmentAttack “classical” view that market forces would lead to equilibriumWhat is needed to push economy back to full equilibrium is consistent government spending/lower taxes to increase AD (fiscal policy) or an increase in the money supply (monetary policy)
14 Income Determination Using Aggregate Demand and Aggregate Supply: Fixed Versus Changing Price Levels The impact of a change in AD differs depending on the shape of the SRAS.PROBLEMS WITH THE KEYNESIAN SHORT- RUN?
15 Keynesian Horizontal Short-Run Doesn’t relate inflationPrices are not totally “sticky”AD1AD27Price LevelSRAS1206Real GDP per Year($ trillions)
16 Income Determination with Fixed Versus Flexible Prices The price levelis fixed and theincrease in ADincreases realGDP to $7 trillionis not fixed andthe increase in ADincreases bothprices and real GDPSRASLRASAD2AD1AD27AD1Price LevelPrice Level1306.5SRAS12061206.0Real GDP per Year($ trillions)Real GDP per Year($ trillions)
17 Modern Keynesian Short-Run Recognizes that some, but notcomplete, prices adjustments,made in the short run.MKSR relates therelationship between PLand Real GDP withincomplete price adjustmentsand incomplete info inthe short runSRASLRASAD2AD1Price Level1306.51206.0Real GDP per Year($ trillions)
18 Economic Growth in an Aggregate Demand and Supply Framework Keynesian macroeconomic analysis relates to short-run fluctuations in unemployment, inflation, and other macroeconomic variables.Over time, economic growth may occur with or without inflation.
19 Economic Growth, Aggregate Demand, and Aggregate Supply LRAS1LRAS2200SRAS1SRAS2AD1AD2150Price LevelE1E2With economic growth,LRAS1 and SRAS1shifts outward withno inflation1005078Real GDP per Year(trillions of 1992 dollars)