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KEYNESIAN ECONOMICS

J.A. SACCO

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Classical Theory Review

• 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 itself- BUT IT DIDN’T!

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AD1

• According to Keynes• Price level will not

decrease back to LRAS when AD decreases

• CLASSICAL THEORY IS WRONG SAYS KEYNES!

Classical Theory and aDecrease in Aggregate Demand

Real GDP per Year

Pri

ce L

evel

Q0

LRAS

AD2

Q1

110E1

100

E2

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Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve

• Some Different Assumptions1) 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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SRAS

Demand DeterminedIncome Equilibrium

AD1

Q1

P3

Q2

AD2

Q3

AD3

With prices stickydownward decreasesin AD will decreasereal national incomeand the price leveldoes not change

Real GDP per Year

Pri

ce L

evel

With excess capacityincreases in ADincreases equilibriumreal national incomeand the price level doesnot change

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Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve

• 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

• “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

Big Question is WHY the SRAS is Horizontal, and prices are constant and not flexible?

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Keynesian Analysisof the Great Depression

• 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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LRAS

AD1929

Keynesian Analysisof the Great Depression

Real GDP per Year($ trillions)

Pri

ce L

evel

SRAS

AD1933

100E1

1.0

E2

0.7

AFollowing the decreasein AD the price levelwould have had to dropto point A to avoidUnemployment as Classical theorists support--it did not!

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Real GDP and thePrice 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 UsingAggregate 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

Real GDP per Year($ trillions)

Pri

ce L

evel

SRAS

AD1

120

6

AD2

7

•Doesn’t relate inflation•Prices are not totally “sticky”

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AD1

AD2

Income Determination with Fixed Versus Flexible Prices

Real GDP per Year($ trillions)

Pri

ce L

evel

Real GDP per Year($ trillions)

Pri

ce L

evel

SRAS

AD1

120

6

AD2

7

SRASSRASLRAS

120

6.0

130

6.5

The price levelis fixed and theincrease in AD increases realGDP to $7 trillion

The price levelis not fixed andthe increase in ADincreases bothprices and real GDP

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AD1

AD2

Modern Keynesian Short-Run

Real GDP per Year($ trillions)

Pri

ce L

evel

SRASSRASLRAS

120

6.0

130

6.5

Recognizes that some, but not complete, prices adjustments, made in the short run.MKSR relates the relationship between PL and Real GDP withincomplete price adjustmentsand incomplete info inthe short run

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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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SRAS2

AD2AD1

LRAS1 LRAS2

Economic Growth, Aggregate Demand, and Aggregate Supply

Real GDP per Year(trillions of 1992 dollars)

Pri

ce L

evel

0

50

100

150

200

7 8

SRAS1

E1E2

With economic growth,LRAS1 and SRAS1 shifts outward withno inflation