Classical and Keynesian

Macro Analysis
The Classical Model

 The first attempt to explain inflation, output,

income, employment, consumption, saving and
investment.
 The classical economists include: Smith, Ricardo,
Malthus, and Say
Assumptions of Classical Model

 Pure Competition Exists

 Wages and Prices are Flexible
 Self Interest
 People don’t have money illusion- they
understand nominal vs. real value.
 Problems in the economy are temporary and will
correct themselves.
Classical Model: RGDP

 Real GDP is Supply Determined.

 The equilibrium Price fluctuates when the ad
curve shifts
J.B. Say’s Law

 Supply creates its own demand.

 Producing goods generates the demand to
purchase other goods.
 Desired expenditures equal actual expenditures.
Leakages 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.
Classical Model: Saving and Investing
 The price of Credit
(interest rate) ensures
that the demand and
supply of credit are
equal
Wage 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.”
Keynesian 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 1930’s the minimum wage
sets a floor below which wages can’t drop.
 Therefore, changes in AD do not necessarily
change price as the classical economist argued.
Demand Determined Real GDP

 According to Keynes, any change in aggregate

demand will change Real GDP, thus output is demand
determined.
 Price level doesn’t change
Keynesian 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.
Real 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.
Keynesian Solutions:
Government 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.
What 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.
Modern 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)
Shifts in LRAS and SRAS

 Any change in the

endowments of the
factors of production
will cause both to shift.
 Ex. technology
Shifts 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.
Changes 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
 Changes 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
Recessionary 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.
Inflationary 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.
“Secular 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
Cost Push Inflation

 When inflation
occurs because of
supply.
 A decrease in SRAS
causes an increase
in the price level.
Demand Pull Inflation

 When inflation occurs

because of demand.
 An increase in
demand causes an
increase in the price
level.
 Effects 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.
 Effects 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
Practicing 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.
Practicing 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?
Practicing 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?