1. IB Economics Macroeconomic Models The New Classical Perspective 2

2. What is the New Classical perspective? 3 New Classical Perspective Price Mechanism Regulates markets Full Employment achieved without intervention The Economy is an Harmonious system Perfect Competitive Equilibrium Sets the Benchmark

3. The New Classical LRAS? 4 In the Long Run all resources including wages change to match changes in the price level LRAS is vertical (perfectly inelastic) at potential GDP or full employment level of GDP Potential GDP is independent of the price level

4. New Classical (Free Market) LRAS 5 LRAS perfectly inelastic at Full Employment Level of Output (Ymax) Potential Output = Quantity and Quality of FOPs not Price

5. Why is the LRAS vertical? 6 Prices increase 5% in the SR but inputs have not yet changed in price. Firms make a quick 5% profit and increase output But in the LR prices of inputs rise by 5% Therefore Firms have no incentive to increase output

6. Implications of the New Classical LRAS a ? 7 In time any inflationary or recessionary gap will disappear and the economy will move to full employment Government do not need to intervene in the market In the LR increases in AD will not impact real GDP but only bring about inflation

7. Long-run equilibrium 8

8. Long-run equilibrium and Decline in AD 9

9. Return to Long-run equilibrium 10

10. Long-run equilibrium 11

11. Long-run equilibrium and Increase in AD 12

12. Return to Long-run equilibrium 13

13. What is the Keynesian perspective? 14 Keynesian Perspective Price Mechanism fails as wages are “downward sticky” Achieving Full Employment needs intervention The Economy is inherently unstable. The economy can get stuck in the SR

14. The Keynesian SR/LRAS? 15 Wages and prices are unlikely to fall during periods of recession. Wages and prices are “downward sticky”. Sticky prices are explained through the actions of oligopolies who fear a prices and unions who resist wage cuts. Potential GDP is independent of the price level because inflexibility of wages and prices stops the economy moving into the LR.

15. Keynesian SR/LRAS 16 Segment 1: Spare capacity in the economy, LRAS perfectly elastic Segment 2: Spare capacity utilized, FOPs’ prices rise Segment 3: Economy at maximum capacity LRAS perfectly inelastic

16. Keynesian SR/LRAS 17  Keynes argued that as there is nothing inherent in the economy to move the SR into the LR, then SRAS = LRAS NB  In diagrams taking a Keynesian you may see the AS curve labeled Keynesian AS or simply LRAS as long as the diagram’s title makes clear which perspective is being adopted

17. Implications of the Keynesian SR/LRAS 18 Wages and prices are downward sticky Unemployment and low incomes may persist in times of recession and depression. The government must intervene using fiscal and monetary policy to increase AD

18. Recessionary Gap in the Keynesian Perspective 19 LRAS

19. Inflationary Gap in the Keynesian Perspective 20

20. Full Employment Equilibrium in the Keynesian Perspective 21

21. Economic Growth: Improved Quantity & Quality of FOPs 22 Higher efficiency Reduction in NRU Greater quantity of resources Higher quality FOPs Better Techn- ology

22. Economic Growth: New Classical Perspective 23

23. Economic Growth: Keynesian Perspective 24