Chapter 11 Classical and Keynesian Macro Analyses.

Chapter 11

Classical and KeynesianMacro Analyses

Slide 11-2

Introduction

Among the many factors influencing the rate of GDP growth is the volume of

business regulation. Concerns about terrorism have multiplied the amount of

documentation that must accompany cargo arriving in U.S. ports. How does

this affect real GDP?

Slide 11-3

Learning Objectives

Discuss the central assumptions of the classical model

Describe the short-run determination of equilibrium GDP and the price level in the classical model

Explain the circumstances under which the short-run aggregate supply curve may be either horizontal or upward-sloping

Slide 11-4

Learning Objectives

Understand what factors cause shifts in the short-run and long-run aggregate supply curves

Evaluate the effects of aggregate demand and supply shocks on equilibrium real output in the short run

Determine the causes of short-run variations in the inflation rate

Slide 11-5

The Classical Model

Equilibrium in the Labor Market

Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve

Output Determination Using Aggregate Demand and Aggregate Supply

Chapter Outline

Slide 11-6

Chapter Outline

Determinants of Aggregate Supply

Effects of a Weaker Dollar

Slide 11-7

Did You Know That...

Different approaches to economic analysis have different views of price flexibility?

The Keynesian approach emphasizes the idea that prices of final goods and services may be slow to respond to higher input prices?

Slide 11-8

The Classical Model

The classical model was the first attempt to explain fluctuations in:– Inflation

– Output

– Income

– Employment

– Consumption

– Saving

– Investment

Slide 11-9

The Classical Model

Assumptions of the classical model– Pure competition exists

– Wages and prices are flexible

– People are motivated by self-interest

– People cannot be fooled by money illusion

Slide 11-10

The Classical Model

Consequences of the assumptions– Minimize the role of government in the

economy

– If all prices and wages are flexible, any problems in the macroeconomy will be temporary

– The power of the market will keep the economy at full-employment in the long run

Slide 11-11

The Classical Model

Say’s Law– Supply creates its own demand.

– Producing goods and services generates the means and the willingness to purchase other goods and services.

Slide 11-12Investment and Saving per Year ($ billions)

Inte

rest

Rat

e (p

erce

nt)

Equating Desired Saving and Investment in the Classical Model

600 700 800 9000

2

4

6

8

10

12

14

DesiredInvestment

DesiredSaving

Figure 11-2

Slide 11-13

Equating Desired Saving and Investment in the Classical Model

Summary– Changes in saving and investment create

a surplus or shortage in the short run.

– In the long run, this is offset by changes in the interest rate.

– This interest rate adjustment returns the market to equilibrium where S = I.

Slide 11-14

The Classical Model

Question– Would unemployment be a problem in the

classical model?

Answer– No, classical economists assumed that the

wage would always adjust to the full employment level.

Slide 11-15

Example: Will Low Rates of Personal Saving Choke Off Investment Spending?

Personal saving rates have fallen dramatically in the U.S. over the past decade.

But rates of gross private domestic investment are steady.

Firms have been able to access sources of financing other than personal saving, such as their own retained earnings and funds invested by foreigners.

Slide 11-16

The Classical Model of the Labor Market

Figure 11-3

Slide 11-17

The Classical Model of the Labor Market

Table 11-1

Slide 11-18

Classical Theory and Vertical Aggregate Supply

In the classical model, long-term unemployment is impossible

The long-term aggregate supply curve is the only one the matters.

Rapid adjustment of prices and wages will move the economy to an equilibrium position on the long-run curve.

Slide 11-19

Classical Theory and Increases in Aggregate Demand

Observations

– Increase in AD creates disequilibrium• Quantity AD (Y1) >

Quantity AS (Y0)

Real GDP per Year

Pric

e Le

vel

Y0

LRAS

AD1

AD2

Y1

A1120

E1

Figure 11-4

Slide 11-20

Classical Theory and Increases in Aggregate Demand

Observations– Price level increases

returning the economy to equilibrium• P = 120,

Real GDP = Y0

– Only the price level changes

– Real GDP supply determined

Real GDP per Year

Pric

e Le

vel

Y0

LRAS

Y1

AD2

AD1

120E1

A1

E2

130

Figure 11-4

Slide 11-21

Effect of a Decrease in Aggregate Demand in the Classical Model

Figure 11-5

Slide 11-22

Some assumptions

– Prices are not flexible

– Short-run approach

Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve

Slide 11-23Real GDP per Year

Pric

e Le

vel

Demand-DeterminedOutput Equilibrium

SRAS

AD1

Y1

P0

Figure 11-6


Pric

e Le

vel


SRAS

AD1

Y1

P0

With excess capacity, increases in AD increase equilibriumreal national income, and the price level does not change.

AD2

Y2

Figure 11-6


Pric

e Le

vel


SRAS

AD1

Y1

P0

AD2AD3

Figure 11-6

Y2Y3

Slide 11-26

Real GDP and the Price Level, 1934–1940

Figure 11-7

Slide 11-27

The Keynesian Short-Run Aggregate Supply Curve

The Keynesian model

– Sources of price rigidities• Union contracts• Long-term contracts for raw materials, etc.

– AD determines equilibrium real GDP

– Capitalism may not be self-regulating

Slide 11-28

The impact of a change in AD differs depending on the shape of the SRAS.

In the Keynesian model, the SRAS curve has one portion that is flat, and another portion that is upward-sloping.

The Keynesian Short-Run Aggregate Supply Curve

Slide 11-29

Income Determination with Fixed versus Flexible Prices

Real GDP per Year($ trillions)

Pric

e Le

vel

SRAS


LRAS

AD1

SRAS

AD1

120

12

120

12.00 0

Figure 11-8

Slide 11-30

Income Determination with Fixed versus Flexible Prices


Pric

e Le

vel

SRAS


12.0

LRAS

AD1

SRAS

AD1

120

12

120

0 0

AD2 AD2

Figure 11-8

13

130

12.5

Slide 11-31

Income Determination UsingAggregate Demand and Aggregate Supply:

Fixed versus Changing Price Levels

The Keynesian model

– Rigid prices

– Short-run view

– AD determines output

The classical model

– Flexible prices

– Long-run view

– LRAS determines output

Slide 11-32

Shifts in Both Short- and Long-Run Aggregate Supply

Figure 11-9

Slide 11-33

Shifts in SRAS Only

Figure 11-10

Slide 11-34


Changes that cause an increase in aggregate supply:– Discoveries of new raw materials

– Increased competition

– A reduction in international trade barriers

– Fewer regulatory impediments to business

– An increase in labor supplied

– Increased training and education

– A decrease in marginal tax rates

– A reduction in input prices

Slide 11-35


Changes that cause a decrease in aggregate supply:

– Depletion of raw materials

– Decreased competition

– An increase in international trade barriers

– More regulatory impediments to business

– A decrease in labor supplied

– Decreased training and education

– An increase in marginal tax rates

– An increase in input prices

Slide 11-36

Consequences of Changes in Aggregate Supply and Demand

Aggregate Demand Shock

– Any shock that causes the aggregate demand curve to shift inward or outward

Aggregate Supply Shock

– Any shock that causes the aggregate supply curve to shift inward or outward

Slide 11-37

The Short-Run Effects of Stable Aggregate Supply and a Decrease in Aggregate

Demand: The Recessionary Gap

Figure 11-11

Slide 11-38

The Short-Run Effects of Stable Aggregate Supply and an Increase in Aggregate

Demand: The Inflationary Gap

Figure 11-12

Slide 11-39

The Effects of Stable Aggregate Demand and a Decrease in Aggregate Supply:

Cost-Push Inflation

Figure 11-14

Slide 11-40

International Example: Korea Experiences Cost-Push Inflation

Winds and flooding from Typhoon Maemi in September 2003 caused significant damage to Korea’s infrastructure and productive capacity.

We depict this as a leftward shift of short-run aggregate supply, with a corresponding temporary decline in real GDP.

Slide 11-41

International Example: Korea Experiences Cost-Push Inflation

Figure 11-15

Slide 11-42

The Effects of a Weaker Dollar

Decrease in the value of the dollar raises the cost of imported inputs.

SRAS decreases

With AD constant, the price level rises

GDP decreases

Figure 11-16, Panel (a)

Slide 11-43

The Effects of a Weaker Dollar

Figure 11-16, Panel (b)

Decrease in the value of the dollar makes net exports rise.

AD increases

With SRAS constant, the price level rises along with GDP

Slide 11-44

Issues and Applications:An Aggregate Supply Shock in Cargo

Measures contained within the 2002 Trade Act require transportation companies to give prior notice to U.S. government officials of shipments arriving internationally.

The costs of complying with this regulation have caused an aggregate supply shock.

Slide 11-45

Summary Discussion of Learning Objectives

The four assumptions of the classical model are: – Pure competition

– Completely flexible wages and prices

– People are motivated by self-interest

– No money illusion

Slide 11-46


Both the short-run and long-run aggregate supply curves are vertical at the full employment level of output.

If output prices and wages and input prices are “sticky,” the short-run aggregate supply curve can be horizontal.

Slide 11-47


Both the long-run and short-run aggregate supply curves will shift due to changes in resource endowments and technology. Changes in resource prices cause the SRAS curve to shift.

Aggregate demand and supply shocks change the equilibrium level of real output in the short-run.

Slide 11-48


Causes of short-run variations in the inflation rate:– An increase in aggregate demand

– A decrease in short-run aggregate supply

End of Chapter 11Classical and KeynesianMacro Analyses

Chapter 11 Classical and Keynesian Macro Analyses.

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