Module 35/19- Classical and
Keynesian Macroanalysis
J.A.SACCO
Classical and Keynesian Macroanalysis
 Section 4A was a “cliffhanger” for section 4B.
 In Section 4A we examined what happens after an
aggregate demand or aggregate supply shock
 What we didn’t analyze is the effect of those shocks
on the determination of equilibrium output,
employment and the price level (inflation).
Classical Analysis
Keynesian Analysis
Two different methods of explaining the macroeconomy and
the flexible nature of prices. Helps to explain equilibrium levels
of GDP and employment.
The Classical Model
 1770’s- First attempt to explain the determinants of the
price level and the national levels of output, income,
employment, consumption, saving, and investment.
Adam Smith
J.B.Say
David Ricardo
Thomas Malthus
The Classical Model
 Beliefs:
I.
II.
III.
All wages and prices are flexible and that competitive
markets exist throughout the economy
(supply/demand)
Economy is self-regulating– economy always capable
of achieving the natural rate of real GDP output and
full employment (LRAS)
The price level of products and input costs change by
the same percentage, that is proportionally, in order to
maintain full employment level of output
The Classical Interpretation
 Say’s Law
 Supply creates its own demand
 Producing goods and services generates the means and
the willingness to purchase other goods and services
 Example- Economy produces 7 trillion GDP (final
goods/services) simultaneously produces the income with
which these goods/services can be demanded.
Actual Aggregate Income = Actual Aggregate Expenditure
Total National Supply Equals its own Demand
5
Say’s Law and the Circular Flow
6
The Classical Model
 Assumptions of the Classical Model
*In order to study the classical model must accept the
following assumptions
1) Pure competition exists- no single buyer or seller of a
good or service can influence price
2) Wages and prices are flexible- All prices and wages
are determined by supply/demand. Buyers/sellers cause
prices to rise and fall to equilibrium levels
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The Classical Model
3) People are motivated by self-interest- Businesses
want to maximize profit. Households want to maximize
standard of living.
4) People cannot be fooled by money illusionBuyers and sellers recognize the change in relative prices,
that is the understand inflation and lost purchasing
power.
8% rise in wages/ 8% rise in price level (inflation)
You are not better off!!!
The Classical Model
 Consequences of the Assumptions
1) Minimize the role of government in the economy
2) If disequilibrium (unemployment/inflation)
occurs it will be temporary
3) The power of market forces will keep the
economy at full-employment in the long-run
Role of Government is minimal!
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Houston, We May Have a Problem!
 What is the problem with the assumption that all
income will be spent to purchase all goods and
services produced by an economy?
Saving
The Problem of Saving
 The Problem of Saving
 While it is true that the income obtained from
producing a certain level of real GDP must be
sufficient to purchase that level of real GDP, there is
no guarantee that all of this income will be spent.
Some of this income might be saved
 Saving is a type of leakage in the circular flow of
income and output
 Therefore aggregate demand will be less than
aggregate supply.
 This goes against the economy achieving the natural
level of real GDP .
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The Problem of Saving
Full employment/No
savings
Below full employment,
because of savings
Leakage
The Classical Model
 Question
 If saving increases won’t AD fall as consumption is
reduced?
 Classical Answer



No, because Saving (S) = Investment (I)
Remember, investment (I) is a component of GDP.
So any income saved would be invested by businesses
so that the leakage of saving (less “C”) would be
matched by the injection of business investment
(more “I”).
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Equating Desired Saving and Investment
in the Classical Model
 Question


How does the market adjust to changes in
investment?
In other words, what happens when demands of
aggregate investment (a right shift) is greater
then the supply of all savings in the economy?
CREDIT MARKET
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Equating Desired Saving and Investment in
the Classical Model
At 10% interest rate, an
Interest Rate (percent)
14
12
10
Saving
increase in investment
creates a shortage (gap),
Investment>Savings.
The increase in
interest rate returns
the market to
equilibrium
8
6
Investment2
Investment1
4
2
0
600
700
800
900
Investment and Saving per Year
($ billions)
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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.
*The credit market is entirely flexible
based on supply and demand.
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Equilibrium in the Labor Market
 Flexibility of the wage rate keeps the
labor market in equilibrium.
If supply of workers
>
Demand for workers
Then wage rate decreases to reach “full employment”
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Equilibrium in the Labor Market
Hourly Wage Rate ($)
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Unemployment
S
Supply of labor
14
Full-employment
equilibrium
12
10
8
6
D
4
Demand of labor
2
0
105 115 125 135 145 155
Employment (millions or workers)
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Changes in the demand for Labor Market
 Question

How does the market adjust to changes ( left
shift) in the demand for labor?
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Equilibrium in the Labor Market
Hourly Wage Rate ($)
Unemployment
16
S
14
Wages adjust to
eliminate the
unemployment
12
10
8
6
4
2
0
D1
D2
105 115 125 135 145 155
Employment (millions or workers)
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Equilibrium in the Labor Market
Once again, just as with the credit market ,
the labor market is also flexible.
 If unemployed (surplus labor) accept lower wage
than all workers can be put back to work
(equilibrium reached)
 Classical economists believe that any unemployment
that occurs in the labor market or any other resource
market is “voluntary unemployment”.
Classical Price Level and Output
Determination
LRAS
 Long term involuntary
Price Level




unemployment is
impossible
Say’s Law- Flexible interest
rates, prices, wages will
keep all markets in
equilibrium
The LRAS (vertical) is the
only aggregate supply curve
that exists in equilibrium
Any shift of AD will soon
cause a change in the price
level
Any AD shock will cause
only “temporary”
disequilibrium.
Q0
Real GDP per Year
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Classical Theory and
Increases in Aggregate Demand
Price Level
LRAS
 Observations
 Initial equilibrium at
P=100 and Q0
100
E1
AD1
Q0
Real GDP per Year
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Classical Theory and
Increases in Aggregate Demand
Price Level
LRAS
100
 Observations
 Increase in AD creates
disequilibrium
 At PL 100- greater
than full employment
exists (shortage)
A1
E1
AD2
 AD (Q1) > LRAS (Q0)
AD1
Q0
Q1
Real GDP per Year
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Classical Theory and an
Increase in Aggregate Demand
Price Level
LRAS
110
100
E2
A1
E1
 Observations
 Classical theory believes
the economy adjusts back
to equilibrium
 Wages/resources are
bidded up. Price level
increases to E2 returning
the economy to equilibrium
AD2
AD1
Q0
Q1
Real GDP per Year



P = 110, Real GDP = Q0
Only the price level changes
Real GDP supply
determined
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Classical Theory and an
Increase in Aggregate Demand
Long-Run Macroeconomic
Equilibrium
Effect of a Decrease in Aggregate Demand in
the Classical Model
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Figure 19.5 Short-Run Versus Long-Run Effects of a Negative Demand Shock
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers
Long-Run Macroeconomic
Equilibrium
Classical Price Level and Output Determination
 Conclusions
 In the long run, everything adjusts so fast that the economy is
essentially always on or quickly moving back to equilibrium.
 Economy is at or soon to be at full employment/equilibrium.
 In the classical model, equilibrium level of real GDP is supply
determined by the LRAS.
 Changes in AD only effect the price level. It does not effect the
output of real goods and services.