Keynesian and Neoclassical Economics

1. Keynesian and Neoclassical Economics Macroeconomics

2. Keynes’ Law and the Macroeconomics of Demand • Demand creates its own supply • The level of GDP in the economy is not primarily determined by the potential of what the economy could supply, but rather by the amount of total demand • Explains the short-run well • Limitations: Economies do face genuine limits to how much they can produce, with the quantity of labor, physical capital and technology

3. The Keynesian AS–AD Model. The Keynesian View of the AS–AD Model uses an AS curve, which is horizontal at levels of output below potential and vertical at potential output. Thus, when beginning from potential output, any decrease in AD affects only output, but not prices; any increase in AD affects only prices, not output.

4. Keynes identified three factors that affect consumption: • Disposable income: For most people, the single most powerful determinant of how much they consume is how much income they have in their take-home pay, also known as disposable income, which is income after taxes • Expected future income: Consumer expectations about future income also are important in determining consumption. If consumers feel optimistic about the future, they are more likely to spend • Wealth or credit: When households experience a rise in wealth, they may be willing to consume a higher share of their income and to save less. How do people spend beyond their income? borrowing or credit

5. Two factors that shape investment: • Expectations of future profits: When an economy is expected to grow, businesses perceive a growing market for their products. Their higher degree of business confidence will encourage new investment • Interest rates: Lower interest rates stimulate investment spending and higher interest rates reduce it

6. Aggregate Demand in Keynesian Analysis

7. Sticky Wages and Prices

8. Jobs Lost/Gained in the Recession/Recovery

9. A Keynesian Perspective of Recession The equilibrium (E0) shows the importance of aggregate demand because this equilibrium is a recession which has occurred because aggregate demand is at AD1instead of AD0. The importance of sticky wages and prices is shown because of the assumption of fixed wages and prices, which make the AS curve flat below potential GDP. Thus, when AD falls, the intersection E1occurs in the flat portion of the AS curve where the price level does not change.

10. Phillips Curve: A More Accurate Model of AS

11. Keynesian Tradeoff Between Unemployment and Inflation A Phillips curve illustrates a tradeoff between the unemployment rate and the inflation rate; if one is higher, the other must be lower. For example, point A illustrates an inflation rate of 5% and an unemployment rate of 4%. If the government attempts to reduce inflation to 2%, then it will experience a rise in unemployment to 7%, as shown at point B

12. Phillips Curves Can Shift • Supply shocks and changes in inflationary expectations can cause the aggregate supply curve, and thus the Phillips curve, to shift • When aggregate supply shifts, the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher (as in the 1970s and early 1980s) or both lower (as in the early 1990s or first decade of the 2000s)

13. GDP Gap Potential (light) and actual (bold) GDP estimates from the Congressional Budget Office. The difference between the two represents the GDP gap

14. Expansionary Fiscal Policy to Fight Unemployment Expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending shifts the aggregate demand curve to the right

15. Contractionary Fiscal Policy to Fight Inflation Contractionary fiscal policy uses tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment

16. The Expenditure-Output Model

17. Equilibrium in the Keynesian Cross Diagram

18. Addressing Recessionary and Inflationary Gaps

19. The Multiplier Effect An original increase of government spending of $100 causes a rise in aggregate expenditure of $100. But that $100 is income to others in the economy, and after they save, pay taxes, and buy imports, they spend $53 of that $100 in a second round. In turn, that $53 is income to others. Thus, the original government spending of $100 is multiplied by these cycles of spending, but the impact of each successive cycle gets smaller and smaller

20. The Multiplier Effect in an Expenditure-Output Model The power of the multiplier effect is that an increase in expenditure has a larger increase on the equilibrium output. The increase in expenditure is the vertical increase from AE0 to AE1. However, the increase in equilibrium output, shown on the horizontal axis, is clearly larger

21. Say’s Law and the Macroeconomics of Supply • Supply creates its own demand • Since every sale represents income to someone, a given value of supply must create an equivalent value of demand somewhere else in the economy • Over periods of some years or decades, as the productive power of an economy to supply goods and services increases, total demand in the economy grows at roughly the same pace • Limitations: Does not explain short run economics or recessions well

22. Neoclassical Economics In the long run, the economy will fluctuate around its potential GDP and its natural rate of unemployment: • the size of the economy is determined by potential GDP (2) wages and prices will adjust in a flexible manner so that the economy will adjust back to its potential GDP level of output

23. Actual and Potential GDP Most economic recessions and upswings are times when the economy is 1–3% below or above potential GDP in a given year. Clearly, short-run fluctuations around potential GDP do exist, but over the long run, the upward trend of potential GDP determines the size of the economy

24. A Vertical AS Curve In the neoclassical model, the aggregate supply curve is drawn as a vertical line at the level of potential GDP. If AS is vertical, then it determines the level of real output, no matter where the aggregate demand curve is drawn. Over time, the LRAS curve shifts to the right as productivity increases and potential GDP expands.

25. The Rebound to Potential GDP after AD Increases The output at E0 is equal to potential GDP. Aggregate demand shifts right from AD0 to AD1. The new equilibrium is E1, with a higher output level of 55 and an increase in the price level to 125. With unemployment rates unsustainably low, wages are bid up by eager employers, which shifts short-run aggregate supply to the left, from AS0 to AS1. The new equilibrium (E2) is at the same original level of output, 50, but at a higher price level of 130. Thus, the long-run aggregate supply curve (ASn), which is vertical at the level of potential GDP, determines the level of real GDP in this economy in the long run

26. A Rebound Back to Potential GDP from a Shift to the Left in AD The original equilibrium (E0) happens at the intersection of the aggregate demand curve (AD0) and the short-run aggregate supply curve (AS0). The output at E0 is equal to potential GDP. Aggregate demand shifts left, from AD0 to AD1. The new equilibrium is at E1, with a lower output level of 45 and downward pressure on the price level of 115. With high unemployment rates, wages are held down. Lower wages are an economy-wide decrease in the price of a key input, which shifts short-run aggregate supply to the right, from AS0 to AS1. The new equilibrium (E2) is at the original level of output, but at a lower price level

27. Zones in the SRAS: Keynes Keynes’ law says demand creates its own supply, so that changes in aggregate demand cause changes in real GDP and employment. Keynes’ law can be shown on the horizontal Keynesian zone of the aggregate supply curve. The Keynesian zone occurs at the left of the SRAS curve where it is fairly flat, so movements in AD will affect output, but have little effect on the price level

28. Zones in the SRAS: Neoclassical Say’s law says supply creates its own demand. Changes in aggregate demand have no effect on real GDP and employment, only on the price level. Say’s law can be shown on the vertical neoclassical zone of the aggregate supply curve. The neoclassical zone occurs at the right of the SRAS curve where it is fairly vertical, and so movements in AD will affect the price level, but have little impact on output

29. Zones in the SRAS: Intermediate The intermediate zone in the middle of the SRAS curve is upward-sloping, so a rise in AD will cause higher output and price level, while a fall in AD will lead to a lower output and price level

30. When does it make sense to use each perspective? • Keynesian thinking makes sense over periods of time too short for wages and prices to adjust fully to demand or supply shocks • Neoclassical thinking makes sense over longer periods of time • Thus, Keynesian thinking is usually applied to understanding business cycles and Neoclassical thinking to economic growth

31. Practice Question What do Keynesian economists suggest the government do in a recession?

32. Quick Review • What are the tenets of Keynesian Economics how do they apply to the aggregate demand and supply model? • How do economists use the Expenditure Output model to explain periods of recession and expansion? • What are the tenets of neoclassical economics? • How do the tenets of Neoclassical economics apply to the aggregate supply and demand model? • Under what circumstances does it make sense to apply the Keynesian and Neoclassical perspectives?