Module 35
May 2015
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According to the classical model of the price
level, the aggregate supply curve is vertical
even in the short run.
Business cycle – American economist Wesley
Mitchell pioneered the quantitative study of
business cycles. His work allowed for the
accurate measurement of business cycles, but
not theory of business cycles.
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John Maynard Keynes – The General Theory of
Employment, Interest, and Money.
Adam Smith – Wealth of Nations
Keynes economics reflect 2 main ideas – the
short-run effects of shifts in aggregate
demand on aggregate output, rather than
long-run determination of the aggregate
price level
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Classical vs. Keynesian
One important difference between classical and
Keynesian economics involves the short-run
aggregate supply curve. Panel (a) shows the
classical view; where the SRAS is vertical…shifts
in the aggregate demand affect the aggregate
price level but not the aggregate output.
(b) shows the Keynesian view, the short run SRAS
curve slopes upward, so shift in the aggregate
demand affect aggregate output as well as
aggregate price
Figure 35.1 Classical Versus Keynesian Macroeconomics
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers
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The second important factor is that classical
economists emphasized the role of changes in
the money supply in shifting the aggregate
demand curve, paying little attention to other
factors. Keynes argued that other factors,
especially changes in animal spirits (business
confidence) are mainly responsible for business
cycles.
Before Keynes, economists argued that a decline
in business confidence would have not effect on
agg PL or agg output…Keynes proved otherwise
Macroeconomic policy activism – the use of
monetary and fiscal policy to smooth out the
business cycle.
Keyne’s general theory was that monetary policy
would not be effective during a recession
Fiscal policy involves gov spending/tax rates and
decisions made about it are political; monetary
policy is free from politics
Most feel that if the central bank was quicker to
react, we would not have experienced such a bad
depression
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Monetarism – asserts that GDP will grow steadily if
the money supply grows steadily
Discretionary monetary policy – is the use of changes
in the interest rate or the money supply to stabilize
the economy
Monetary policy rule – a formula that determines the
central bank’s actions
Quantity theory of money – emphasizes the positive
relationship between the price level and the money
supply. It relies on the velocity equation (𝑀 × 𝑉 = 𝑃 ×
𝑌)
Velocity of money – the ratio of nominal GDP to the
money supply. It is a measure of the # of times the
average dollar bill is spent per year.
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Natural rate hypothesis – to avoid
accelerating inflation over time, the
unemployment rate must be high enough
that the actual inflation rate equals the
expected inflation rate
Political business cycle – results when
politicians use macroeconomic policy to serve
political ends
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New classical macroeconomics – is an approach
to the business cycle that returns to the classical
view that shifts in the aggregate demand curve
affect only the aggregate price level, not
aggregate output
Rational expectations – the view that individuals
and firms make decisions optimally, using all
available information
New Keynesian economics – market
imperfections can lead to price stickiness for the
economy as a whole.
Real business cycle theory – claims that
fluctuations in the rate of growth of total factor
productivity cause the business cycle