Macroeconomic Theories Classical vs Keynesian Economics

Economic Schools of Thought NeoClassical Economics |--------------------------------| Classical Economics |----------------------------| Keynesian Economics |----------------------------| 1800 1929 1980 2008 1936 1979 Housing Bubble Now What? Great Depression? Prices were not flexible! What Now? Keynesian Economics did not help here!

Stock Market suddenly falls 25% Gov’t Intervention with Fiscal Policy “Self Regulation”? Use Expansionary Fiscal Policy ↑ Gov’t Spending & ↓ Income Taxes Impact: G ↑ & C ↑ => AD ↑ LRAS1 Price Level Real GDP SRAS1 AD1 AD2 P1 --------------- E1 -------- --------- P2 Y2 E2 Y1

Reading Read Keynesian Handout

AS Price Level Classical Range Intermediate Range Keynesian Range AD Economy is at Full Employment when AS turns Vertical AS Price Level Classical Range Intermediate Range Keynesian Range AD Real GDP

CLASSICAL VIEW Markets are naturally self regulating No government intervention necessary Recessions are temporary Wages & prices are flexible Against minimum wages, welfare, government assistance Great Depression challenged Classical View

KEYNSIAN VIEW Economy is inherently unstable not self regulating Recessions can be long & permanent Major government intervention necessary Wages and prices are fixed/sticky AS curve is very flat (fixed) or upward sloping (sticky) Support welfare & government assistance Stagflation challenged Keynesian view

Reconciling 2-Views Most economists believe classical theory describes world in the long run but not short run Prices, Wages & interest rates are at least somewhat sticky in the short run Keynesian economics focuses on AD and failed to explain the Stagflation of the late 1970’s

Classical Model Failure: The Great Depression Real GDP ↓ 27% Unemployment 3% → 25% Price Levels fell Price Level LRAS2 AD2 AD1 However, Wages did not adjust Real GDP

“Supply Shock” in SRAS A sudden shift in short run aggregate supply: Stagflation is caused by adverse supply shock SRAS shifts left Output falls & Price level rises period of recession and inflation. Example: late 1970’s in USA (oil crisis) Challenge: Policymakers who can influence AD cannot offset both simultaneously (Output falling & Price level rising) Keynesian economics “failed”! SRAS2