1. KEYNESIAN ECONOMICS
J.A. SACCO

2. Classical Theory Review
All resources fully used
No unused capacity
Full employment/ Supplied determined
Economy 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 Model
Flexible prices
Long-run view
LRAS determines output
The Keynesian Model
Rigid prices
Short-run view
AD determines output

4. Keynesian Foundations
Post WWI- Europe in economic decline
Great Depression- 1930’s
Basis 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 DemandQ0
LRAS
According to Keynes
Price level will not decrease back to LRAS when AD decreases
CLASSICAL THEORY IS WRONG SAYS KEYNES!
AD1
AD2
110 E1 Q1
100 E2
Price Level
Real GDP per Year

6. Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve
Some Different Assumptions
1) Short-run approach to the macroeconomy
2) Concentrated on reasons for continuing recessions
3) 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 constant
6)The SRAS curve assumes high unemployment and unused capacity

8. Demand Determined Income Equilibrium
With excess capacity
increases in AD
increases equilibrium
real national income
and the price level does
not change Q3
AD3
SRAS
AD1 Q2
AD2
Price Level Q1 P3
With prices sticky
downward decreases
in AD will decrease
real national income
and the price level
does not change
Real 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 possible
Therefore since wages will not be cut to employ all workers- wages will remain the same for some while others will remain unemployed
Thus the “classical” view of full employment no longer holds true- economy is not self-regulating
Price of wages are “sticky” downward
Labor unions and long term contracts make downward inflexibility of the nominal wage not possible
Also 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 1937
Real GDP fell from $1 trillion to $700 billion
1933 economy operated at 30% below potential

11. Keynesian Analysis of the Great Depression
LRAS
AD1933
AD1929
SRAS
100 E1
1.0 E2
0.7
Price Level A
Following the decrease
in AD the price level
would have had to drop
to point A to avoid
Unemployment as Classical theorists support--it did not!
Real GDP per Year
($ trillions)

12. Real GDP and the Price Level, 1934-1940

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 GDP
General economy wide equilibrium can occur and endure even if there is excess capacity
Capitalism is NOT a self-regulating system sustaining full employment
Attack “classical” view that market forces would lead to equilibrium
What 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 inflation
Prices are not totally “sticky”
AD1
AD2 7
Price Level
SRAS
120 6
Real GDP per Year
($ trillions)

16. Income Determination with Fixed Versus Flexible Prices
The price level
is fixed and the
increase in AD
increases real
GDP to $7 trillion
is not fixed and
the increase in AD
increases both
prices and real GDP
SRAS
LRAS
AD2
AD1
AD2 7
AD1
Price Level
Price Level
130
6.5
SRAS
120 6
120
6.0
Real GDP per Year
($ trillions)
Real GDP per Year
($ trillions)

17. Modern Keynesian Short-Run
Recognizes that some, but not
complete, prices adjustments,
made in the short run.
MKSR relates the
relationship between PL
and Real GDP with
incomplete price adjustments
and incomplete info in
the short run
SRAS
LRAS
AD2
AD1
Price Level
130
6.5
120
6.0
Real 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
LRAS1
LRAS2
200
SRAS1
SRAS2
AD1
AD2
150
Price Level E1 E2
With economic growth,
LRAS1 and SRAS1
shifts outward with
no inflation
100 50 7 8
Real GDP per Year
(trillions of 1992 dollars)