Classical and Keynesian Macro Analysis

1
Classical and Keynesian Macro Analysis
2
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

3
Assumptions 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.

4
Classical Model RGDP

• Real GDP is Supply Determined.
• The equilibrium Price fluctuates when the ad
  curve shifts

5
J.B. Says Law

• Supply creates its own demand.
• Producing goods generates the demand to purchase
  other goods.
• Desired expenditures equal actual expenditures.

6
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.

7
Classical Model Saving and Investing

• The price of Credit (interest rate) ensures that
  the demand and supply of credit are equal

8
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.

9
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 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.

10
Demand Determined Real GDP

• According to Keynes, any change in aggregate
  demand will change Real GDP, thus output is
  demand determined.
• Price level doesnt change

11
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.

12
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.

13
Keynesian 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.

14
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.

15
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)

16
Shifts in LRAS and SRAS

• Any change in the endowments of the factors of
  production will cause both to shift.
• Ex. technology

17
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.

18
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

19
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

20
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.

21
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.

22
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

23
Cost Push Inflation

• When inflation occurs because of supply.
• A decrease in SRAS causes an increase in the
  price level.

24
Demand Pull Inflation

• When inflation occurs because of demand.
• An increase in demand causes an increase in the
  price level.

25
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.

26
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

27
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.

28
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?

29
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?