Download appendix to chapter 26

APPENDIX TO CHAPTER 26
Policy Disputes Using the Self-Correcting
Aggregate Demand and Supply Model
In the appendix to the chapter on aggregate demand and supply, the classical selfcorrecting aggregate demand and supply model was explained without disagreement.
Expansionary and contractionary fiscal policy was discussed in the chapter on fiscal
policy, and this chapter explained monetary policy. In this appendix, we combine these
topics and examine contrasting fiscal and monetary policies using the self-correcting
model.
The Classical versus Keynesian Views of Expansionary Policy
The Keynesian activist approach rejects classical nonintervention policy to stabilize the
economy using discretionary fiscal policy or activist monetary policy. Exhibit A-1
illustrates opposing theories for restoring an economy in recession to full employment. In
both parts (a) and (b), the economy starts with a real GDP of $8 trillion and a price level
of 150 at macro equilibrium E1. Since full-employment real GDP is $12 trillion, the
recessionary gap equals $4 trillion. In part (a), the economy closes the gap through the
self-correction process. The key classical assumption is that nominal wages are flexible
and fall as a result of competition among unemployed workers for jobs. Over time, the
result is that the short-term aggregate supply curve (SRAS1) shifts rightward to SRAS2
and the economy automatically adjusts to long-run macro full-employment equilibrium at
E2 with a price level of 100.
Part (b) illustrates the opposing Keynesian theory. This view argues that nominal
wages are fixed in the short run. In contrast to the self-correction model, Keynesians
advocate using discretionary fiscal policy in which the federal government manages the
aggregate demand curve (AD) by increasing government spending or cutting taxes. Both
of these policy options work through the multiplier process and increase AD1 to AD2. The
result is that the economy achieves full-employment at macro equilibrium point E2 where
the price level is 200.
Activist monetary policy can also stabilize the economy. The Federal Reserve can
increase the money supply, which lowers the interest rate, and in response business
investment spending increases. As a result, AD1 shifts to AD2 in part (b) of Exhibit A-1,
and full employment is restored at E2.
Note that both approaches in parts (a) and (b) restore full-employment real GDP;
however, the impact on the price level is quite different. If classical theory is correct, the
price level falls from 150 to 100. In contrast, if Keynesian theory is correct, the price
level rises from 150 to 200, resulting in a higher inflation rate.
[Exhibit A-1]
CONCLUSION The classical approach to a recession is to let market forces
shift the short-run aggregate supply curve rightward and restore the economy to
full employment. The opposing Keynesian approach to cure a recession is to use
discretionary fiscal and monetary policy to increase aggregate demand and
achieve full-employment real GDP.
Classical versus Keynesian Views of Contractionary Policy
Exhibit A-2 shows alternative theories for closing an inflationary gap. The classical
nonintervention policy relies on competition among firms in response to a shortage of
labor. In parts (a) and (b), the economy is at macro equilibrium at point E1 where the
price level is 150 and real GDP is $16 trillion. There is an inflationary gap of $4 trillion
greater than the potential real GDP of $12 trillion. In part (a), classical theory assumes
flexible wages, so nominal wages rise causing the SRAS1 to shift upward to SRAS2, and
the economy reaches full-employment real GDP at point E2 with a price level of 200.
In part (b), Keynesian contractionary policy aims at decreasing AD1 to AD2 using
cuts in government spending or tax hikes. Working through the multiplier process, the
inflationary gap is eliminated, and the economy moves from point E1 to E2 where the
price level falls from 150 to 100 and full-employment real GDP of $12 trillion is
achieved.
26A-2
Exhibit A-1 Opposing Anti-Recession Theories
Part (a) illustrates classical theory, which advocates nonintervention fiscal and monetary
policy. The classical assumption is that nominal wages are flexible. At point E1,
unemployed workers compete for jobs, and the wage rate falls causing the short-run
aggregate supply curve to shift from SRAS1 to SRAS2. Full employment is therefore
automatically restored at point E2.
In part (b), Keynesian policy advocates interventionist fiscal and monetary policy.
Discretionary fiscal policy increases government spending or cuts taxes to increase the
aggregate demand curve from AD1 to AD2. Discretionary monetary policy would
increase the money supply to increase AD1 to AD2.
26A-3
Monetary policy can also be used to shift the aggregate demand curve leftward. In
this case, the Federal Reserve could follow a contractionary policy and decrease the
money supply, resulting in a higher interest rate and firms respond by decreasing their
investment spending. Consequently, AD1 decreases to AD1 and full-employment real
GDP is reached at E2.
In the previous exhibit, opposing theories have different impacts on the price
level. In part (a) of Exhibit A-2, the classical approach leads to an increase in the price
level from 150 to 200. In contrast, the Keynesian approach yields a decrease in the price
level from 150 to 100.
CONCLUSION The classical approach to an inflationary gap is to let market
forces shift the short-run aggregate supply curve leftward and restore the
economy to full employment. The opposing Keynesian approach to cure inflation
uses discretionary fiscal and monetary policy to decrease aggregate demand and
achieve full-employment real GDP.
[Exhibit A-2]
26A-4
Exhibit A-2 Opposing Anti-Inflation Theories
In part (a), the classical assumption is that at point E1 firms face a labor shortage and their
competition for available workers drives up the nominal wage rate. Under a
nonintervention policy, the short-run aggregate supply curve shifts leftward from SRAS1
to SRAS2, and the economy is automatically restored to full employment at E2.
Part (b) shows the effect of Keynesian contractionary policy. Discretionary fiscal
policy decreases government spending or increases taxes to shift the aggregate demand
curve leftward from AD1 to AD2. Discretionary monetary policy would decrease the
money supply to decrease AD1 to AD2.
26A-5
SUMMARY

The Keynesian prescription for a recession rejects the classical assumption that
wages are flexible and will fall, causing the short-run aggregate supply curve to
shift downward and restore full-employment GDP. Instead, Keynesians support
expansionary fiscal and monetary policy to increase aggregate demand and return
the economy to the natural rate of unemployment.

The Keynesian cure for inflation also rejects the classical assumption that wages
are flexible and will rise, causing the short-run aggregate supply curve to shift
upward and restore full-employment GDP. In contrast, Keynesian theory
advocates contractionary fiscal and monetary policy to decrease aggregate
demand and achieve full-employment macro equilibrium.
SUMMARY OF CONCLUSION STATEMENTS

The classical approach to a recession is to let market forces shift the short-run
aggregate supply curve rightward and restore the economy to full employment.
The opposing Keynesian approach to cure a recession is to use discretionary fiscal
and monetary policy to increase aggregate demand and achieve full-employment
real GDP.

The classical approach to an inflationary gap is to let market forces shift the shortrun aggregate supply curve leftward and restore the economy to full employment.
The opposing Keynesian approach to cure inflation uses discretionary fiscal and
monetary policy to decrease aggregate demand and achieve full-employment real
GDP.
26A-6
PRACTICE QUIZ
For a visual explanation of the correct answers, visit the tutorial at
http://tucker.swlearning.com.
1.
Assume the economy is experiencing a recessionary gap. Classical economists
would support which of the following policies:
a.
b.
c.
d.
2.
Assume the economy is in short-run equilibrium at a real GDP below its potential
real GDP. According to classical self-correction theory, which of the following
policies should be followed?
a.
b.
c.
d.
3.
wages will remain fixed.
monetary policy will sell government securities.
higher wages will shift the short-run aggregate supply curve leftward.
lower wages will shift the short-run aggregate supply curve rightward.
Assume the economy is operating at a real GDP above full-employment real
GDP. Keynesian economists would prescribe which of the following policies.
a.
b.
c.
d.
5.
The Federal Reserve should increase the money supply.
The federal government should increase spending.
The federal government should cut taxes.
None of the above.
Assuming the economy is in a recession, classical economists predict that:
a.
b.
c.
d.
4.
Contractionary
Expansionary
Nonintervention
Fixed wage
Nonintervention
Fixed rule
Contractionary
Expansionary
Assume the economy is in short-run equilibrium at a real GDP above its potential
real GDP. According to Keynesian theory, which of the following policies should
be followed?
a.
b.
c.
d.
The Federal Reserve should use open market operations and buy U.S.
government securities.
The Federal Reserve should follow a fixed rule.
The federal government should cut taxes.
Fiscal policy and monetary policy should be contractionary.
26A-7
6.
Assume the economy is experiencing an inflationary gap. Keynesian economists
would believe that
a.
wages will remain inflexible.
b.
the federal government should decrease spending to shift the aggregate
demand curve leftward.
c.
the Federal Reserve should lower the interest rate.
d.
the federal government should increase spending to shift the aggregate
demand curve rightward.
26A-8