1. Classical vs. Keynesian Economists Which model best describes our economy?

2. Keynesian vs. Classical Approach Stock Market suddenly falls 25% AD 1 LRAS 1 Price Level Real GDP SRAS 1 What Now? Tax Cuts? Gov’t Spending? New Incentives? Self-Regulation? AD 2 --------------- P1P1 Y1Y1 E1E1 -------- --------- P2P2 Y2Y2 E2E2

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

4. Economic Schools of Thought 1900 1929 Classical Economics |----------------------------| Keynesian Economics |----------------------------| NeoClassical Economics |--------------------------------| 1936 1979 1980 2008 Great Depression? Prices were not flexible! What Now? Keynesian Economics did not help here!

5. CLASSICAL VIEW 1.Markets are naturally self regulating 2.No government intervention necessary 3.Recessions are temporary 4.Wages & prices are flexible 5.against minimum wages, welfare, government assistance 6.Real Variables do not depend on nominal variables 7.Great Depression challenged Classical View

6. Classical View 9-2b FIGURE 9-1 Aggregate Supply and Aggregate Demand in Classical Economics

7. LRAS 1 Price Level Real GDP AD 1 Classical Model Failure : The Great Depression AD 2 Real GDP ↓ 27% Unemployment 3% → 25% Price Levels fell However, Wages did not adjust

8. KEYNSIAN VIEW 1.Economy is inherently unstable not self regulating 2.Recessions can be long & permanent 3.Major government intervention necessary 4.Wages and prices are sticky/fixed AS curve is very flat or upward sloping 5.Support welfare and government assistance 6.Stagflation challenged Keynesian view

9. Keynesian Failure: “Oil Shock” Quantity of Output Price Level 0 AD 3.... and Price level ↑. 2.... causes R-GDP to fall... 1. An adverse shift in the SRAS SRAS 1 LRAS Y A P SRAS 2 B Y2Y2 P2P2 Shifting AD would make inflation worse!

10. 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

11. Adverse Shifts in SRAS Consider an adverse shift in short run aggregate supply: curve shifts to the left Output falls below natural rate of employment BOTH unemployment & price level rise

12. Stagflation A period of recession and inflation. –Output falls and price level rises –Example: late 1970’s in USA (oil crisis) Challenge: Policymakers who can influence aggregate demand cannot offset both simultaneously

13. Classical Recovery Quantity of Output Price Level 0 SRAS LRAS AD 1 A P Y AD 2 SRAS 2 1. A decrease in aggregate demand... 2.... causes output to fall in the short run... 3.... but over time, the short-run aggregate-supply curve shifts... 4.... and output returns to its natural rate. CP3P3 B P2P2 Y2Y2

14. Alphabet Recovery Part 2 http://www.pbs.org/newshour/bb/business/ july-dec11/makingsense_10-07.htmlhttp://www.pbs.org/newshour/bb/business/ july-dec11/makingsense_10-07.html