Keynesian vs New Classical Different Interpretations of AS and therefore of Equilibrium…particularly in the Long Run
Review: simple equilibria a) In the short run with a gap With no gap and at Potential Y= LR equilibrium
The DEBATE Will the economy automatically adjust to the LR equilibrium? It depends on the shape of the SRAS and on how markets & prices (especially wages) behave. Simply the answers are: Keynesians: No New Classical: Yes
In addition to the upwards sloping SRAS……… The long-run aggregate supply curve (LRAS) (New Classical) shows the relationship between the price level and output (real GDP) produced by firms when the prices of all resources, especially price of labor (wages), are flexible and change along with changes in the price level. It assumes the economy has reached its potential The Keynesian AS curve is for both LR and SR. It assumes spare capacity at low levels of AD and sticky prices/wages
Keynesian AS (SRAS &LRAS?) Curve (Group III Wed 18th) Segment 1: spare capacity in the economy. Wages and factor prices very sticky Segment 2: spare capacity being utilised. FoPs prices rising Economy starts to overheat Segment 3 : Capacity fully utilised (on the ppf). Cannot produce any more unless capacity is increased. Spare capacity in the economy
If a deflationary/recessionary gap…. Although there is a Gap high unemployment Wages and other factor prices will NOT fall. Therefore Yequilibrium does not change Governments must intervene using……….. fiscal and monetary policy to increase AD
Great Depression of 1930s
Keynesian SRAS=LRAS Keynes argued that as there is nothing inherent in the economy to move the SR into the LR SRAS = LRAS (NOTE: In diagrams taking a Keynesian viewpoint you may see the AS curve labeled Keynesian AS or simply LRAS. Either is all right, as long as the diagram’s title makes clear which perspective is being adopted)
Inflationary Gap in the Keynesian Perspective
Full Employment Equilibrium in the Keynesian Perspective …… Full Employment Equilibrium in the Keynesian Perspective …….but only happens by chance
New Classical (free market) viewhandout pp4/5 New Classical Perspective Price Mechanism Regulates markets Full Employment (NRU) achieved without intervention The Economy is an Harmonious system Perfectly Competitive Equilibrium Sets the Benchmark
New Classical (Free Market) LRAS In the Long Run all resources including wages change to match changes in the price level Why is the LRAS vertical? LRAS perfectly inelastic at Full Employment Level of Output (Ymax) Potential Output is determined by the Quantity and Quality of Factors of production (so independent of the price level)
Long-run equilibrium
Long-run equilibrium and Decline in AD
Return to Long-run equilibrium
Long-run equilibrium
Return to Long-run equilibrium
Implications of the New Classical LRAS ? In time any inflationary or recessionary gap will disappear and the economy will move to full employment (potential GDP with only the natural rate of unemp.) Governments do NOT need to intervene in the market In the LR increases in AD will not impact real GDP but only bring about inflation Group Work (3 groups)
Economic Growth: Definition: Increase in REAL GDP and/or increase in POTENTIAL OUTPUT New Classical Perspective
Keynesian Perspective: Keynesian curve can also shift right in the LR as factors of production increase
Recap : the Keynesian perspective Price Mechanism fails as wages are “sticky” and prices are determined in imperfectly competitive markets Achieving Full Employment needs intervention The Economy is inherently unstable. The economy can get stuck in the SR
Wages and prices are downward sticky Implications of the Keynesian AS (inflexibility of wages and prices stops the economy moving into the LR). Wages and prices are downward sticky Unemployment and low incomes may persist in times of recession and depression. The government must intervene using fiscal and monetary policy to increase AD
The Two Macroeconomic Schools of Thought AD = C + I + G + NX (X – M) LRAS = function of (Labor, Land, Capital, Entrepreneurs)