Understanding Keynesian Economics: Classical vs. Keynesian Theory Review

1. KEYNESIAN ECONOMICS J.A. SACCO

2. 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/inflation are temporary and economy always adjusting back to LRAS

3. The Classical Model Flexible prices Long-run view LRAS determines output The Keynesian Model Rigid prices Short-run view AD determines output Classical vs. Keynesian

4. 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!

5. LRAS 110 E1 100 E2 AD1 AD2 Q1 Q0 Classical Theory and aDecrease in Aggregate Demand • According to Keynes • Price level will not decrease back to LRAS when AD decreases • CLASSICAL THEORY IS WRONG SAYS KEYNES! Price Level Real GDP per Year

6. 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.

7. 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

8. SRAS P3 AD3 AD1 AD2 Q3 Q1 Q2 Demand DeterminedIncome Equilibrium With excess capacity increases in AD increases equilibrium real national income and the price level does not change Price Level With prices sticky downward decreases in AD will decrease real national income and the price level does not change Real GDP per Year

9. 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 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?

10. 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

11. LRAS SRAS E2 E1 100 A 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! AD1933 AD1929 0.7 1.0 Keynesian Analysisof the Great Depression Price Level Real GDP per Year ($ trillions)

12. Real GDP and thePrice Level, 1934-1940

13. 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)

14. 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?

15. SRAS 120 AD2 AD1 6 7 Keynesian Horizontal Short-Run • Doesn’t relate inflation • Prices are not totally “sticky” Price Level Real GDP per Year ($ trillions)

16. The price level is fixed and the increase in AD increases real GDP to $7 trillion The price level is not fixed and the increase in AD increases both prices and real GDP LRAS SRAS SRAS 130 SRAS 120 120 AD2 AD1 AD2 AD1 6 7 6.0 6.5 Income Determination with Fixed Versus Flexible Prices Price Level Price Level Real GDP per Year ($ trillions) Real GDP per Year ($ trillions)

17. LRAS SRAS SRAS 130 120 AD2 AD1 6.0 6.5 Modern Keynesian Short-Run • Recognizes that some, but not complete, prices adjustments, made in the short run. • MKSR relates the relationship between PL and Real GDP with incomplete price adjustments and incomplete info in the short run Price Level Real GDP per Year ($ trillions)

18. 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.

19. LRAS1 LRAS2 SRAS1 SRAS2 With economic growth, LRAS1 and SRAS1 shifts outward with no inflation E1 E2 AD1 AD2 Economic Growth, Aggregate Demand, and Aggregate Supply 200 150 Price Level 100 50 0 7 8 Real GDP per Year (trillions of 1992 dollars) Clifford