Section 4B- Classical and Keynesian Macroanalysis J.A.SACCO

Classical and Keynesian Macroanalysis Section 4A was a “cliffhanger” for section 4B. In Section 4A we examined what happens after an aggregate demand or supply shock What we didn’t analyze is the effect of those shocks on the determination of equilibrium output, employment and the price level (inflation). Classical Analysis Keynesian Analysis Two different methods of explaining the macroeconomy and the flexible nature of prices. Helps to explain equilibrium levels of GDP and employment.

The Classical Model 1770’s- First attempt to explain the determinants of the price level and the national levels of output, income, employment, consumption, saving, and investment. Adam Smith J.B.Say David Ricardo Thomas Malthus

Beliefs: The Classical Model All wages and prices are flexible and that competitive markets exist throughout the economy (supply/demand) Economy is self-regulating– economy always capable of achieving the natural rate of real GDP output and full employment (LRAS) The price level of products and input costs change by the same percentage, that is proportionally, in order to maintain full employment level of output

The Classical Interpretation Say’s Law Supply creates its own demand Producing goods and services generates the means and the willingness to purchase other goods and services Example- Economy produces 7 trillion GDP (final goods/services) simultaneously produces the income with which these goods/services can be demanded. Actual Aggregate Income = Actual Aggregate Expenditure Total National Supply Equals its own Demand

Say’s Law and the Circular Flow

Houston, We May Have a Problem! What is the problem with the assumption that all income will be spent to purchase all goods and services produced by an economy? Saving

The Problem of Saving The Problem of Saving While it is true that the income obtained from producing a certain level of real GDP must be sufficient to purchase that level of real GDP, there is no guarantee that all of this income will be spent. Some of this income might be saved Saving is a type of leakage in the circular flow of income and output Therefore aggregate demand will be less than aggregate supply. This goes against the economy achieving the natural level of real GDP .

The Problem of Saving Full employment/No savings Below full employment, because of savings Leakage

The Classical Model Classical Answer Question If saving increases won’t AD fall as consumption is reduced? Classical Answer No, because Saving (S) = Investment (I) Remember, investment (I) is a component of GDP. So any income saved would be invested by businesses so that the leakage of saving (less “C”) would be matched by the injection of business investment (more “I”).

The Classical Model Assumptions of the Classical Model *In order to study the classical model must accept the following assumptions 1) All savings will become investment to achieve the full GDP 2) Pure competition exists- no single buyer or seller of a good or service can influence price 3) Wages and prices are flexible- All prices and wages are determined by supply/demand. Buyers/sellers cause prices to rise and fall to equilibrium levels

The Classical Model 4) People are motivated by self-interest- Businesses want to maximize profit. Households want to maximize standard of living. 5) People cannot be fooled by money illusion- Buyers and sellers recognize the change in relative prices, that is they understand inflation and lost purchasing power. 8% rise in wages/ 8% rise in price level (inflation) You are not better off!!!

Role of Government is minimal! The Classical Model Consequences of the Assumptions 1) Minimize the role of government in the economy 2) If disequilibrium (unemployment/inflation) occurs it will be temporary 3) The power of market forces will keep the economy at full-employment in the long-run Role of Government is minimal!

The Classical Model Therefore according to the Classical Approach to the macroeconomy economy, equilibrium in all markets (credit, labor, and the even the macroeconomy) are determined by supply and demand forces!!!

Equating Desired Saving and Investment in the Classical Model Market Forces in Action to Reach Equilibrium Question How does the market adjust to changes in investment? In other words, what happens when demands of aggregate investment (a right shift) is greater then the supply of all savings in the economy? CREDIT MARKET

Equating Desired Saving and Investment in the Classical Model At 10% interest rate, an increase in investment creates a shortage (gap), Investment>Savings. The increase in interest rate returns the market to equilibrium Saving 14 Investment2 Investment1 12 10 Interest Rate (percent) 8 6 4 2 600 700 800 900 Investment and Saving per Year ($ billions)

Equating Desired Saving and Investment in the Classical Model Summary Changes in saving and investment create a surplus or shortage in the short-run. In the long-run this is offset by changes in the interest rate. This interest rate adjustment returns the market to equilibrium where S = I. *The credit market is entirely flexible based on supply and demand.

Equilibrium in the Labor Market Flexibility of the wage rate also keeps the labor market in equilibrium. > If supply of workers Demand for workers Then wage rate decreases to reach “full employment”

Equilibrium in the Labor Market Supply of labor S 16 Unemployment D 14 Full-employment equilibrium 12 10 Hourly Wage Rate ($) 8 6 4 Demand of labor 2 105 115 125 135 145 155 Employment (millions or workers)

Changes in the demand for Labor Market Question How does the market adjust to changes ( left shift) in the demand for labor?

Equilibrium in the Labor Market Unemployment S 16 D1 14 D2 Wages adjust to eliminate the unemployment 12 10 Hourly Wage Rate ($) 8 6 4 2 105 115 125 135 145 155 Employment (millions or workers)

Equilibrium in the Labor Market If unemployed (surplus labor) accept lower wage than all workers can be put back to work (equilibrium reached) Classical economists believe that any unemployment that occurs in the labor market or any other resource market is “voluntary unemployment”. Once again, just as with the credit market , the labor market is also flexible.

Classical Price Level and Output Determination Long term involuntary unemployment is impossible Say’s Law- Flexible interest rates, prices, wages will keep all markets in equilibrium The LRAS (vertical) is the only aggregate supply curve that exists in equilibrium Any shift of AD will soon cause a change in the price level Any AD shock will cause only “temporary” disequilibrium. Q0 LRAS Price Level Real GDP per Year

Long-Run Macroeconomic Equilibrium Observations Initially in long run equilibrium, then a demand shock: Classical theory believes the economy adjusts back to equilibrium. WHY? Wages/resources are bidded up. Price level increases to E” returning the economy to equilibrium PL= P”, RGDP = back to Yf Only the price level changes Real GDP supply is determined The model of AD/AS predicts that in the long run, when all prices are flexible, that the AD, SRAS and LRAS curves will all intersect at potential output Yp. Why? Take a look at what happens when the economy is not at Yp. Suppose that AD decreased and shifted the curve to the left. In the short run, real GDP Ye falls and is below Yp and the aggregate price level would also fall.   The amount that GDP falls below potential output is called a recessionary gap. What happens next? The labor market is weakened by the poor economy and unemployment begins to rise as workers are laid off. Eventually nominal wages begin to fall. As nominal wages fall, SRAS begins to shift to the right. The recessionary gap begins to shrink because real GDP is rising. Once real GDP has returned to Yp, the economy is back in long-run equilibrium. The price level has fallen even further. Suppose that AD increased and shifted the curve to the right. In the short run, real GDP Ye increases and is above Yp and the aggregate price level would also rise. The amount that GDP rises above potential output is called an inflationary gap. The labor market is strengthened by the booming economy and unemployment begins to fall as workers are hired. Eventually nominal wages begin to rise. As nominal wages rise, SRAS begins to shift to the left. The inflationary gap begins to shrink because real GDP is falling. The price level has increased even further. Note: the instructor should replicate the graphs to show the adjustment to a positive AD shock in a similar manner to the graphs associated with the negative AD shock. Whenever the economy is out of long-run equilibrium, there is either a recessionary or an inflationary gap. This output gap can be measured as a percentage Ye lies away from Yp. Output gap = 100*(Ye – Yp)/Yp Summarize for the students: Recessionary gap: output gap is negative, nominal wages eventually fall, moving the economy back to potential output and bringing the output gap back to zero. Inflationary gap: output gap is positive, nominal wages eventually rise, also moving the economy back to potential output and again bringing the output gap back to zero. So in the long run the economy is self­ -­ correcting: shocks to aggregate demand affect aggregate output in the short run but not in the long run.

Classical Theory and an Increase in Aggregate Demand

Effect of a Decrease in Aggregate Demand in the Classical Model Graph a decrease in aggregate demand.

Long-Run Macroeconomic Equilibrium The model of AD/AS predicts that in the long run, when all prices are flexible, that the AD, SRAS and LRAS curves will all intersect at potential output Yp. Why? Take a look at what happens when the economy is not at Yp. Suppose that AD decreased and shifted the curve to the left. In the short run, real GDP Ye falls and is below Yp and the aggregate price level would also fall.   The amount that GDP falls below potential output is called a recessionary gap. What happens next? The labor market is weakened by the poor economy and unemployment begins to rise as workers are laid off. Eventually nominal wages begin to fall. As nominal wages fall, SRAS begins to shift to the right. The recessionary gap begins to shrink because real GDP is rising. Once real GDP has returned to Yp, the economy is back in long-run equilibrium. The price level has fallen even further. Suppose that AD increased and shifted the curve to the right. In the short run, real GDP Ye increases and is above Yp and the aggregate price level would also rise. The amount that GDP rises above potential output is called an inflationary gap. The labor market is strengthened by the booming economy and unemployment begins to fall as workers are hired. Eventually nominal wages begin to rise. As nominal wages rise, SRAS begins to shift to the left. The inflationary gap begins to shrink because real GDP is falling. The price level has increased even further. Note: the instructor should replicate the graphs to show the adjustment to a positive AD shock in a similar manner to the graphs associated with the negative AD shock. Whenever the economy is out of long-run equilibrium, there is either a recessionary or an inflationary gap. This output gap can be measured as a percentage Ye lies away from Yp. Output gap = 100*(Ye – Yp)/Yp Summarize for the students: Recessionary gap: output gap is negative, nominal wages eventually fall, moving the economy back to potential output and bringing the output gap back to zero. Inflationary gap: output gap is positive, nominal wages eventually rise, also moving the economy back to potential output and again bringing the output gap back to zero. So in the long run the economy is self­ -­ correcting: shocks to aggregate demand affect aggregate output in the short run but not in the long run.

Figure 19.5 Short-Run Versus Long-Run Effects of a Negative Demand Shock Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Classical Price Level and Output Determination Conclusions In the long run, everything adjusts so fast that the economy is essentially always on or quickly moving back to equilibrium. Economy is at or soon to be at full employment/equilibrium. In the classical model, equilibrium level of real GDP is supply determined by the LRAS. Changes in AD only effect the price level. It does not effect the output of real goods and services.