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Principles of Macroeconomics - Chapter 11

This document provides an overview of classical and Keynesian macroeconomic models. The classical model assumes flexible prices and wages and says that supply creates its own demand through Say's Law. The Keynesian model argues that prices are sticky in the short-run due to contracts, allowing for unemployment. It models the economy using aggregate demand (AD) and aggregate supply (AS) curves. The short-run AS curve is upward sloping, while the long-run AS curve is vertical. Changes in AD or short-run AS can affect output and inflation in the short-run.

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67 views

Principles of Macroeconomics - Chapter 11

This document provides an overview of classical and Keynesian macroeconomic models. The classical model assumes flexible prices and wages and says that supply creates its own demand through Say's Law. The Keynesian model argues that prices are sticky in the short-run due to contracts, allowing for unemployment. It models the economy using aggregate demand (AD) and aggregate supply (AS) curves. The short-run AS curve is upward sloping, while the long-run AS curve is vertical. Changes in AD or short-run AS can affect output and inflation in the short-run.

Uploaded by

Meghedi B.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Chapter 11: Classical Keynesian Macro Analysis

1. Classical Model around 1700 attempt to explain what determines price level,
output, income, employment, consumption, savings, and investment.

A. Say’s Law – Supply creates its own demand or AE = desired AE = actual AE


Implication of say’s Law- People produce more goods and services that they
want to trade for other goods.
Ou
t p
t
u c o
In me

Say’s Law in modern economy

Supply of Goods
and Services

Demand of Goods
and Services

Unemployment may occur.

B. Assumptions of the Classical Model


1. Pure competition exists – no single buyer/seller effects price.
2. Wages and Prices are flexible – prices, wages and interest rates are free to
move to the level dictated by supply and demand in the lung-run.
3. People are motivated by self-interest.
Businesses want to maximize profit, households want to maximize their self-
interest.
4. People can’t be fooled by money illusion.
Buyers and sellers react to changes in relative prices, not to changes to
money prices when relative prices stay unchanged.
C. Equilibrium in the Credit Market
When savings occur, it is not reflected in Demand, there consumption can
decrease and output decrease.
Classical economists believe if economy saves it will invest, so saving =
investment.

D. Equilibrium in Labor Market

E. Classical theory- Vertical Aggregate Supply and Price Level


Because of flexible interest rates, prices and ages tend to keep workers fully
employed so LRAS is vertical and there is full employment.
F. If Ad increase prices will increase and wages will increase as demand for
labor would go up, other input prices will rise as well. Real GDP will
remain unchanged.

If AD decreases it will be the reverse.

Keynesian Economics and Keynesian Short-Run AS Curve


John Meynard Keynes and his believes
Prices, especially price of labor are inflexible downward due to existence of long-
term contracts. This means prices are sticky.
A. Demand Determined Real GDP
B. The Keynesian short-run aggregate supply curve

-Keynesian short-run supply curve is called SRAS.


-Because of the existence of long-term contracts in wages, in the short run
prices are sticky which makes involuntary unemployment possible.

C. Output Determinants using Aggregate Demand and Aggregate Supply

Increase in AD or SRAS increases real GDP


I. Upward sloping SRAS is when prices in the economy can vary.
Why SRAS is upward sloping?
1. flexibility of working hours
2. capital can be used more intensively
3. profits will rise if prices go up and wages stay the same

II. Shift in LARS and SRAS and effects on Price and GDP
A. If Labor, Capital, and Technology increase, it means when there is
an increase in the factors of production it will shift LRAS and
SRAS.
B.
If Lp↑, Kp↑, Tp↑
Changes in input
prices will shift
SRAS.

III. Changes in Aggregate Demand


Increases/ decreases in AD will shift the curve to the right or left.
A.
Decrease in AD, shifts
AD curve to the left,
P↓, Real GDP↓

B.

Increase in AD shifts AD
to right
P↑, Real GDP↑
Explication Short-Run Variations in Inflation
Demand-Pull vs. Cost-Push Inflation
Demand-pull inflation – inflation caused by increase in AD that are not matched by
increase in AS.
Cost-push inflation- inflation caused by decrease in AS.

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