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Adam Smith 1723-1790 Classical vs. Keynesian John Maynard Keynes 1883-1946 1 Classical vs. Keynesian Debates Over Aggregate Supply Classical Theory 1. 2. A change in AD will not change output even in the short run because prices of resources (wages) are very flexible. AS is vertical so AD can’t increase without causing inflation. Price level AS AD Qf Real domestic output, GDP 3 Debates Over Aggregate Supply Classical Theory 1. 2. A change in AD will not change output even in the short run because prices of resources (wages) are very flexible. AS is vertical so AD can’t increase without causing inflation. Price level AS Recessions caused by a fall in AD are temporary. Price level will fall and economy will fix itself. No Government Involvement Required AD AD1 Qf Real domestic output, GDP 4 Debates Over Aggregate Supply Keynesian Theory 1. 2. A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession doesn’t cause inflation Price level AS AD Qf Real domestic output, GDP 5 Debates Over Aggregate Supply Keynesian Theory 1. 2. A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession puts no pressure on prices AS Price level AD1 “Sticky Wages” prevents wages to fall. The government should increase spending to close the gap AD Q1 Qf Real domestic output, GDP 6 Debates Over Aggregate Supply Keynesian Theory 1. 2. A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. Increase in AD during a recession puts no pressure on prices AS Price level AD1 When there is high unemployment, an increase in AD doesn’t lead to higher prices until you get close to full employment AD3 AD2 Q1 Qf Real domestic output, GDP 7 The Ratchet Effect A ratchet (socket wrench) permits one to crank a tool forward but not backward. Like a ratchet, prices can easily move up but not down! 8 Does deflation (falling prices) often occur? Not as often as inflation. Why? •If prices were to fall, the cost of resources must fall or firms would go out of business. •The cost of resources (especially labor) rarely fall because: •Labor Contracts (Unions) •Wage decrease results in poor worker morale. •Firms must pay to change prices (ex: re-pricing items in inventory, advertising new prices to consumers, etc.) 9 Three Ranges of Aggregate Supply 1. Keynesian Range- Horizontal at low output 2. Intermediate Range- Upward sloping 3. Classical Range- Vertical at Physical Capacity AS Price level Classical Range Keynesian Range Intermediate Range Qf Real domestic output, GDP 10 The Phillips Curve Shows tradeoff between inflation and unemployment. What happens to inflation and unemployment when AD increase? In general, there is an inverse relationship between unemployment and inflation 12 Short Run Phillips Curve When the economy is overheating, there is low unemployment but high inflation Inflation When there is a recession, unemployment is high but inflation is low 5% 1% SRPC 2% 9% Unemployment 13 Short Run Phillips Curve What happens when AS falls causing stagflation? Increase in unemployment and inflation Inflation 5% SRPC1 1% SRPC 2% 9% Unemployment 14 Short Run vs. Long Run What happens when AD increases? What happens in the long run? Inflation Long Run Phillips Curve In the long run, wages and resource prices increase. AS falls. SRPC shifts right. 5% 3% SRPC1 1% SRPC 2% 5% 9% Unemployment 15 Short Run vs. Long Run In the long run there is no tradeoff between inflation and unemployment Inflation Long Run Phillips Curve 5% The LRPC is vertical at the Natural Rate of Unemployment 3% 1% 2% 5% 9% Unemployment 16 Short Run vs. Long Run What happens when AD falls? What happens in the long run? Inflation Long Run Phillips Curve 5% In the long run wages fall and there is no tradeoff between inflation and unemployment 3% 1% 2% 5% SRPC SRPC1 Unemployment 9% 17 AD/AS and the Phillips Curve AD/AS and the Phillips Curve Show what happens on both graphs if AD increase Price Level LRAS Inflation LRPC AS PLe AD1 SRPC AD QY GDPR UY Unemployment 19 AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC with the recessionary gap. What happens when AD falls? Price Level LRAS Inflation LRPC AS PLe AD1 QY SRPC AD GDPR UY Unemployment 20 AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC at full employment. What happens when AS falls? Price Level LRAS AS1 Inflation LRPC AS PLe SRPC1 AD QY GDPR SRPC UY Unemployment 21 AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC with an recessionary gap. What happens when AS goes up? Price Level LRAS AS Inflation LRPC AS1 PLe SRPC AD QY GDPR SRPC1 UY Unemployment 22 Price Level LRAS SRAS Inflation LRPC SRPC QY GDPR UY Unemployment 23 Price Level SRAS LRAS Inflation LRPC PLe AD AD3 QY GDPR AD2 SRPC UY Unemployment 24 Price Level LRAS AS1 SRAS Inflation LRPC AS2 PLe SRPC1 AD QY GDPR SRPC2 SRPC UY Unemployment 25 Price Level LRAS AS2 AS Inflation LRPC PLe AD2 AD QY GDPR SRPC1 SRPC UY Unemployment 26 Analyzing the Economy Graphically 27 Use the following models to show full employment, a recessionary gap, and an inflationary gap. 1. PPC 2. Business Cycle 3. AD/AS 4. Phillips Curve 28 The Good, the Bad, and the Ugly Unemployment Inflation GDP Growth Good 6% or less 1%-4% 2.5%-5% Worry 6.5%-8% 5%-8% 1%-2% Bad 8.5 % or more 9% or more .5% or less 29