Transcript 03- Keynesian vs. Classical, Phillips Curvex

Adam Smith
1723-1790
Classical
vs.
Keynesian
John Maynard Keynes
1883-1946
1
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
2
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
3
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
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 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
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
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
6
Classical vs. Keynesian
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