1. Keynesian vs New Classical
Different Interpretations of AS and therefore of Equilibrium…particularly in the Long Run

2. Review: simple equilibria
a) In the short run with a gap
With no gap and
at Potential Y= LR equilibrium

3. The DEBATE
Will the economy automatically adjust to the LR equilibrium?
It depends on the shape of the SRAS and on how markets & prices (especially wages) behave.
Simply the answers
are:
Keynesians: No
New Classical: Yes

4. In addition to the upwards sloping SRAS………
The long-run aggregate supply curve (LRAS) (New Classical) shows the relationship between the price level and output (real GDP) produced by firms when the prices of all resources, especially price of labor (wages), are flexible and change along with changes in the price level. It assumes the economy has reached its potential
The Keynesian AS curve is for both LR and SR. It assumes spare capacity at low levels of AD and sticky prices/wages

5. Keynesian AS (SRAS &LRAS?) Curve (Group III Wed 18th)
Segment 1: spare capacity in the economy. Wages and factor prices very sticky
Segment 2: spare capacity being utilised.
FoPs prices rising
Economy starts to overheat
Segment 3 : Capacity fully utilised (on the ppf). Cannot produce any more unless capacity is increased.
Spare
capacity in the economy

6. If a deflationary/recessionary gap….
Although there is a
Gap  high unemployment
Wages and other factor prices will NOT fall.
Therefore Yequilibrium does not change
Governments must intervene using……….. fiscal and monetary policy to increase AD

7. Great Depression of 1930s

8. Keynesian SRAS=LRAS
Keynes argued that as there is nothing inherent in the economy to move the SR into the LR  SRAS = LRAS
(NOTE: In diagrams taking a Keynesian viewpoint you may see the AS curve labeled Keynesian AS or simply LRAS. Either is all right, as long as the diagram’s title makes clear which perspective is being adopted)

9. Inflationary Gap in the Keynesian Perspective

10. Full Employment Equilibrium in the Keynesian Perspective ……
Full Employment Equilibrium in the Keynesian Perspective …….but only happens by chance

11. New Classical (free market) viewhandout pp4/5
New Classical Perspective
Price Mechanism
Regulates markets
Full Employment (NRU) achieved without intervention
The Economy is an Harmonious system
Perfectly Competitive Equilibrium Sets the Benchmark

12. New Classical (Free Market) LRAS In the Long Run all resources including wages change to match changes in the price level Why is the LRAS vertical?
LRAS perfectly inelastic at Full Employment Level of Output (Ymax)
Potential Output is determined by the Quantity and Quality of Factors of production (so independent of the price level)

13. Long-run equilibrium

14. Long-run equilibrium and Decline in AD

15. Return to Long-run equilibrium

16. Long-run equilibrium

17. Return to Long-run equilibrium

18. Implications of the New Classical LRAS ?
In time any inflationary or recessionary gap will disappear and the economy will move to full employment (potential GDP with only the natural rate of unemp.)
Governments do NOT need to intervene in the market
In the LR increases in AD will not impact real GDP but only bring about inflation
 Group Work (3 groups)

19. Economic Growth: Definition: Increase in REAL GDP and/or increase in POTENTIAL OUTPUT New Classical Perspective

20. Keynesian Perspective: Keynesian curve can also shift right in the LR as factors of production increase

21. Recap : the Keynesian perspective
Price Mechanism fails as wages are “sticky” and prices are determined in imperfectly competitive markets
Achieving Full Employment needs intervention
The Economy is inherently unstable.
The economy can get stuck in the SR

22. Wages and prices are downward sticky
Implications of the Keynesian AS (inflexibility of wages and prices stops the economy moving into the LR).
Wages and prices are downward sticky
Unemployment and low incomes may persist in times of recession and depression.
The government must intervene using fiscal and monetary policy to increase AD

23. The Two Macroeconomic Schools of Thought
AD = C + I + G + NX (X – M)
LRAS = function of (Labor, Land, Capital, Entrepreneurs)