1. Unit 3: Aggregate Demand and Supply and Fiscal Policy 1

2. Adam Smith 1723-1790 John Maynard Keynes 1883-1946 2 Classical vs. Keynesian

3. Debates Over Aggregate Supply Classical Theory Prices are flexible, making the aggregate supply curve vertical, even in the short run –Thus, an increase in the money supply or in aggregate demand affects the aggregate price level but not aggregate output Price level Real domestic output, GDP AS QfQf AD 3

4. Debates Over Aggregate Supply Classical Theory 1.A change in AD will not change output even in the short run because prices of resources (wages) are very flexible. 2.AS is vertical so AD can’t increase without causing inflation. Price level Real domestic output, GDP AS QfQf AD 4

5. Debates Over Aggregate Supply Classical Theory 1.A change in AD will not change output even in the short run because prices of resources (wages) are very flexible. 2.AS is vertical so AD can’t increase without causing inflation. Price level Real domestic output, GDP AS QfQf AD 5 Recessions caused by a fall in AD are temporary. Price level will fall and economy will fix itself. No Government Involvement Required AD 1

6. 6 John Maynard Keynes “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.

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8. Debates Over Aggregate Supply Keynesian Theory 1.A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Price level Real domestic output, GDP AS QfQf AD 8

9. Debates Over Aggregate Supply Keynesian Theory 1.A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Price level Real domestic output, GDP AS QfQf AD 9 Q1Q1 “Sticky Wages” prevents wages from falling. The government should deficit spend to close the gap AD 1

10. Debates Over Aggregate Supply Keynesian Theory 1.A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. 2.Increase in AD during a recession does not lead to inflation Price level Real domestic output, GDP AS QfQf AD 2 10 AD 1 Q1Q1 When there is high unemployment, an increase in AD doesn’t lead to higher prices until you get close to full employment AD 3

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

12. Keynes vs. Hayek Rap Battle 12