Unit 3: Aggregate Demand and Supply and Fiscal Policy 1

Classical vs. Keynesian Adam Smith 1723-1790 John Maynard Keynes 1883-1946

Keynes vs. Hayek Rap Battle 4

Debates Over Aggregate Supply Classical Theory A change in AD will not change output even in the short run because prices of resources (wages) are very flexible. AS is vertical so AD can’t increase without causing inflation. AS Price level AD Qf Real domestic output, GDP

Debates Over Aggregate Supply Classical Theory A change in AD will not change output even in the short run because prices of resources (wages) are very flexible. AS is vertical so AD can’t increase without causing inflation. AS Recessions caused by a fall in AD are temporary. Price level Price level will fall and economy will fix itself. No Government Involvement Required AD AD1 Qf Real domestic output, GDP 6

Do you agree or disagree? “The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again” Translation: In times of need, economists should do more than say that the economy will fix itself. They should suggest policies that can help the economy, like deficit spending. Do you agree or disagree? John Maynard Keynes

Debates Over Aggregate Supply Keynesian Theory A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession doesn’t cause inflation AS Price level AD Qf Real domestic output, GDP 8

Debates Over Aggregate Supply Keynesian Theory A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession puts no pressure on prices AS Price level “Sticky Wages” prevents wages from falling. The government should deficit spend to close the gap AD AD1 Q1 Qf Real domestic output, GDP 9

Debates Over Aggregate Supply Keynesian Theory A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession puts no pressure on prices AS When there is high unemployment, an increase in AD doesn’t lead to higher prices until you get close to full employment Price level AD3 AD1 AD2 Q1 Qf Real domestic output, GDP 10

Three Ranges of Aggregate Supply 1. Keynesian Range- Horizontal at low output 2. Intermediate Range- Upward sloping 3. Classical Range- Vertical at Physical Capacity AS Price level Classical Range Keynesian Range Intermediate Range Qf Real domestic output, GDP 11

2006B Practice FRQ 12

2006B Practice FRQ 13