Transcript Keynesian Economics

KEYNESIAN ECONOMICS
J.A. SACCO
1
Classical Theory Review
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All resources fully used
No unused capacity
Full employment/ Supplied determined
Economy is flexible- Prices, wages, savings,
investment, resources, labor, etc., all moving towards
equilibrium based on market forces (supply/demand)
• Shift of AD only changes price level not output (GDP)
• No short run equilibrium - Recessions are temporary
and economy always adjusting back to LRAS
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Classical vs. Keynesian
• The Classical Model
– Flexible prices
– Long-run view
– LRAS determines
output
• The Keynesian Model
– Rigid prices
– Short-run view
– AD determines output
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Keynesian Foundations
• Post WWI- Europe in economic decline
• Great Depression- 1930’s
Basis for John Maynard Keynes and his theories.
If classical approach was correct then,
economy would have corrected itselfBUT IT DIDN’T!
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Classical Theory and a
Decrease in Aggregate Demand
Price Level
LRAS
• According to Keynes
• Price level will not
decrease back to LRAS
when AD decreases
• CLASSICAL
THEORY IS WRONG
AD1
SAYS KEYNES!
110
E1
100
E2
AD2
Q1
Q0
Real GDP per Year
5
Keynesian Economics and the Keynesian Short-Run
Aggregate Supply Curve
• Some Different Assumptions
1) Short-run approach to the macroeconomy
2) Concentrated on reasons for continuing
recessions
3) Horizontal portion of AS curve is called the
Keynesian short-run AS.
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Keynesian Economics and the Keynesian
Short-Run Aggregate Supply Curve
4) Prices are not flexible/demand shocks will not raise
or lower prices- it will only affect output (Real GDP)
5) Level of output is “demand determined”
and the price level is constant
6)The SRAS curve assumes high unemployment and
unused capacity
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Price Level
Demand Determined
Income Equilibrium
With excess capacity
increases in AD
increases equilibrium
real national income
and the price level does
not change
SRAS
P3
With prices sticky
downward decreases
in AD will decrease
real national income
and the price level
does not change
AD3
Q3
Q1
Real GDP per Year
AD1
AD2
Q2
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Keynesian Economics and the Keynesian
Short-Run Aggregate Supply Curve
Big Question is WHY the SRAS is Horizontal,
and prices are constant and not flexible?
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Price of wages are “sticky”
downward
Labor unions and long
term contracts make
downward inflexibility of
the nominal wage not
possible
Also employers unwilling to
cut wages because they feel
workers would not work as
hard—loss of productivity
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“Sticky” wages make
involuntary unemployment
possible
Therefore since wages will
not be cut to employ all
workers- wages will remain
the same for some while
others will remain
unemployed
Thus the “classical” view of
full employment no longer
holds true- economy is not
self-regulating
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Keynesian Analysis
of the Great Depression
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1929 unemployment -- 3%
End of 1929 unemployment -- 9%
1933 unemployment -- 25%
1929 Real GDP not reached until 1937
Real GDP fell from $1 trillion to $700
billion
• 1933 economy operated at 30% below
potential
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Keynesian Analysis
of the Great Depression
LRAS
Price Level
SRAS
100
Following the decrease
in AD the price level
would have had to drop
to point A to avoid
Unemployment as
Classical theorists
support--it did not!
E2
E1
A
AD1933 AD1929
0.7
1.0
Real GDP per Year
($ trillions)
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Real GDP and the
Price Level, 1934-1940
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Final Thoughts on Keynes
• So in situations of excess capacity and large amounts of
unemployment—the price level will NOT fall. Instead what
occurs is continued unemployment and reduced GDP
• General economy wide equilibrium can occur and endure even if
there is excess capacity
• Capitalism is NOT a self-regulating system sustaining full
employment
• Attack “classical” view that market forces would lead to
equilibrium
• What is needed to push economy back to full equilibrium is
consistent government spending/lower taxes to increase AD
(fiscal policy) or an increase in the money supply (monetary
policy)
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Income Determination Using
Aggregate Demand and Aggregate Supply:
Fixed Versus Changing Price Levels
• The impact of a change in AD differs
depending on the shape of the SRAS.
PROBLEMS WITH THE KEYNESIAN SHORT- RUN?
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Keynesian Horizontal Short-Run
Price Level
•Doesn’t relate inflation
•Prices are not totally “sticky”
SRAS
120
AD1
6
AD2
7
Real GDP per Year
($ trillions)
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Income Determination with
Fixed Versus Flexible Prices
The price level
is not fixed and
the increase in AD
increases both
prices and real GDP
SRAS
120
Price Level
Price Level
The price level
is fixed and the
increase in AD
increases real
GDP to $7 trillion
LRAS
SRAS
130
120
AD2
AD1
6
AD1
AD2
7
Real GDP per Year
($ trillions)
6.0 6.5
Real GDP per Year
($ trillions)
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Modern Keynesian Short-Run
LRAS
SRAS
Price Level
Recognizes that some, but not
complete, prices adjustments,
made in the short run.
MKSR relates the
relationship between PL
130
and Real GDP with
120
incomplete price adjustments
and incomplete info in
the short run
AD2
AD1
6.0 6.5
Real GDP per Year
($ trillions)
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Economic Growth in an Aggregate Demand and
Supply Framework
• Keynesian macroeconomic analysis relates
to short-run fluctuations in unemployment,
inflation, and other macroeconomic
variables.
• Over time, economic growth may occur
with or without inflation.
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Economic Growth, Aggregate Demand, and
Aggregate Supply
LRAS1
Price Level
200
LRAS2
SRAS1
SRAS2
150
E1
100
E2
With economic growth,
LRAS1 and SRAS1
shifts outward with
no inflation
50
AD1
0
7
AD2
8
Real GDP per Year
(trillions of 1992 dollars)
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