Theories, Models, and The Fundamental Macro Debate

1
Theories, Models, and The Fundamental Macro Debate

• Our first venture into theories and models in
  macroeconomics.
• Theory -- An assertion about the causes of
  observed behavior, in order to predict outcomes.
• Model -- A formalization of a theory, done to
  make concise predictions.

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Classical Versus Keynesian Macroeconomic Theories
-- The Fundamental Debate

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Classical Thought -- The Economy (Adam
Smith)

• Classical Macroeconomics -- Because the nominal
  wage rate (W), prices (P), and interest rates (i)
  are flexible, the economy will automatically
  correct itself without need of policy.

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Classical Response to a Sluggish Economy (Y lt YN)

• W? ? labor more attractive to
• hire
• P? ? goods and services
• cheaper to purchase
• i? ? cheaper cost of borrowing,
• prompting more durable
• goods consumption and
• investment

5
Keynesian Thought -- The Economy (1936)

• Keynesian Macroeconomics -- Because the nominal
  wage rate (W), prices (P), or interest rates (i)
  are inflexible, the economy will not
  automatically correct itself, and therefore needs
  overt policy.

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Possible Reasons for Inflexibility or Stickiness

• W ? long-term labor contracts
• P ? costly for firms to change
• prices for goods and
• services they produce
• i ? Federal Reserve target
• variable for monetary policy

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Practical Thoughts -- Classical Vs Keynesian

• There are several Keynesian models, all based
  upon inflexibility.
• Was the Great Depression an aberration?
• What better represents the macroeconomy?
• How long is the short-run?