Download Keynesian vs New Classical

Keynesian vs New Classical
Different Interpretations of AS and
therefore of Equilibrium…particularly
in the Long Run
Review: simple equilibria
a) In the short run with a gap
b)
With no gap and
at Potential Y= LR equilibrium
The DEBATE
• It depends on the shape of the
• Will the
SRAS and on how markets &
economy
prices
(especially
wages)
behave.
automatically
adjust to the • Simply the answers
are:
LR
equilibrium? • Keynesians: No
• New Classical: Yes
In addition to the upwards sloping
SRAS………
– The long-run aggregate supply curve (LRAS)
(New Classical) shows the relationship between
the price level and output (real GDP) produced
by firms when the prices of all resources,
especially price of labor (wages), are flexible and
change along with changes in the price level. It
assumes the economy has reached its potential
– The Keynesian AS curve is for both LR and SR. It
assumes spare capacity at low levels of AD and
sticky prices/wages
Keynesian AS (SRAS &LRAS?) Curve
(Group III Wed 18th)
• Segment 1: spare capacity in the
economy. Wages and factor
prices very sticky
• Segment 2: spare capacity being
utilised.
• FoPs prices rising
•
Economy starts to overheat
• Segment 3 : Capacity fully utilised
(on the ppf). Cannot produce any
more unless capacity is increased.
• Spare
• capacity in the economy
If a deflationary/recessionary gap….
• Although there is a
Gap  high unemployment
• Wages and other factor
prices will NOT fall.
• Therefore Yequilibrium does
not change
• Governments must
intervene using………..
fiscal and monetary policy
to increase AD
Great Depression of 1930s
Keynesian SRAS=LRAS
• Keynes argued that as there is nothing
inherent in the economy to move the SR into
the LR  SRAS = LRAS
(NOTE: In diagrams taking a Keynesian viewpoint you
may see the AS curve labeled Keynesian AS or simply
LRAS. Either is all right, as long as the diagram’s title
makes clear which perspective is being adopted)
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Inflationary Gap in the
Keynesian Perspective
9
Full Employment Equilibrium
in the Keynesian Perspective …….but only happens by chance
10
New Classical (free market)
viewhandout pp4/5
Price Mechanism
Regulates markets
Perfectly
Competitive
Equilibrium
Sets the
Benchmark
New Classical
Perspective
The Economy is
an Harmonious
system
Full
Employment
(NRU) achieved
without
intervention
New Classical (Free Market) LRAS
In the Long Run all resources including wages change to match
changes in the price level Why is the LRAS vertical?
LRAS perfectly inelastic
at Full Employment
Level of Output (Ymax)
Potential Output is
determined by the
Quantity and Quality of
Factors of production (so
independent of the price
level)
12
Long-run equilibrium
13
Long-run equilibrium and Decline in AD
14
Return to Long-run equilibrium
15
Long-run equilibrium
16
Return to Long-run equilibrium
17
Implications of the New Classical LRAS ?
• In time any inflationary or recessionary gap
will disappear and the economy will move to
full employment (potential GDP with only the
natural rate of unemp.)
• Governments do NOT need to intervene in the
market
• In the LR increases in AD will not impact real
GDP but only bring about inflation
•  Group Work (3 groups)
18
Economic Growth:
Definition:
Increase in REAL GDP and/or increase in POTENTIAL OUTPUT
New Classical Perspective
19
Keynesian Perspective:
Keynesian curve can also shift right in the LR as factors of
production increase
20
Recap : the Keynesian perspective
Price Mechanism fails as wages are
“sticky” and prices are determined
in imperfectly competitive markets
The economy
can get stuck
in the SR
Keynesian
Perspective
Achieving Full
Employment
needs
intervention
The Economy
is inherently
unstable.
21
Implications of the
Keynesian AS (inflexibility of wages and prices stops the
economy moving into the LR).
Wages and prices
are downward
sticky
Unemployment and
low incomes may
persist in times of
recession and
depression.
The government must
intervene using fiscal
and monetary policy to
increase AD
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The Two Macroeconomic Schools of Thought
• AD = C + I + G + NX (X – M)
• LRAS = function of (Labor, Land, Capital, Entrepreneurs)