ClassicalandKeynesian

MacroAnalysis
TheClassicalModel

Thefirstattempttoexplaininflation,output,
income,employment,consumption,savingand
investment.
Theclassicaleconomistsinclude:Smith,Ricardo,
Malthus,andSay
AssumptionsofClassicalModel

PureCompetitionExists
WagesandPricesareFlexible
SelfInterest
Peopledonthavemoneyillusionthey
understandnominalvs.realvalue.
Problemsintheeconomyaretemporaryandwill
correctthemselves.
ClassicalModel:RGDP

RealGDPisSupplyDetermined.
TheequilibriumPricefluctuateswhenthead
curveshifts
J.B.SaysLaw

Supplycreatesitsowndemand.
Producinggoodsgeneratesthedemandto
purchaseothergoods.
Desiredexpendituresequalactualexpenditures.
Leakagesinsavings

Whenpeoplesavemoneythereisaleakagein
thecircularflowandplannedconsumptioncan
fallshortofrealGDP.
Classicaleconomistsarguethatdollarssaved
willbematchedbybusinessinvestment
equally.
ClassicalModel:SavingandInvesting
ThepriceofCredit
(interestrate)ensures
thatthedemandand
supplyofcreditare
equal
Wage and employment
equilibrium in classical model
In the classical model if there is
unemployment, beyond the natural rate,
wage rates should fall to the point where
unemployed workers will be attractive to hire.
Therefore, in the classical model people will
not be unemployed for very long and the
model tends towards full employment.
KeynesianShortRunAggregate
Supply

JohnMaynardKeynesarguedthatwageswerenot
asflexibleastheclassicalmodelsuggested,due
tolaborunionsandcontracts.
Inadditionsincethe1930stheminimumwage
setsafloorbelowwhichwagescantdrop.
Therefore,changesinADdonotnecessarily
changepriceastheclassicaleconomistargued.
DemandDeterminedRealGDP

AccordingtoKeynes,anychangeinaggregatedemand
willchangeRealGDP,thusoutputisdemanddetermined.
Priceleveldoesntchange
KeynesianShortRunAggregate
Supply

Thehorizontalportionofthesupplycurveiswhere
thereishighunemploymentandunusedcapacity.
AleftwardshiftreducesrealGDPcreating
unemployment.
Keynesarguesthatcapitalismmaynotbeself
regulating,astheclassicaleconomistssuggest.
Onceaneconomyisinrecession,itneeds
increasesinADtomovetowardfullemployment.
RealGDPandPriceLevel19341940

Accordingto
Keynesiantheory,ina
depressedeconomyan
increaseinaggregate
spendingcanincrease
outputwithoutraising
prices.
Keynesian Solutions:
Government Spending
Keynes argued that when the economy goes
into recession due to lower consumption,
investment, and net exports, the government
needs to step in and spend money.
Keynesian policy is often linked to the New
Deal since FDR increased government funded
programs during the Great Depression.
Modern Keynesianism is connected to
Democratic Party economic policy.
What do you think?
During recessions, such as the recent Great
Recession, Democrats such as President
Obama enacted an economic stimulus
which increased government spending in a
variety of areas.
Republican economic policy opposed this
approach, arguing for cutting back
government spending and lowering taxes as
a way to jumpstart the economy.
ModernKeynesianAnalysis
(SRAS)ShortRunAggregateSupply

ModernKeynesiansagreethat
pricesarenotcompletely
stickythereissomeprice
adjustment.
TheresultisanSRAScurve
thatslopesupward
PriceandRGDPcanincrease
together.
SRAScanexceedfull
employment(LRAS)
ShiftsinLRASandSRAS

Anychangeinthe
endowmentsofthe
factorsofproduction
willcausebothtoshift.
Ex.technology
ShiftsinSRASOnly

Shortlivedeventswill
changeSRASbutwill
notchangeLRAS.
Ex.Astormthat
damagesportsalongthe
coastwillonlydecrease
RGDPtemporarilyorin
theshortrun.
ChangesthatCauseanIncreasein
(AS)
Discovernewrawmaterials
IncreasedCompetition
ReduceTradeBarriers
Reducebusinessregulation
DecreaseBusinessTaxes
Reductiontoinputprices
 ChangesthatCauseaDecrease
in(AS)
Depletionofrawmaterials
DecreasedCompetition
IncreaseinTradeBarriers
Increaseinbusinessregulation
Taxesincrease
Inputpricesincrease
RecessionaryGap

WhenASisstableandAD
decreases,pricelevelandReal
GDPdecline.
Thedifferenceorgapbetween
equilibriumRealGDPat
SRASandequilibriumatfull
employmentiscalledthe
recessionarygap.E1toE2.
InflationaryGap

WhenASisstableandAD
increases,pricelevelandReal
GDPrise.
Thedifferenceorgapbetween
equilibriumRealGDPat
SRASandequilibriumatfull
employmentiscalledthe
inflationarygap.
E1toE2.
Secular Deflation
Price level declines which are caused by
increasing economic growth is referred to as
secular deflation.
Graph secular deflation using the classical
model. Increase the LRAS to show secular
deflation.
Now make a second graph showing deflation
caused by decreasing Aggregate Demand
CostPushInflation

Wheninflation
occursbecauseof
supply.
AdecreaseinSRAS
causesanincrease
inthepricelevel.
DemandPullInflation

Wheninflationoccurs
becauseofdemand.
Anincreasein
demandcausesan
increaseintheprice
level.
 EffectsofWeakDollarValue
Aweakerdollarcauses
thecostofimported
inputstoincrease,thus
decreasingtheSRAS
Weakerdollarsalsocause
anincreaseintheADof
USgoods(exports).
Forthisreasonweknow
thatpricelevelswillrise
withaweakdollar,but
thequantityofRGDPis
indeterminate.
 EffectsofaStrongDollar
Astrongdollarcausesthecost
ofimportedinputsto
_______________,thus
_____________theSRAS
Strongdollarsalsocausean
____________intheADof
USgoods(exports).
Forthisreasonweknowthat
______________willfallwith
astrongdollar,butthe
RGDP_________________.
Graphtheimpactofa
strongdollaronASandAD
Practicing the Macro Model
Draw a macro economic model with a
contractionary gap. Include the LRAS, AD curve,
and an upward diagonally sloping SRAS. Be
sure to correctly label each part of your graph.
Imagine that a weak US dollar expands US
exports. What impact will this have on the AD
curve? How will this increase in exports effect
Real GDP and Price level. Show this on your
graph above.
Practicing the Macro Model
Draw a macro economic model with a
inflationary gap. Include the LRAS, AD curve,
and an upward diagonally sloping SRAS. Be
sure to correctly label each part of your
graph.
Imagine the government steps in and
decreases government spending to slow the
inflation. What will happen to price level and
real GDP on the model above?
Practicing the Macro Model
Create a simple AD/AS model. What will
happen to prices and real GDP if the
government increases spending?
Create a Classical Macro model. What will
happen to prices and real GDP if the
government increases spending?
Create a short run Keynesian model. What
will happen to prices and Real GDP if the
government increases spending?