Classical and Keynesian Macro Analysis

The Classical Model The first attempt to explain inflation, output, income, employment, consumption, saving and investment. The classical economists include: Smith, Ricardo, Malthus, and Say

Assumptions of Classical Model Pure Competition Exists Wages and Prices are Flexible Self Interest People don’t have money illusion- they understand nominal vs. real value. Problems in the economy are temporary and will correct themselves.

Classical Model: RGDP Real GDP is Supply Determined. The equilibrium Price fluctuates when the ad curve shifts

J.B. Say’s Law Supply creates its own demand. Producing goods generates the demand to purchase other goods. Desired expenditures equal actual expenditures.

Leakages in savings When people save money there is a leakage in the circular flow and planned consumption can fall short of real GDP. Classical economists argue that dollars saved will be matched by business investment equally.

Classical Model: Saving and Investing The price of Credit (interest rate) ensures that the demand and supply of credit are equal

Wage and employment equilibrium in classical model In the classical model if there is unemployment, beyond the natural rate, wage rates should fall to the point where unemployed workers will be attractive to hire. Therefore, in the classical model people will not be unemployed for very long and the model tends towards “full employment.”

Keynesian Short Run Aggregate Supply John Maynard Keynes argued that wages were not as flexible as the classical model suggested, due to labor unions and contracts. In addition since the 1930’s the minimum wage sets a floor below which wages can’t drop. Therefore, changes in AD do not necessarily change price as the classical economist argued.

Demand Determined Real GDP According to Keynes, any change in aggregate demand will change Real GDP, thus output is demand determined. Price level doesn’t change

Keynesian Short Run Aggregate Supply The horizontal portion of the supply curve is where there is high unemployment and unused capacity. A leftward shift reduces real GDP creating unemployment. Keynes argues that capitalism may not be self regulating, as the classical economists suggest. Once an economy is in recession, it needs increases in AD to move toward full employment.

Real GDP and Price Level 1934-1940 According to Keynesian theory, in a depressed economy an increase in aggregate spending can increase output without raising prices.

Keynesian Solutions: Government Spending Keynes argued that when the economy goes into recession due to lower consumption, investment, and net exports, the government needs to step in and spend money. Keynesian policy is often linked to the New Deal since FDR increased government funded programs during the Great Depression. Modern Keynesianism is connected to Democratic Party economic policy.

What do you think? During recessions, such as the recent Great Recession, Democrats such as President Obama enacted an “economic stimulus” which increased government spending in a variety of areas. Republican economic policy opposed this approach, arguing for cutting back government spending and lowering taxes as a way to jumpstart the economy.

Modern Keynesian Analysis (SRAS) Short Run Aggregate Supply Modern Keynesians agree that prices are not completely “sticky” there is some price adjustment. The result is an SRAS curve that slopes upward Price and RGDP can increase together. SRAS can exceed full employment (LRAS)

Shifts in LRAS and SRAS Any change in the endowments of the factors of production will cause both to shift. Ex. technology

Shifts in SRAS Only Short lived events will change SRAS but will not change LRAS. Ex. A storm that damages ports along the coast will only decrease RGDP temporarily or in the short run.

Changes that Cause an Increase in (AS) Discover new raw materials Increased Competition Reduce Trade Barriers Reduce business regulation Decrease Business Taxes Reduction to input prices

Changes that Cause a Decrease in (AS) Depletion of raw materials Decreased Competition Increase in Trade Barriers Increase in business regulation Taxes increase Input prices increase

Recessionary Gap When AS is stable and AD decreases, price level and Real GDP decline. The difference or gap between equilibrium Real GDP at SRAS and equilibrium at full employment is called the recessionary gap. E1 to E2.

Inflationary Gap When AS is stable and AD increases, price level and Real GDP rise. The difference or gap between equilibrium Real GDP at SRAS and equilibrium at full employment is called the inflationary gap. E1 to E2.

“Secular Deflation” Price level declines which are caused by increasing economic growth is referred to as secular deflation. Graph secular deflation using the classical model. Increase the LRAS to show secular deflation. Now make a second graph showing deflation caused by decreasing Aggregate Demand

Cost Push Inflation When inflation occurs because of supply. A decrease in SRAS causes an increase in the price level.

Demand Pull Inflation When inflation occurs because of demand. An increase in demand causes an increase in the price level.

Effects of Weak Dollar Value A weaker dollar causes the cost of imported inputs to increase, thus decreasing the SRAS Weaker dollars also cause an increase in the AD of US goods (exports). For this reason we know that price levels will rise with a weak dollar, but the quantity of RGDP is indeterminate.

Effects of a Strong Dollar A strong dollar causes the cost of imported inputs to _______________, thus _____________the SRAS Strong dollars also cause an ____________ in the AD of US goods (exports). For this reason we know that ______________ will fall with a strong dollar, but the RGDP_________________. Graph the impact of a strong dollar on AS and AD

Practicing the Macro Model Draw a macro economic model with a contractionary gap. Include the LRAS, AD curve, and an upward diagonally sloping SRAS. Be sure to correctly label each part of your graph. Imagine that a weak US dollar expands US exports. What impact will this have on the AD curve? How will this increase in exports effect Real GDP and Price level. Show this on your graph above.

Practicing the Macro Model Draw a macro economic model with a inflationary gap. Include the LRAS, AD curve, and an upward diagonally sloping SRAS. Be sure to correctly label each part of your graph. Imagine the government steps in and decreases government spending to slow the inflation. What will happen to price level and real GDP on the model above?

Practicing the Macro Model Create a simple AD/AS model. What will happen to prices and real GDP if the government increases spending? Create a Classical Macro model. What will happen to prices and real GDP if the government increases spending? Create a short run Keynesian model. What will happen to prices and Real GDP if the government increases spending?