1. Macroeconomic Theories
Classical vs Keynesian Economics

2. Economic Schools of Thought
NeoClassical Economics
| |
Classical Economics
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Keynesian Economics
| |
Housing
Bubble
Now What?
Great Depression?
Prices were not flexible!
What Now?
Keynesian Economics did not help here!

3. Stock Market suddenly falls 25%
Gov’t Intervention with Fiscal Policy
“Self Regulation”?
Use Expansionary Fiscal Policy
↑ Gov’t Spending & ↓ Income Taxes
Impact: G ↑ & C ↑ => AD ↑
LRAS1
Price
Level
Real
GDP
SRAS1
AD1
AD2 P1 E1 P2 Y2 E2 Y1

4. Reading
Read Keynesian Handout

5. AS Price Level Classical Range Intermediate Range Keynesian Range AD
Economy is at Full Employment when AS turns Vertical AS
Price
Level
Classical Range
Intermediate Range
Keynesian Range AD
Real GDP

6. CLASSICAL VIEW Markets are naturally self regulating
No government intervention necessary
Recessions are temporary
Wages & prices are flexible
Against minimum wages, welfare, government assistance
Great Depression challenged Classical View

7. KEYNSIAN VIEW Economy is inherently unstable
not self regulating
Recessions can be long & permanent
Major government intervention necessary
Wages and prices are fixed/sticky
AS curve is very flat (fixed) or upward sloping (sticky)
Support welfare & government assistance
Stagflation challenged Keynesian view

8. Reconciling 2-Views
Most economists believe classical theory describes world in the long run but not short run
Prices, Wages & interest rates are at least somewhat sticky in the short run
Keynesian economics focuses on AD and failed to explain the Stagflation of the late 1970’s

9. Classical Model Failure: The Great Depression
Real GDP ↓ 27%
Unemployment 3% → 25%
Price Levels fell
Price
Level
LRAS2
AD2
AD1
However,
Wages did not adjust
Real
GDP

10. “Supply Shock” in SRAS A sudden shift in short run aggregate supply:
Stagflation is caused by adverse supply shock
SRAS shifts left
Output falls & Price level rises
period of recession and inflation.
Example: late 1970’s in USA (oil crisis)
Challenge: Policymakers who can influence AD cannot offset both simultaneously (Output falling & Price level rising)
Keynesian economics “failed”!
SRAS2