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Chapter 11
Classical and KeynesianMacro Analyses
Slide 11-2
Introduction
Among the many factors influencing the rate of GDP growth is the volume of
business regulation. Concerns about terrorism have multiplied the amount of
documentation that must accompany cargo arriving in U.S. ports. How does
this affect real GDP?
Slide 11-3
Learning Objectives
Discuss the central assumptions of the classical model
Describe the short-run determination of equilibrium GDP and the price level in the classical model
Explain the circumstances under which the short-run aggregate supply curve may be either horizontal or upward-sloping
Slide 11-4
Learning Objectives
Understand what factors cause shifts in the short-run and long-run aggregate supply curves
Evaluate the effects of aggregate demand and supply shocks on equilibrium real output in the short run
Determine the causes of short-run variations in the inflation rate
Slide 11-5
The Classical Model
Equilibrium in the Labor Market
Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve
Output Determination Using Aggregate Demand and Aggregate Supply
Chapter Outline
Slide 11-6
Chapter Outline
Determinants of Aggregate Supply
Effects of a Weaker Dollar
Slide 11-7
Did You Know That...
Different approaches to economic analysis have different views of price flexibility?
The Keynesian approach emphasizes the idea that prices of final goods and services may be slow to respond to higher input prices?
Slide 11-8
The Classical Model
The classical model was the first attempt to explain fluctuations in:– Inflation
– Output
– Income
– Employment
– Consumption
– Saving
– Investment
Slide 11-9
The Classical Model
Assumptions of the classical model– Pure competition exists
– Wages and prices are flexible
– People are motivated by self-interest
– People cannot be fooled by money illusion
Slide 11-10
The Classical Model
Consequences of the assumptions– Minimize the role of government in the
economy
– If all prices and wages are flexible, any problems in the macroeconomy will be temporary
– The power of the market will keep the economy at full-employment in the long run
Slide 11-11
The Classical Model
Say’s Law– Supply creates its own demand.
– Producing goods and services generates the means and the willingness to purchase other goods and services.
Slide 11-12Investment and Saving per Year ($ billions)
Inte
rest
Rat
e (p
erce
nt)
Equating Desired Saving and Investment in the Classical Model
600 700 800 9000
2
4
6
8
10
12
14
DesiredInvestment
DesiredSaving
Figure 11-2
Slide 11-13
Equating Desired Saving and Investment in the Classical Model
Summary– Changes in saving and investment create
a surplus or shortage in the short run.
– In the long run, this is offset by changes in the interest rate.
– This interest rate adjustment returns the market to equilibrium where S = I.
Slide 11-14
The Classical Model
Question– Would unemployment be a problem in the
classical model?
Answer– No, classical economists assumed that the
wage would always adjust to the full employment level.
Slide 11-15
Example: Will Low Rates of Personal Saving Choke Off Investment Spending?
Personal saving rates have fallen dramatically in the U.S. over the past decade.
But rates of gross private domestic investment are steady.
Firms have been able to access sources of financing other than personal saving, such as their own retained earnings and funds invested by foreigners.
Slide 11-16
The Classical Model of the Labor Market
Figure 11-3
Slide 11-17
The Classical Model of the Labor Market
Table 11-1
Slide 11-18
Classical Theory and Vertical Aggregate Supply
In the classical model, long-term unemployment is impossible
The long-term aggregate supply curve is the only one the matters.
Rapid adjustment of prices and wages will move the economy to an equilibrium position on the long-run curve.
Slide 11-19
Classical Theory and Increases in Aggregate Demand
Observations
– Increase in AD creates disequilibrium• Quantity AD (Y1) >
Quantity AS (Y0)
Real GDP per Year
Pric
e Le
vel
Y0
LRAS
AD1
AD2
Y1
A1120
E1
Figure 11-4
Slide 11-20
Classical Theory and Increases in Aggregate Demand
Observations– Price level increases
returning the economy to equilibrium• P = 120,
Real GDP = Y0
– Only the price level changes
– Real GDP supply determined
Real GDP per Year
Pric
e Le
vel
Y0
LRAS
Y1
AD2
AD1
120E1
A1
E2
130
Figure 11-4
Slide 11-21
Effect of a Decrease in Aggregate Demand in the Classical Model
Figure 11-5
Slide 11-22
Some assumptions
– Prices are not flexible
– Short-run approach
Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve
Slide 11-23Real GDP per Year
Pric
e Le
vel
Demand-DeterminedOutput Equilibrium
SRAS
AD1
Y1
P0
Figure 11-6
Slide 11-24Real GDP per Year
Pric
e Le
vel
Demand-DeterminedOutput Equilibrium
SRAS
AD1
Y1
P0
With excess capacity, increases in AD increase equilibriumreal national income, and the price level does not change.
AD2
Y2
Figure 11-6
Slide 11-25Real GDP per Year
Pric
e Le
vel
Demand-DeterminedOutput Equilibrium
SRAS
AD1
Y1
P0
AD2AD3
Figure 11-6
Y2Y3
Slide 11-26
Real GDP and the Price Level, 1934–1940
Figure 11-7
Slide 11-27
The Keynesian Short-Run Aggregate Supply Curve
The Keynesian model
– Sources of price rigidities• Union contracts• Long-term contracts for raw materials, etc.
– AD determines equilibrium real GDP
– Capitalism may not be self-regulating
Slide 11-28
The impact of a change in AD differs depending on the shape of the SRAS.
In the Keynesian model, the SRAS curve has one portion that is flat, and another portion that is upward-sloping.
The Keynesian Short-Run Aggregate Supply Curve
Slide 11-29
Income Determination with Fixed versus Flexible Prices
Real GDP per Year($ trillions)
Pric
e Le
vel
SRAS
Real GDP per Year($ trillions)
LRAS
AD1
SRAS
AD1
120
12
120
12.00 0
Figure 11-8
Slide 11-30
Income Determination with Fixed versus Flexible Prices
Real GDP per Year($ trillions)
Pric
e Le
vel
SRAS
Real GDP per Year($ trillions)
12.0
LRAS
AD1
SRAS
AD1
120
12
120
0 0
AD2 AD2
Figure 11-8
13
130
12.5
Slide 11-31
Income Determination UsingAggregate Demand and Aggregate Supply:
Fixed versus Changing Price Levels
The Keynesian model
– Rigid prices
– Short-run view
– AD determines output
The classical model
– Flexible prices
– Long-run view
– LRAS determines output
Slide 11-32
Shifts in Both Short- and Long-Run Aggregate Supply
Figure 11-9
Slide 11-33
Shifts in SRAS Only
Figure 11-10
Slide 11-34
Determinants of Aggregate Supply
Changes that cause an increase in aggregate supply:– Discoveries of new raw materials
– Increased competition
– A reduction in international trade barriers
– Fewer regulatory impediments to business
– An increase in labor supplied
– Increased training and education
– A decrease in marginal tax rates
– A reduction in input prices
Slide 11-35
Determinants of Aggregate Supply
Changes that cause a decrease in aggregate supply:
– Depletion of raw materials
– Decreased competition
– An increase in international trade barriers
– More regulatory impediments to business
– A decrease in labor supplied
– Decreased training and education
– An increase in marginal tax rates
– An increase in input prices
Slide 11-36
Consequences of Changes in Aggregate Supply and Demand
Aggregate Demand Shock
– Any shock that causes the aggregate demand curve to shift inward or outward
Aggregate Supply Shock
– Any shock that causes the aggregate supply curve to shift inward or outward
Slide 11-37
The Short-Run Effects of Stable Aggregate Supply and a Decrease in Aggregate
Demand: The Recessionary Gap
Figure 11-11
Slide 11-38
The Short-Run Effects of Stable Aggregate Supply and an Increase in Aggregate
Demand: The Inflationary Gap
Figure 11-12
Slide 11-39
The Effects of Stable Aggregate Demand and a Decrease in Aggregate Supply:
Cost-Push Inflation
Figure 11-14
Slide 11-40
International Example: Korea Experiences Cost-Push Inflation
Winds and flooding from Typhoon Maemi in September 2003 caused significant damage to Korea’s infrastructure and productive capacity.
We depict this as a leftward shift of short-run aggregate supply, with a corresponding temporary decline in real GDP.
Slide 11-41
International Example: Korea Experiences Cost-Push Inflation
Figure 11-15
Slide 11-42
The Effects of a Weaker Dollar
Decrease in the value of the dollar raises the cost of imported inputs.
SRAS decreases
With AD constant, the price level rises
GDP decreases
Figure 11-16, Panel (a)
Slide 11-43
The Effects of a Weaker Dollar
Figure 11-16, Panel (b)
Decrease in the value of the dollar makes net exports rise.
AD increases
With SRAS constant, the price level rises along with GDP
Slide 11-44
Issues and Applications:An Aggregate Supply Shock in Cargo
Measures contained within the 2002 Trade Act require transportation companies to give prior notice to U.S. government officials of shipments arriving internationally.
The costs of complying with this regulation have caused an aggregate supply shock.
Slide 11-45
Summary Discussion of Learning Objectives
The four assumptions of the classical model are: – Pure competition
– Completely flexible wages and prices
– People are motivated by self-interest
– No money illusion
Slide 11-46
Summary Discussion of Learning Objectives
Both the short-run and long-run aggregate supply curves are vertical at the full employment level of output.
If output prices and wages and input prices are “sticky,” the short-run aggregate supply curve can be horizontal.
Slide 11-47
Summary Discussion of Learning Objectives
Both the long-run and short-run aggregate supply curves will shift due to changes in resource endowments and technology. Changes in resource prices cause the SRAS curve to shift.
Aggregate demand and supply shocks change the equilibrium level of real output in the short-run.
Slide 11-48
Summary Discussion of Learning Objectives
Causes of short-run variations in the inflation rate:– An increase in aggregate demand
– A decrease in short-run aggregate supply
End of Chapter 11Classical and KeynesianMacro Analyses