1. Classical and Keynesian Macro Analyses
Chapter 11
Classical and Keynesian Macro Analyses

2. Introduction
Among the many factors influencing the rate of GDP growth is the volume of business regulation. Concerns about terrorism have multiplied the amount of documentation that must accompany cargo arriving in U.S. ports. How does this affect real GDP?

3. Learning Objectives
Discuss the central assumptions of the classical model
Describe the short-run determination of equilibrium GDP and the price level in the classical model
Explain the circumstances under which the short-run aggregate supply curve may be either horizontal or upward-sloping

4. Learning Objectives
Understand what factors cause shifts in the short-run and long-run aggregate supply curves
Evaluate the effects of aggregate demand and supply shocks on equilibrium real output in the short run
Determine the causes of short-run variations in the inflation rate

5. Chapter Outline The Classical Model Equilibrium in the Labor Market
Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve
Output Determination Using Aggregate Demand and Aggregate Supply

6. Chapter Outline Determinants of Aggregate Supply
Effects of a Weaker Dollar

7. Did You Know That...
Different approaches to economic analysis have different views of price flexibility?
The Keynesian approach emphasizes the idea that prices of final goods and services may be slow to respond to higher input prices?

8. The Classical Model
The classical model was the first attempt to explain fluctuations in:
Inflation
Output
Income
Employment
Consumption
Saving
Investment

9. The Classical Model Assumptions of the classical model
Pure competition exists
Wages and prices are flexible
People are motivated by self-interest
People cannot be fooled by money illusion

10. The Classical Model Consequences of the assumptions
Minimize the role of government in the economy
If all prices and wages are flexible, any problems in the macroeconomy will be temporary
The power of the market will keep the economy at full-employment in the long run

11. The Classical Model Say’s Law Supply creates its own demand.
Producing goods and services generates the means and the willingness to purchase other goods and services.

12. Equating Desired Saving and Investment in the Classical Model14
Desired
Investment 12 10 8
Interest Rate (percent) 6 4 2
600
700
800
900
Investment and Saving per Year ($ billions)
Figure 11-2

13. 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.

14. The Classical Model Question Answer
Would unemployment be a problem in the classical model?
Answer
No, classical economists assumed that the wage would always adjust to the full employment level.

15. Example: Will Low Rates of Personal Saving Choke Off Investment Spending?
Personal saving rates have fallen dramatically in the U.S. over the past decade.
But rates of gross private domestic investment are steady.
Firms have been able to access sources of financing other than personal saving, such as their own retained earnings and funds invested by foreigners.

16. The Classical Model of the Labor Market
Figure 11-3

17. The Classical Model of the Labor Market
Table 11-1

18. Classical Theory and Vertical Aggregate Supply
In the classical model, long-term unemployment is impossible
The long-term aggregate supply curve is the only one the matters.
Rapid adjustment of prices and wages will move the economy to an equilibrium position on the long-run curve.

19. Classical Theory and Increases in Aggregate Demand
LRAS
Observations
Increase in AD creates disequilibrium
Quantity AD (Y1) > Quantity AS (Y0)
AD2
AD1
Price Level A1
120 E1 Y1
Real GDP per Year
Figure 11-4

20. Classical Theory and Increases in Aggregate Demand
LRAS
Observations
Price level increases returning the economy to equilibrium
P = 120, Real GDP = Y0
Only the price level changes
Real GDP supply determined
AD2
AD1 E2
130
Price Level A1
120 E1 Y1
Real GDP per Year
Figure 11-4

21. Effect of a Decrease in Aggregate Demand in the Classical Model
Figure 11-5

22. Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve
Some assumptions
Prices are not flexible
Short-run approach

23. Demand-Determined Output Equilibrium
AD1
Price Level Y1 P0
SRAS
Real GDP per Year
Figure 11-6

24. Demand-Determined Output Equilibrium
With excess capacity, increases in AD increase equilibrium
real national income, and the price level does not change.
AD1
AD2
Price Level Y1 P0
SRAS Y2
Real GDP per Year
Figure 11-6

25. Demand-Determined Output Equilibrium
AD3
AD1
AD2
Price Level Y1 P0
SRAS Y3 Y2
Real GDP per Year
Figure 11-6

26. Real GDP and the Price Level, 1934–1940
Figure 11-7

27. The Keynesian Short-Run Aggregate Supply Curve
The Keynesian model
Sources of price rigidities
Union contracts
Long-term contracts for raw materials, etc.
AD determines equilibrium real GDP
Capitalism may not be self-regulating

28. The Keynesian Short-Run Aggregate Supply Curve
The impact of a change in AD differs depending on the shape of the SRAS.
In the Keynesian model, the SRAS curve has one portion that is flat, and another portion that is upward-sloping.

29. Income Determination with Fixed versus Flexible Prices
SRAS
LRAS
AD1
AD1
Price Level
SRAS
120 12
120
12.0
Real GDP per Year ($ trillions)
Real GDP per Year ($ trillions)
Figure 11-8

30. Income Determination with Fixed versus Flexible Prices
SRAS
12.0
LRAS
AD2
AD2
AD1
AD1
130
12.5
Price Level
SRAS
120 12
120 13
Real GDP per Year ($ trillions)
Real GDP per Year ($ trillions)
Figure 11-8

31. Income Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing Price Levels
The Keynesian model
Rigid prices
Short-run view
AD determines output
The classical model
Flexible prices
Long-run view
LRAS determines output

32. Shifts in Both Short- and Long-Run Aggregate Supply
Figure 11-9

33. Shifts in SRAS Only
Figure 11-10

34. Determinants of Aggregate Supply
Changes that cause an increase in aggregate supply:
Discoveries of new raw materials
Increased competition
A reduction in international trade barriers
Fewer regulatory impediments to business
An increase in labor supplied
Increased training and education
A decrease in marginal tax rates
A reduction in input prices

35. Determinants of Aggregate Supply
Changes that cause a decrease in aggregate supply:
Depletion of raw materials
Decreased competition
An increase in international trade barriers
More regulatory impediments to business
A decrease in labor supplied
Decreased training and education
An increase in marginal tax rates
An increase in input prices

36. Consequences of Changes in Aggregate Supply and Demand
Aggregate Demand Shock
Any shock that causes the aggregate demand curve to shift inward or outward
Aggregate Supply Shock
Any shock that causes the aggregate supply curve to shift inward or outward

37. The Short-Run Effects of Stable Aggregate Supply and a Decrease in Aggregate Demand: The Recessionary Gap
Figure 11-11

38. The Short-Run Effects of Stable Aggregate Supply and an Increase in Aggregate Demand: The Inflationary Gap
Figure 11-12

39. The Effects of Stable Aggregate Demand and a Decrease in Aggregate Supply: Cost-Push Inflation
Figure 11-14

40. International Example: Korea Experiences Cost-Push Inflation
Winds and flooding from Typhoon Maemi in September 2003 caused significant damage to Korea’s infrastructure and productive capacity.
We depict this as a leftward shift of short-run aggregate supply, with a corresponding temporary decline in real GDP.

41. International Example: Korea Experiences Cost-Push Inflation
Figure 11-15

42. The Effects of a Weaker Dollar
Decrease in the value of the dollar raises the cost of imported inputs.
SRAS decreases
With AD constant, the price level rises
GDP decreases
Figure 11-16, Panel (a)

43. The Effects of a Weaker Dollar
Decrease in the value of the dollar makes net exports rise.
AD increases
With SRAS constant, the price level rises along with GDP
Figure 11-16, Panel (b)

44. Issues and Applications: An Aggregate Supply Shock in Cargo
Measures contained within the Trade Act require transportation companies to give prior notice to U.S. government officials of shipments arriving internationally.
The costs of complying with this regulation have caused an aggregate supply shock.

45. Summary Discussion of Learning Objectives
The four assumptions of the classical model are:
Pure competition
Completely flexible wages and prices
People are motivated by self-interest
No money illusion

46. Summary Discussion of Learning Objectives
Both the short-run and long-run aggregate supply curves are vertical at the full employment level of output.
If output prices and wages and input prices are “sticky,” the short-run aggregate supply curve can be horizontal.

47. Summary Discussion of Learning Objectives
Both the long-run and short-run aggregate supply curves will shift due to changes in resource endowments and technology. Changes in resource prices cause the SRAS curve to shift.
Aggregate demand and supply shocks change the equilibrium level of real output in the short-run.

48. Summary Discussion of Learning Objectives
Causes of short-run variations in the inflation rate:
An increase in aggregate demand
A decrease in short-run aggregate supply

49. Classical and Keynesian Macro Analyses
End of Chapter 11
Classical and Keynesian Macro Analyses