Economic Theories
Chap 12, 16, 17, 19
and Last Word Pg 177
Chap 12,16,17,19 Vocabulary
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Supply-side fiscal
policy
Say’s Law
Laissez-faire
Stagflation
Aggregate supply
shocks
Classical View
Keynesian View
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Monetarism
Equation of
exchange
Monetary rule
Rational
Expectations
Theory
Neo-classical
Economics
John Maynard Keynes
(pronounced: kaynz)

John Maynard Keynes, 5
June 1883 – 21 April 1946),
was a British economist
whose ideas have profoundly
affected the theory and
practice of modern
macroeconomics, as well as
the economic policies of
governments. He greatly
refined earlier work on the
causes of business cycles, and
advocated the use of fiscal
and monetary measures to
mitigate the adverse effects
of economic recessions and
depressions.
Keynesian (Mainstream) Economic Theory
John Maynard Keynes, 1930s
•Prices and Wages are downwardly
Inflexible
•Active Government action is required to
stabilize the Economy
•Economy does not self correct
• Horizontal Aggregate Supply
Curve moves to Full-Employment
• Unstable Aggregate Demand
• Velocity of money is NOT stable
(New)Keynesian (AS/AD)
Price Level
Full
Employment
B
A
AS
A deepening
recession
moving from
point A to B
P1
AD1
AD2
Q2
Q1
Real Domestic Output/GDP
Classical Economic Theory
Adam Smith - 1776
• Laissez-faire – NO government intervention
• Economy is self-correcting (Invisible Hand)
• Prices are upwardly and downwardly flexible
• Vertical Aggregate Supply Curve (LRAS)
• Stable Aggregate Demand
• Say’s Law – supply creates its own demand
• Real Output Depends Upon…
• Quantity of money possessed by households &
businesses
Full Employment
THE LONG RUN AGGREGATE SUPPLY
(LRAS) REPRESENTS FULL EMPLOYMENT.

LRAS
SRAS
MAYBE,THE MOST
IMPORTANT
GRAPH IN
MACROECONOMICS
Price
Level
P
AD
YF
Full Employment
GDPR
Real GDP
Definitions for
Long-Run v. Short-Run

Long-Run
• When wages become
adjusted for price level
changes. These wage
changes have the
effect of shifting the
SRAS to an equilibrium
point on the LRAS. On
the next slide,
movement from point
“b” to point “c”
indicates a response in
the long run.

Short-Run
• In the short run,
wages are fixed and
do not affect the cost
of production, despite
an increase or
decrease in price
level. For example on
the next slide
movement from point
“a” to point “b”
reflects the short run.
Keynesian Correction for a
Recession


The next slide shows how Keynesian
(or Mainstream) economic theory
moves to correct a recession.
The Economy moves from point “b”
to “c” as aggregate demand
increases and full employment is
restored.
KEYNESIAN VIEW FOR HOW
A RECESSION IS CORRECTED
ASLR
AS2
Price Level
AS1
c
P3
b
P2
a
P1
Maybe
higher price
levels *and
an
inflationary
spiral
AD2
AD1
o
Q2 Q 1
Real domestic output
Classical View of how an
Economy Corrects a Recession


The next slide reflects how an economy
self corrects a recession (movement
from point “a” to “b”)
As unemployment increases to point
“b”, workers are willing to accept lower
wages and Aggregate Supply increases
as production costs decline. The
economy returns from point “b” to
point “a” without government
intervention.
CLASSICAL VIEW OF HOW A
RECESSION IS CORRECTED
ASLR
AS2
Price Level
AS1
b
P2
a
P1
Nominal
wages fall &
AS returns
to its original
location
AD1
o
Q2 Q 1
Real domestic output
How Classical Economics
self-corrects inflation
• Normally, there is a short-run trade-off
between the rate of inflation and the rate of
unemployment.
• Approximately 70% of the cost of production
is wages. As unemployment decreases, upward
pressure is put on wages and AS decreases
resulting in wage-push inflation and increased
production costs. The economy moves from
point “b” to point “c”.
CLASSICAL VIEW OF SELF-CORRECTION
FOR INFLATION
SRAS2
AS
LR
Price Level
SRAS1
P3
P2
P1
Selfc
Correction
b
for an
a
AD2 increase in
AD AD
1
Q1
Real Domestic Output
A Review of the Classical
Economic Graphs

You must know what happens to
Price Level, Output (GDP), and the
unemployment rate as AS or AD
shift.
Increase in AD:
LRAS
PL
SRAS

P

P1
AD1
AD

Y
YF
GDPR
Price level increases, GDP increases and unemployment
decreases
Decrease in AD:
LRAS
PL
SRAS

P

P1
AD
AD1

YF
Y
GDPR
The decrease in AD causes the price level to decrease,
The GDP to decrease and unemployment to increase.
Increase in SRAS
SRAS
LRAS
PL
SRAS1

P

P1
AD

Y
YF
GDPR
Price level decreases, GDP increases and unemployment
decreases
Decrease in SRAS
SRAS1
LRAS
PL
SRAS

P

P1
AD

Y1
YF
GDPR
Increase in input costs causes SRAS to decrease. GDP
decreases, unemployment increases and Price increases
Recessionary Gap

An Recessionary gap exists when equilibrium
occurs below full employment output.
AD
PL
LRAS
SRAS
P
Y YF
GDPR
Inflationary Gap

An inflationary gap exists when equilibrium
occurs beyond full employment output.
PL
LRAS
SRAS
P
AD
YF Y
GDPR
ECONOMIC GROWTH
LRAS1
PL
SRAS
LRAS
SRAS1
P
AD1

YF
AD
YF
GDPR
Economic growth occurs as an economy is able to produce more goods and
increase the Real GDP. In the graph above, growth occurs as both AD and
SRAS increase simultaneously and this enables price level to remain stable.
This is what occurred In the U.S. during the 1990s. This is the same as an
increase reflected on the Production Possibilities Curve.
Capital Goods
Growth Illustrated on PPC
or Increased LRAS
.

PPC
Consumer Goods
PPC1
Full Employment
THE LONG RUN AGGREGATE SUPPLY
(LRAS) REPRESENTS FULL EMPLOYMENT.

PL
LRAS
SRAS
AGAIN, MAYBE,
THE MOST
IMPORTANT
GRAPH IN
MACROECONOMICS
P
AD
YF
GDPR
The “Original” PHILLIPS CURVE
Phillips curve
suggests inflation
and unemployment
are inversely related.
Annual rate of inflation
(percent)
7
6
5
4
3
2
1
0
SRPC
1
2
3
4
5
6
7
Unemployment rate (percent)
Trouble for the Phillips Curve
in the 70s and 80s
I
N
F
L
A
T
I
O
N
π%
4%
2%
(symbol for
Pi = inflation
rate in
macroeconomics)
The relationship
between unemployment
and inflation was not
as strong.
.
. .
. ..
.
. . .
. ..
.
5%
UNEMPLOYMENT
7%
.
PC
u%
The Long-Run Phillips Curve
π%
LRPC
I
N
F
L
A
T
I
O
N
The LRPC is the same as
the Full Employment Rate
(NRU). If NRU changes, so
does the LRPC
SRPC
un %
u%
The Long-Run Phillips Curve
(LRPC)
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Because the Long-Run Phillips Curve exists
at the natural rate of unemployment (un),
structural changes in the economy that
affect un will also cause the LRPC to shift.
Increases in un will shift LRPC 
Decreases in un will shift LRPC  (and if we
think back to Chapter 8, we may remember
that economists are predicting that the NRU
will increase for the U.S. economy so the
LRPC and the LRAS will shift to the left.
The Short-Run Phillips Curve
(SRPC)

Today many economists reject the concept of a
stable Phillips curve, but accept that there may
be a short-term trade-off between u% & π%
(symbol for Pi = inflation rate in
macroeconomics) given stable inflation
expectations. Most believe that in the long-run
u% & π% are independent at the natural rate of
unemployment. Modern analysis shows that the
SRPC may shift left or right. The key to
understanding shifts in the Phillips curve is
inflationary expectations!
Relating Phillips Curve to AS/AD
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Changes in the AS/AD model can also be seen
in the Phillips Curves
An easy way to understand how changes in the
AS/AD model affect the Phillips Curve is to
think of the two sets of graphs as mirror
images.
NOTE: The 2 models are not equivalent. The
AS/AD model is static, but the Phillips Curve
includes change over time. Whereas AS/AD
shows one time changes in the price-level as
inflation or deflation, The Phillips curve
illustrates continuous change in the price-level
as either increased inflation or disinflation.
Increase in AD = Up/left
movement along SRPC
PL
SRAS
SRPC

π1
π


P1
..
AD1
AD

Y
YF

P
.
.
LRAS
π%
GDPR
un
u
C↑, IG↑, G↑ and/or XN↑
.: AD  .: GDPR↑ & PL↑ .: u%↓ & π%↑ .: up/left along SRPC
u%
Decrease in AD = Down/right
along SRPC
LRAS
PL

P1
.
SRAS
SRPC
π

.

P
π%
.
.
π1
AD
AD1

YF
Y

GDPR
u
un
u%
C↓, IG↓, G↓ and/or XN↓
.: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓ .: down/right along SRPC
SRAS  = SRPC 
PL
LRAS
.
P1
Y
YF
LRPC
π1
.
GDPR
un
π
AD

SRPC1


.
SRAS1

SRPC
.

P
π%

SRAS
u
u%
Inflationary Expectations↓, Input Prices↓, Productivity↑,
Business Taxes↓, and/or Deregulation
.: SRAS  .: GDPR↑ & PL↓ .: u%↓ & π%↓ .: SRPC  (Disinflation)
SRAS  = SRPC 
SRAS1
SRAS
.


.
π1
π
AD

Y1
YF
LRPC
SRPC

P1
P
π%
LRAS

PL
SRPC1
.
.

GDPR
u n u1
u%
Inflationary Expectations↑, Input Prices↑, Productivity↓,
Business Taxes↑, and/or Increased Regulation
.: SRAS  .: GDPR↓ & PL↑ .: u%↑ & π%↑ .: SRPC  (Stagflation)
Monetarist Economic Theory
(a Neoclassical Theory)
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Neoclassical Theories agree with the basic premises
of Classical Theory but have expanded on the basic
theory. They use the LRAS Model.
Milton Friedman (Monetarist Theory)
Agrees with Classical Theory (no Government
intervention).
His Equation of Exchange is basis of Monetarism:
 M V = P Q (like: C + In + G + Xn = GDP)
 M=money supply
 V=velocity of money
 P=price level
 Q=quantity of goods produced (AS)
Monetarist (contd.)
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MV = PQ similar to C+I+G+Xn=GDP
Government’s role in the economy is to
increase Money Supply by the same amount
as projected GDP growth (3.5%)
Government should adopt the prescribed
increase in M as a “Monetary Rule”
Velocity of money is stable
Discretionary monetary and fiscal policies
disrupt self-correction
By adopting a “Monetary Rule”, businesses
and consumers can better anticipate Fed
actions.
Rational Expectations Theory
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Another neoclassical theory which uses a
LRAS model.
Assumes there should be monetary rule but
it is not specifically contained in the theory
Any actions by the government to “fix” the
economy will be offset by individuals who
act rationally (e.g. if G lowers interest rate
to fight a recession, personal consumption
and investment spending may still not
occur as people and businesses may assum
that the recession may NOT be ending.)
Supply Side Economic Theory
•Government should focus on Aggregate Supply, not
Aggregate Demand
•Decrease Taxes and create Incentives to Work
•Creates Incentives to Save and Invest
•Supply Side economics was tried during the Reagan
Administration and was commonly referred to as
“Reaganomics”. (or in Ferris Bueller as “VooDoo
Economics)
•The Laffer Curve is a basic assumption of Supply
Side economics. A criticism of the Laffer Curve is
that it is difficult to identify the “optimum” tax rate.
THE LAFFER CURVE
Tax rate (percent)
100
n
m
m
Maximum
Tax
Revenue
l
0
Tax revenue (dollars)
How Theories Differ
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Role of Government
Economy self corrects
Flexibility of prices
Laissez Faire Economics
Monetary Rule
Velocity of Money