Macroeconomic Models IV What’s the deal with Keynes and those other dudes?

IB Syllabus Alternate Views of AS  Explain, using a diagram, that the monetarist/new classical model of the long- run aggregate supply curve (LRAS) is vertical at the level of potential output (full employment output) because aggregate supply in the long run is independent of the price level  Explain, using a diagram, that the Keynesian model of the aggregate supply curve has three sections because of “wage/price” downward inflexibility and different levels of spare capacity in the economy

Viewpoint 1: Classical Economics (Section 8.3) Adam Smith started it: The Wealth of Nations Father of Modern Economics Launches the science with his book, embraced by many others Associated with “classical economics” “Laissez-faire economics,” “Free market economics” “Supply-side economics” Classical Economists assume: Wages and prices are fully flexible (more on this in a sec) The economy is a harmonious, self-adjusting system that tends toward equilibrium The competitive market ensures that all resources/labor/technology will be utilized/employed fully—demand always catches up with supply “Neo-classicists”—Classical theories regain a following, beginning in the 1950’s – some tweaks but similar to Classical approach

The Classical Aggregate Supply Curve Classical economists believe that… The Aggregate Supply curve is vertical Aggregate Supply is inelastic; it settles at the full employment level of GDP (potential Output or Y p ) Potential Output depends on the quantity and quality of the factors of production (i.e., productivity) Output is NOT dependent on the price level—the market self-corrects Price Level Real GDP AD AS YPYP

Flexible Wages and Factor Prices Classical economists believe… If the price level increases (periods of inflation): Short-run: Wages constant, profits increase, firms produce more But then: Wages and other factor prices increase at rates equal to the rate of inflation Long-run result: Firms have no incentive to increase output If the price level decreases (periods of deflation): Short-run: Wages constant, profits decrease, firms produce less But then: Wages and other factor prices decrease at rates equal to the rate of deflation Long-run result: Firms have no incentive to decrease output Bottom Line: Prices do not affect Output—AS is inelastic/vertical

Long-Run Macroeconomic Equilibrium: Neoclassical View Long-run Equilibrium in the Neoclassical view Aggregate Demand Short-Run Aggregate Supply (SRAS) Long-Run Aggregate Supply (LRAS) Real GDP PL YPYP

Implications of the Classical View What does a vertical AS curve mean for the long run? What happens with a change in AD? ___________________ _________________________________________________ What happens with a change in PL? ____________________ _________________________________________________ Do Inflationary/Recessionary gaps persist in the long run? Why or why not? _________________________________________ _________________________________________________ Classical economists believe that the economy has a built-in tendency towards __________________________________

You Draw! Show the long-run equilibrium that results (classical view) Inflationary Gap Recessionary Gap See page 239 YPYP YPYP

More Implications Why would classical economists be referred to as “ Supply Side ” economists? If the government wanted to help the economy grow, what could it do?

Changing the LRAS Curve Moving further out on the PPC: Increases in efficiency Reductions in the natural rate of unemployment Moving the PPC outward: Increases in the quantities of the factors of production Improvements in the quality of factors of production Improvements in technology

Test Your Understanding With a partner, review the questions on: Page 241—TYU 8.6, 1 a-e

Macroeconomic Models V Spotlight on Keynes

Viewpoint 2: Keynesian Economics (Section 8.4) John Maynard Keynes The basis for modern macroeconomics Theories gained traction during the Great Depression The fundamental problem with classical economics: “Getting stuck in the short run” Economy is not a harmonious, self-adjusting system moving towards equilibrium Asymmetry between wage movements going up and down Expansion: AD shifts to the right, U < natural rate  Wages increase Contraction: AD shifts to the left, U > natural rate  Wages ‘stick’ as factor prices, and thus prices, are not flexible downward Menu costs Contracts/Unions

The Keynesian Aggregate Supply Curve (original version) Keynes believed that: The AS curve has two parts: It is horizontal at low levels of output (perfectly elastic) It is vertical only at very high levels of output (perfectly inelastic) At low levels of output, AD can (and should) be increased without affecting Price Levels Price Level Real GDP AD AS

More on… The Keynesian Aggregate Supply Curve Horizontal section: When real GDP is low PL remains constant as GDP increases During period of low output/high unemployment – Firms can increase output without having to bid up wages and factor prices Vertical section: Output is at its maximum; firms are employing all available resources Price levels increase rapidly with increases in AD

Implication time… Inflexible wages and prices mean the economy cannot move into the Long Run (i.e., we’re stuck on the horizontal part of the AS curve) Thus, a recessionary gap is not self-corrected, at least not in any acceptable timeframe: Pure Keynesians would say there is no LRAS! – “In the long run, we are all dead” Need more Aggregate Demand! We could increase AD without increasing PL! Growth results from increases in both AS and AD (See page 244)

The Keynesian Aggregate Supply Curve (modified to reflect more recent consensus) Three-part Aggregate Supply curve Horizontal: Perfectly elastic at low levels of output Upward-sloping: Factor prices increase with increase in output Vertical: Perfectly inelastic as output reaches full capacity Price Level Real GDP AD AS Y max YPYP

The Keynesian Aggregate Supply Curve (modified to reflect more recent consensus) Three-part Aggregate Supply curve I: Recessionary gap II: Full employment equilibrium III: Inflationary gap Price Level Real GDP AS YPYP You Draw the AD curves!

Implication time… Why would Keynesian Economists be referred to as “ demand ” side or “demand driven” economists? How would they view the role of government?

Compare and Contrast ClassicalKeynesian Proponents? Wage Flexibility Shape of AS curve(s) The long-run? Economy self-adjusts? How to increase GDP? Impact of increasing AD?

The Consensus… Here ’ s how we look at it now… Classical Economists are right – in the long run Keynesian Economists are also right – at times This is how we will view AS and AD going forward Price Level Real GDP AD LRAS SRAS