Title: Classical and Keynesian Macro Analysis
1Classical and Keynesian Macro Analysis
2The Classical Model
- The first attempt to explain inflation, output,
income, employment, consumption, saving and
investment. - The classical economists include Smith, Ricardo,
Malthus, and Say
3Assumptions of Classical Model
- Pure Competition Exists
- Wages and Prices are Flexible
- Self Interest
- People dont have money illusion- they understand
nominal vs. real value. - Problems in the economy are temporary and will
correct themselves.
4Classical Model RGDP
- Real GDP is Supply Determined.
- The equilibrium Price fluctuates when the ad
curve shifts
5J.B. Says Law
- Supply creates its own demand.
- Producing goods generates the demand to purchase
other goods. - Desired expenditures equal actual expenditures.
6Leakages in savings
- When people save money there is a leakage in the
circular flow and planned consumption can fall
short of real GDP. - Classical economists argue that dollars saved
will be matched by business investment equally.
7Classical Model Saving and Investing
- The price of Credit (interest rate) ensures that
the demand and supply of credit are equal
8Wage and employment equilibrium in classical model
- In the classical model if there is unemployment,
beyond the natural rate, wage rates should fall
to the point where unemployed workers will be
attractive to hire. - Therefore, in the classical model people will not
be unemployed for very long and the model tends
towards full employment.
9Keynesian Short Run Aggregate Supply
- John Maynard Keynes argued that wages were not as
flexible as the classical model suggested, due to
labor unions and contracts. - In addition since the 1930s the minimum wage
sets a floor below which wages cant drop. - Therefore, changes in AD do not necessarily
change price as the classical economist argued.
10Demand Determined Real GDP
- According to Keynes, any change in aggregate
demand will change Real GDP, thus output is
demand determined. - Price level doesnt change
11Keynesian Short Run Aggregate Supply
- The horizontal portion of the supply curve is
where there is high unemployment and unused
capacity. - A leftward shift reduces real GDP creating
unemployment. - Keynes argues that capitalism may not be self
regulating, as the classical economists suggest. - Once an economy is in recession, it needs
increases in AD to move toward full employment.
12Real GDP and Price Level 1934-1940
- According to Keynesian theory, in a depressed
economy an increase in aggregate spending can
increase output without raising prices.
13Keynesian SolutionsGovernment Spending
- Keynes argued that when the economy goes into
recession due to lower consumption, investment,
and net exports, the government needs to step in
and spend money. - Keynesian policy is often linked to the New Deal
since FDR increased government funded programs
during the Great Depression. - Modern Keynesianism is connected to Democratic
Party economic policy.
14What do you think?
- During recessions, such as the recent Great
Recession, Democrats such as President Obama
enacted an economic stimulus which increased
government spending in a variety of areas. - Republican economic policy opposed this approach,
arguing for cutting back government spending and
lowering taxes as a way to jumpstart the economy.
15Modern Keynesian Analysis(SRAS) Short Run
Aggregate Supply
- Modern Keynesians agree that prices are not
completely sticky there is some price
adjustment. - The result is an SRAS curve that slopes upward
- Price and RGDP can increase together.
- SRAS can exceed full employment (LRAS)
16Shifts in LRAS and SRAS
- Any change in the endowments of the factors of
production will cause both to shift. - Ex. technology
17Shifts in SRAS Only
- Short lived events will change SRAS but will not
change LRAS. - Ex. A storm that damages ports along the coast
will only decrease RGDP temporarily or in the
short run.
18Changes that Cause an Increase in (AS)
- Discover new raw materials
- Increased Competition
- Reduce Trade Barriers
- Reduce business regulation
- Decrease Business Taxes
- Reduction to input prices
19Changes that Cause a Decrease in (AS)
- Depletion of raw materials
- Decreased Competition
- Increase in Trade Barriers
- Increase in business regulation
- Taxes increase
- Input prices increase
20Recessionary Gap
- When AS is stable and AD decreases, price level
and Real GDP decline. - The difference or gap between equilibrium Real
GDP at SRAS and equilibrium at full employment is
called the recessionary gap. E1 to E2.
21Inflationary Gap
- When AS is stable and AD increases, price level
and Real GDP rise. - The difference or gap between equilibrium Real
GDP at SRAS and equilibrium at full employment is
called the inflationary gap. - E1 to E2.
22Secular Deflation
- Price level declines which are caused by
increasing economic growth is referred to as
secular deflation. - Graph secular deflation using the classical
model. Increase the LRAS to show secular
deflation. - Now make a second graph showing deflation caused
by decreasing Aggregate Demand
23Cost Push Inflation
- When inflation occurs because of supply.
- A decrease in SRAS causes an increase in the
price level.
24Demand Pull Inflation
- When inflation occurs because of demand.
- An increase in demand causes an increase in the
price level.
25Effects of Weak Dollar Value
- A weaker dollar causes the cost of imported
inputs to increase, thus decreasing the SRAS - Weaker dollars also cause an increase in the AD
of US goods (exports). - For this reason we know that price levels will
rise with a weak dollar, but the quantity of RGDP
is indeterminate.
26Effects of a Strong Dollar
- A strong dollar causes the cost of imported
inputs to _______________, thus _____________the
SRAS - Strong dollars also cause an ____________ in the
AD of US goods (exports). - For this reason we know that ______________ will
fall with a strong dollar, but the
RGDP_________________. - Graph the impact of a strong dollar on AS and AD
27Practicing the Macro Model
- Draw a macro economic model with a contractionary
gap. Include the LRAS, AD curve, and an upward
diagonally sloping SRAS. Be sure to correctly
label each part of your graph. - Imagine that a weak US dollar expands US exports.
What impact will this have on the AD curve? How
will this increase in exports effect Real GDP and
Price level. Show this on your graph above.
28Practicing the Macro Model
- Draw a macro economic model with a inflationary
gap. Include the LRAS, AD curve, and an upward
diagonally sloping SRAS. Be sure to correctly
label each part of your graph. - Imagine the government steps in and decreases
government spending to slow the inflation. What
will happen to price level and real GDP on the
model above?
29Practicing the Macro Model
- Create a simple AD/AS model. What will happen to
prices and real GDP if the government increases
spending? - Create a Classical Macro model. What will happen
to prices and real GDP if the government
increases spending? - Create a short run Keynesian model. What will
happen to prices and Real GDP if the government
increases spending?