Chapter 26 The Neoclassical Perspective Principles of Economics Chapter 26 The Neoclassical Perspective PowerPoint Image Slideshow

The great recession The impact of the Great Recession can be seen in many areas of the economy that impact our daily lives. One of the most visible signs can be seen in the housing market where many homes and other buildings are abandoned, including ones that midway through construction.

The gdp gap Actual GDP falls below potential GDP during and after recessions, like the recessions of 1980 and 1981–82, 1990–91, 2001, and 2008– 09 and continues below potential GDP through 2012. In other cases, actual GDP can be above potential GDP for a time, as in the late 1990s.

The Neoclassical View: Wage & Price Flexibility The labor market is brought to equilibrium by rising and falling wage rates. There should not be any persistent unemployment above the natural rate.

The Neoclassical View: Wage & Price Flexibility In a recession, when the demand for labor declines, the equilibrium wage will fall. Any unemployed worker who wants a job will have one, but at lower wage rate. So, the market arrives at a new equilibrium with a lower wage rate and reduced employment. In this model, unemployment is voluntary as some workers choose not to get jobs at lower wages.

The Neoclassical View: Wage & Price Flexibility The neoclassical idea that wages adjust to clear the labor market is consistent with the view that wages respond quickly to price changes. This means that the economy stabilizes at full-employment GDP and the long-run AS is a vertical line. Therefore, monetary and fiscal policy cannot affect the level of output and employment in the long-run.

The long-run aggregate supply In the neoclassical model, AS is is a vertical line at potential GDP. Hence, only AS determines the level of output, no matter where AD is located. Over time, the AS curve shifts to the right as productivity increases and potential GDP expands.

The acceleration hypothesis In the long-run, the economy stabilizes at potential GDP. An expansion of the AD will be just inflationary.

The acceleration hypothesis As AD increases, output grows beyond potential GDP and price level rises. Workers adjust their expectations for price inflation to get wage increases. SRAS declines moving back the economy to potential GDP, but higher prices.

Long-run Phillips curve A vertical line AS at potential GDP indicates a vertical Phillips Curve at the natural unemployment rate.

Effect of stabilization policy As aggregate demand shifts to the right, the GDP and unemployment do not change. However, there is inflationary pressure for a higher price level as the equilibrium changes from E0 to E1 to E2.