Macroeconomics 2

Abdul Hadi Ilman

Sumbawa University of Technology

What will we learn?

Trying to integrate two quite different schools of thought
New Classical vs Keynesian
Classical micro-foundation, and excluding market failure
Keynesian macro policy, and excluding micro-foundation
The development of the New Neoclassical Synthesis
a system that involved the Classical model determining full equilibrium,
and a Keynesian model of temporarily sticky prices determining the
approach to that full equilibrium
Short run issues: dynamics, expectations, and micro-foundations
Long run issues: natural unemployment rate, old and new growth theory

What will we learn? The

applications
the Lucas critique of standard methods
for evaluating policy,
credibility and dynamic consistency
issues in policy design,

tax reform (trickle-down controversies

and whether second-best initial
conditions ease the trade-off between
efficiency and equity objectives),

the sustainability of rising debt levels

and an evaluation of Europe's Stability
Pact,

theories of the natural unemployment

rate and the possibility of multiple
equilibria,

the optimal inflation rate,

alternative low-income support

policies, and globalization (including
the alleged threat to the scope for
independent macro policy).

the implications of alternative monetary

policies for pursuing price stability (pricelevel vs inflation-rate targeting, fixed vs
flexible exchange rates),

Keynes and the

Classic
Chapter 1
Makroekonomi 2
Abdul Hadi Ilman

Introduction
Keynesian view is that adjustment back to equilibrium simply does not
take place without policy assistance.
(i) the economy has multiple equilibria, only one of which involves "full"
employment; or
(ii) there is only one equilibrium, and it involves "full" employment, but the economic
system is unstable without the assistance of policy, so it cannot reach the "full"
employment equilibrium on its own.

Stability vs outright instability

Chapter 1: Specification in the labor market, to clarify the cause of
unemployment:
Perfectly flexbile money wages (Classical)
Completely fixed money wages (Keynesian)

Introduction
Chapter 2, we assume that nominal rigidities are only temporary, and we consider a dynamic analysis
that has Classical properties in full equilibrium, but Keynesian features in the transitional periods on the
way to full equilibrium
In Chapter 3, we enrich this dynamic analysis by exploring alternative ways of bringing expectations into
the analysis. we will have identified two important considerations that make macroeconomic
convergence more problematic: firms' reactions to sticky prices and sales constraints, and expectations.
In Chapter 4, we rectify one major limitation of the analysis to that point that formal microfoundations have been missing. The intertemporal optimization that is needed to overcome this
limitation is explained in Chapter 4.
in Chapter 5, we examine the New Classical approach to business cycle analysis the modern, more
micro-based version of the market-clearing approach to macroeconomics, in which no appeal to sticky
prices is involved.
Finally, in Chapters 6 and 7, we examine what has been called the "New" Neoclassical Synthesis a
business-cycle analysis that blends the microeconomic rigour of the New Classicals with the empirical
applicability that has always been the focus of the Keynesian tradition and the original Neoclassical
Synthesis.

Criteria for Model Selection

Broad criteria for macro models
First, models must be subjected to empirical tests, to see whether the
predictions are consistent with actual experience.
Second, should be evaluated as to their consistency with optimizing
underpinnings. Microeconomics base
Frustrating debate in 1970s and 1980s between these two schools of
thought
In 1990s, there were constructive dialogs to combine the best features
of the competing approaches so that now the subject is empirically
applicable, has solid micro-foundations, and it allows for market failure

Classical Economics
Economists:
Adam Smith( Scottish
philosopher)
Alfred Marshall(British economist)
Arthur Cecil Pigou (British
economist)

CENTRAL PRINCIPLE
The economy is best
organised as a selfregulating system of
markets.

David Ricardo (British economist)

JS.Mill
Malthus

Known also as: laissez

faire, liberal, supply side

Classical Economics
Wages and prices are
fully flexible in order to
clear markets rapidly.

Economy operates at full

employment most of the
time. Classical aggregate
curve is vertical

Minimal govt intervention

reflecting distrust of
government and belief in
its inefficiency.
Unemployment in the
economy is either
Voluntary or due to some
External Interference.

Keynesian Economics
Advocates:
Francis Ysidro Edge
Worth
Jean-Baptist Say
Paul Samuelson
John Maynard Keynes

CENTRAL PRINCIPLE
The economy often
operates at less than full
employment; market
system does not self adjust.

Known also as: interventionist, demand side

Key Differences
IN THE CLASSICAL WORLD
Free market economies are always stable
Tending towards full employment & full production equilibrium
Free fluctuating pricies in the three macro markets (Goods, money,
labor)
IN THE KEYNESIAN WORLD
Free market economies are unstable
Equilibrium but no reason for full employment/full production

Classical Model
Assumptions:

Endogenous variables:
Y, N, r, P, and W
Classical Dichotomy: the key real variables (output and employment) are determined solely on the
basis of aggregate supply relationships (the factor market relations and the production function), while
the demand considerations (the IS and LM curves) determine the other variables (r and P) residually

Classical View on
Unemployment

The labor &the other resources are always fully employed.

General unemployment is assumed to be impossible.
If there is any unemployment, it is assumed to be temporary/

abnormal.
In the long run the economy will have full employment/natural

rate of unemployment if wages & prices are flexible

Classicals Reason for Full

Employment
Says law: Supply creates its own demand.

Abstinence theory of interest: Interest rate influences peoples

saving.
Classical theorists held that wages & prices would change
proportionally
Graphically the pure classical theorists would have a vertical AS
curve. That shows the same GDP associated with full employment,
at each level in the economy.

Classicals Reason for

Unemployment
Intervention by the

Classical unemployment occurs

government/private

when real wages are kept above the

monopoly.

market clearing wage rate, leading

Wrong calculation by
entrepreneurs &
inaccurate decisions
Artificial resistance

to a surplus of labor supplied

Classical unemployment sometimes
known as real wage unemployment.
Because it refers to real wages
being too high.

Keynesian Economics
Markets clear only slowly, if at al
In a depression or recession,
much employment is
involuntary.
Economy operates less often than
full employment, since market
dont clear
Govt intervention may be desirable
to stabilize the business cycle.
(Fiscal and monetary policies)

Demand becomes
much bigger driving
force
Supply will adjust to
demand
According to Keynes;
Demand creates its
own supply

Keynesian policy Implications

Under the classical system, government had no role in
management of the economy- Laissez faire do nothing.
Under Keynes, Government must step into to correct
instability of the economy.
If the economy faces recessionary gap, govt must increase
demand by spending more; lowering taxes;lowering interest;
If the economy faces an inflationary gap, govt must reduce
demand by spending less; raise taxes; increase interest rate;

Keynesians view on
Unemployment

Keynesian theory holds that unemployment is the normal state of

the economy & significant government intervention is required if
employment/output targets are to be reached
Central Keynesian conclusion:
AD determines real GDP
In short run, AD can be adjusted to achieve target GDP &
unemployment levels with prices not changing (fixed, flat price)

Conclusion
Unemployment can exist only in the presence of some stickiness
in money wage.
Should we advocate increased wage flexibility so as to avoid at
least some unemployment?
Micro view: private agents must have adopted the institution of
temporarily rigid wages (contracts) for a reason and that reason
must be understood before one can be confident that increasing
wage flexibility is "good."
Macro view: the microeconomic costs of increased flexibility
would not be large and, therefore, directly proceed with a
macroeconomic analysis -of whether the built-in stability of the
overall economy is enhanced by wage flexibility

Tugas
Buktikan bahwa slope AD negative