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

2. 1.Explain an Inflationary Gap. Draw one 2.Explain a Recessionary Gap. Draw one 3.What is Stagflation? Review 2

3. Adam Smith 1723-1790 John Maynard Keynes 1883-1946 3 Classical vs. Keynesian

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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

6. 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 6 Recessions caused by a fall in AD are temporary. Price level will fall and economy will fix itself. No Government Involvement Required AD 1

7. 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 doesn’t cause inflation Price level Real domestic output, GDP AS QfQf AD 7

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. 2.Increase in AD during a recession puts no pressure on prices Price level Real domestic output, GDP AS QfQf AD 8 Q1Q1 “Sticky Wages” prevents wages to fall. The government should increase spending to close the gap AD 1

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. 2.Increase in AD during a recession puts no pressure on prices Price level Real domestic output, GDP AS QfQf AD 2 9 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

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 Price level Real domestic output, GDP AS QfQf 10 Keynesian Range Intermediate Range Classical Range

11. 2006B Practice FRQ 11 C. Assume the policy makers assume prices and wages are not flexible. Explain what will happen to each of the following. (i) short-run aggregate supply (ii) aggregate demand (iii) employment

12. 2006B Practice FRQ 12

13. 13 Practice Assume the economy is operating more than full employment. a. Draw a correctly labeled graph of aggregate demand and aggregate supply, show each of the following. (i)Long-run aggregate supply curve (ii) Current output and price level b. Assume the policy makers assume prices and wages are not flexible. Explain what will happen to each of the following. (i) short-run aggregate supply (ii) aggregate demand (iii) employment c. Assume the policy makers assume prices and wages are flexible. Explain what will happen to each of the following. (i) short-run aggregate supply (ii) aggregate demand (iii) employment

14. Video: Classical vs. Keynesian -in the video they choose to represent classical economic, through economists F.A. Hayek and Keynesian theory is represented by John Maynard Keynes If we are in a recession how to these two beliefs get our country back to the LRAS 14