1. CH. 11- Classical and Keynesian Macroanalysis
J.A.SACCO

2. Classical and Keynesian Macroanalysis
Section 4A was a “cliffhanger” for section 4B.
In Section 4A we examined what happens after an aggregate demand or supply shock
What we didn’t analyze is the effect of those shocks on the determination of equilibrium output, employment and the price level (inflation).
Classical Analysis
Keynesian Analysis
Two different methods of explaining the macroeconomy and the flexible nature of prices. Helps to explain equilibrium levels of GDP and employment.

3. The Classical Model
1770’s- First attempt to explain the determinants of the price level and the national levels of output, income, employment, consumption, saving, and investment.
Adam Smith
J.B.Say
David Ricardo
Thomas Malthus

4. Beliefs: The Classical Model
All wages and prices are flexible and that competitive markets exist throughout the economy (supply/demand)
Economy is self-regulating– economy always capable of achieving the natural rate of real GDP output and full employment (LRAS)
The price level of products and input costs change by the same percentage, that is proportionally, in order to maintain full employment level of output

5. The Classical Interpretation
Say’s Law
Supply creates its own demand
Producing goods and services generates the means and the willingness to purchase other goods and services
Example- Economy produces 7 trillion GDP (final goods/services) simultaneously produces the income with which these goods/services can be demanded.
Actual Aggregate Income = Actual Aggregate Expenditure
Total National Supply Equals its own Demand

6. Say’s Law and the Circular Flow

7. The Classical Model Assumptions of the Classical Model
*In order to study the classical model must accept the following assumptions
1) Pure competition exists- no single buyer or seller of a good or service can influence price
2) Wages and prices are flexible- All prices and wages are determined by supply/demand. Buyers/sellers cause prices to rise and fall to equilibrium levels

8. The Classical Model
3) People are motivated by self-interest- Businesses want to maximize profit. Households want to maximize standard of living.
4) People cannot be fooled by money illusion- Buyers and sellers recognize the change in relative prices, that is they understand inflation and lost purchasing power.
8% rise in wages/ 8% rise in price level (inflation)
You are not better off!!!

9. Roll of Government is minimal!
The Classical Model
Consequences of the Assumptions
1) Minimize the role of government in the economy
2) If disequilibrium (unemployment/inflation) occurs it will be temporary
3) The power of market forces will keep the economy at full-employment in the long-run
Roll of Government is minimal!

10. Houston, We May Have a Problem!
What is the problem with the assumption that all income will be spent to purchase all goods and services produced by an economy?
Saving

11. The Problem of Saving The Problem of Saving
While it is true that the income obtained from producing a certain level of real GDP must be sufficient to purchase that level of real GDP, there is no guarantee that all of this income will be spent. Some of this income might be saved
Saving is a type of leakage in the circular flow of income and output
Therefore aggregate demand will be less than aggregate supply.
This goes against the economy achieving the natural level of real GDP .

12. The Problem of Saving Full employment/No savings
Below full employment, because of savings
Leakage

13. The Classical Model Classical Answer Question
If saving increases won’t AD fall as consumption is reduced?
Classical Answer
No, because Saving (S) = Investment (I)
Remember, investment (I) is a component of GDP.
So any income saved would be invested by businesses so that the leakage of saving (less “C”) would be matched by the injection of business investment (more “I”).

14. Equating Desired Saving and Investment in the Classical Model
Question
How does the market adjust to changes in investment?
In other words, what happens when demands of aggregate investment (a right shift) is greater then the supply of all savings in the economy?
CREDIT MARKET

15. Equating Desired Saving and Investment in the Classical Model
At 10% interest rate, an
increase in investment
creates a shortage (gap),
Investment>Savings.
The increase in
interest rate returns
the market to
equilibrium
Saving 14
Investment2
Investment1 12 10
Interest Rate (percent) 8 6 4 2
600
700
800
900
Investment and Saving per Year
($ billions)

16. Equating Desired Saving and Investment in the Classical Model
Summary
Changes in saving and investment create a surplus or shortage in the short-run.
In the long-run this is offset by changes in the interest rate.
This interest rate adjustment returns the market to equilibrium where S = I.
*The credit market is entirely flexible
based on supply and demand.

17. Equilibrium in the Labor Market
Flexibility of the wage rate also keeps the labor market in equilibrium.
>
If supply of workers
Demand for workers
Then wage rate decreases to reach “full employment”

18. Equilibrium in the Labor Market
Supply of labor S 16
Unemployment D 14
Full-employment
equilibrium 12 10
Hourly Wage Rate ($) 8 6 4
Demand of labor 2
105
115
125
135
145
155
Employment (millions or workers)

19. Changes in the demand for Labor Market
Question
How does the market adjust to changes ( left shift) in the demand for labor?

20. Equilibrium in the Labor Market
Unemployment S 16 D1 14 D2
Wages adjust to
eliminate the
unemployment 12 10
Hourly Wage Rate ($) 8 6 4 2
105
115
125
135
145
155
Employment (millions or workers)

21. Equilibrium in the Labor Market
If unemployed (surplus labor) accept lower wage than all workers can be put back to work (equilibrium reached)
Classical economists believe that any unemployment that occurs in the labor market or any other resource market is “voluntary unemployment”.
Once again, just as with the credit market ,
the labor market is also flexible.

22. Classical Price Level and Output Determination
Long term involuntary unemployment is impossible
Say’s Law- Flexible interest rates, prices, wages will keep all markets in equilibrium
The LRAS (vertical) is the only aggregate supply curve that exists in equilibrium
Any shift of AD will soon cause a change in the price level
Any AD shock will cause only “temporary” disequilibrium. Q0
LRAS
Price Level
Real GDP per Year

23. Classical Theory and Increases in Aggregate DemandQ0
LRAS
Observations
Initial equilibrium at P=100 and Q0
AD1
Price Level
100 E1
Real GDP per Year

24. Classical Theory and Increases in Aggregate Demand
LRAS
Observations
At PL 100, an increase in AD creates disequilibrium
At PL 100- greater than full employment exists (shortage)
AD (Q1) > AS (Q0)
Price Level A1
100 E1
AD2
AD1 Q0 Q1
Real GDP per Year

25. Classical Theory and an Increase in Aggregate Demand
LRAS
Observations
Classical theory believes the economy adjusts back to equilibrium. WHY?
Wages/resources are bidded up. Price level increases to E2 returning the economy to equilibrium
P = 110, Real GDP = Q0
Only the price level changes
Real GDP supply is determined
110 E2
Price Level A1
100 E1
AD2
AD1 Q0 Q1
Real GDP per Year

26. Classical Theory and an Increase in Aggregate Demand

27. Long-Run Macroeconomic Equilibrium
The model of AD/AS predicts that in the long run, when all prices are flexible, that the AD, SRAS and LRAS curves will all intersect at potential output Yp.
Why? Take a look at what happens when the economy is not at Yp.
Suppose that AD decreased and shifted the curve to the left.
In the short run, real GDP Ye falls and is below Yp and the aggregate price level would also fall.
The amount that GDP falls below potential output is called a recessionary gap.
What happens next?
The labor market is weakened by the poor economy and unemployment begins to rise as workers are laid off. Eventually nominal wages begin to fall. As nominal wages fall, SRAS begins to shift to the right.
The recessionary gap begins to shrink because real GDP is rising.
Once real GDP has returned to Yp, the economy is back in long-run equilibrium.
The price level has fallen even further.
Suppose that AD increased and shifted the curve to the right.
In the short run, real GDP Ye increases and is above Yp and the aggregate price level would also rise.
The amount that GDP rises above potential output is called an inflationary gap.
The labor market is strengthened by the booming economy and unemployment begins to fall as workers are hired. Eventually nominal wages begin to rise. As nominal wages rise, SRAS begins to shift to the left.
The inflationary gap begins to shrink because real GDP is falling.
The price level has increased even further.
Note: the instructor should replicate the graphs to show the adjustment to a positive AD shock in a similar manner to the graphs associated with the negative AD shock.
Whenever the economy is out of long-run equilibrium, there is either a recessionary or an inflationary gap.
This output gap can be measured as a percentage Ye lies away from Yp.
Output gap = 100*(Ye – Yp)/Yp
Summarize for the students:
Recessionary gap: output gap is negative, nominal wages eventually fall, moving the economy back to potential output and bringing the output gap back to zero.
Inflationary gap: output gap is positive, nominal wages eventually rise, also moving the economy back to potential output and again bringing the output gap back to zero.
So in the long run the economy is self­ -­ correcting: shocks to aggregate demand affect aggregate output in the short run but not in the long run.

28. Effect of a Decrease in Aggregate Demand in the Classical Model
Graph a decrease in aggregate demand.

29. Figure Short-Run Versus Long-Run Effects of a Negative Demand Shock Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

30. Long-Run Macroeconomic Equilibrium
The model of AD/AS predicts that in the long run, when all prices are flexible, that the AD, SRAS and LRAS curves will all intersect at potential output Yp.
Why? Take a look at what happens when the economy is not at Yp.
Suppose that AD decreased and shifted the curve to the left.
In the short run, real GDP Ye falls and is below Yp and the aggregate price level would also fall.
The amount that GDP falls below potential output is called a recessionary gap.
What happens next?
The labor market is weakened by the poor economy and unemployment begins to rise as workers are laid off. Eventually nominal wages begin to fall. As nominal wages fall, SRAS begins to shift to the right.
The recessionary gap begins to shrink because real GDP is rising.
Once real GDP has returned to Yp, the economy is back in long-run equilibrium.
The price level has fallen even further.
Suppose that AD increased and shifted the curve to the right.
In the short run, real GDP Ye increases and is above Yp and the aggregate price level would also rise.
The amount that GDP rises above potential output is called an inflationary gap.
The labor market is strengthened by the booming economy and unemployment begins to fall as workers are hired. Eventually nominal wages begin to rise. As nominal wages rise, SRAS begins to shift to the left.
The inflationary gap begins to shrink because real GDP is falling.
The price level has increased even further.
Note: the instructor should replicate the graphs to show the adjustment to a positive AD shock in a similar manner to the graphs associated with the negative AD shock.
Whenever the economy is out of long-run equilibrium, there is either a recessionary or an inflationary gap.
This output gap can be measured as a percentage Ye lies away from Yp.
Output gap = 100*(Ye – Yp)/Yp
Summarize for the students:
Recessionary gap: output gap is negative, nominal wages eventually fall, moving the economy back to potential output and bringing the output gap back to zero.
Inflationary gap: output gap is positive, nominal wages eventually rise, also moving the economy back to potential output and again bringing the output gap back to zero.
So in the long run the economy is self­ -­ correcting: shocks to aggregate demand affect aggregate output in the short run but not in the long run.

31. Classical Price Level and Output Determination
Conclusions
In the long run, everything adjusts so fast that the economy is essentially always on or quickly moving back to equilibrium.
Economy is at or soon to be at full employment/equilibrium.
In the classical model, equilibrium level of real GDP is supply determined by the LRAS.
Changes in AD only effect the price level. It does not effect the output of real goods and services.