Classical Viewpoint vs Keynesian Viewpoint
• Classical View
– The government should have a very, very limited role in the
economy. Only to ensure free markets.
– The crowding out and net export effect have a very large impact
on ADAS and completely undo fiscal policy
– The economy can fix itself through wage adjustments in the long
run
• Keynesian Viewpoint
– The government must intervene in the market place when we
have major problems (recession and inflation).
– The Long Run is too long away to wait for the economy to fix
itself. People are suffering now, so must help them now (think
great depression)
– Crowding out and net export effect are very small and will have
very little effect on ADAS
How significant is crowding-out?
Price
Level
LRAS
SRAS
Price
Level
LRAS
SRAS
AD2
AD1
YF
AD2
AD1
AD3
AD3
Real GDP
Keynesian
YF
Real GDP
Classical
How does the economy fix itself?
• In the short run wages do not adjust to price level changes.
We don’t get a raise every month when CPI numbers are
released.
• In the long run wages will adjust to price level changes.
• If we are in a recession, wages go down
– People lose their jobs and take lower paying ones or take a pay
decrease
– Companies can offer lower starting salaries to employees
because there is a lot of competition for each job
• When we have inflation, wages go up.
– There is typically low unemployment (very low, below natural
rate)
– Our real wages have decreased, so we will ask for wages
– Starting salaries will be higher because there is a lot of
competition for each worker.
LR changes for recession
PL
LRAS
a
PL1
PL2
• In the short run, a  AD moves
equilibrium from a to b, thus
SRAS1
PL and output and 
SRAS2 unemployment.
b
c
PL3
AD2
Y2 YF
AD1
• In the long run, a  AD
eventually moves the economy
from a to c (after a  wages
SRAS)  PL but having no
change in output and
unemployment (back to YF).
GDPR
Conclusion: In the LR, an  AD does not have an effect on output and unemployment.
LR changes for inflation
PL
PL3
SRAS2
SRAS1
LRAS
c
b
PL2
PL1
• In the short run, an  AD
moves equilibrium from a to b,
thus  PL and output and 
unemployment.
a
YF Y2
• In the long run, an  AD
eventually moves the economy
AD2 from a to c  (after a wage 
 SRAS) resulting in an PL
but no change in output and
unemployment.
AD1
GDPR
Conclusion: In the LR, an  AD does not have an effect on output and unemployment.
No trade-off exists between inflation and unemployment in the LR.
PracticeLRASProblems
Price Level
SRAS
AD
Real GDP
• According to the graph above, which of the following is true about the LR
equilibrium of the economy depicted?
a)
b)
c)
d)
e)
The economy is in long-run equilibrium
The aggregate demand curve will shift to the left to restore LR equilibrium
The long-run aggregate supply curve will shift to the right to restore LR
equilibrium
Without fiscal policy stimulus, the economy will remain in a recession.
As wages increase, the SRAS curve will shift to the left to restore LR
equilibrium
Practice Problems
• An economy is in a short run equilibrium at a level of
output that is less than full-employment output. If
there is no fiscal or monetary policy interventions,
which of the following changes in output and the price
level would occur in the long run?
Output
Price Level
a)
b)
c)
d)
e)
Increase
Increase
Decrease
Decrease
No Change
Decrease
Increase
Decrease
Increase
No Change
Assume that the United States economy is currently in a recession in a short-run
equilibrium.
A. Draw a correctly labeled graph of the short-run and long-run Phillips curves. Use
the letter A to label a point that could represent the current state of the
economy in recession.
B. Draw a correctly labeled graph of aggregate demand and aggregate supply in the
recession and show each of the following.
i.
ii.
C.
The long-run equilibrium output, labeled Yf
The current equilibrium output and price levels, labeled Ye and PLe, respectively
To balance the federal budget, suppose that the government decides to raise
income taxes while maintaining the current level of government spending. On
the graph drawn in part (b), show the effect of the increase in taxes. Label the
new equilibrium output and price levels Y2 and PL2, respectively.
Assume that the Federal Reserve uses monetary policy to stimulate the
economy.
D.
i.
ii.
iii.
E.
What open-market policy should the Federal Reserve implement?
Using a correctly labeled graph of the money market, show how the policy in part (d)(i)
affects nominal interest rates.
What will be the impact of the policy on the price level? Explain.
Now assume instead that the government and the Federal Reserve take no policy
action in response to the recession.
i.
ii.
In the long run, will the short-run aggregate supply increase, decrease, or remain
unchanged? Explain.
In the long run, what will happen to the natural rate of unemployment?
Assume that the economy of Meekland is in a long-run equilibrium with a
balanced government budget.
A. Using a correctly labeled graph of aggregate supply and aggregate
demand, show each of the following.
i.
ii.
B.
C.
D.
E.
F.
Long-run aggregate supply
The output level, labeled YE, and the price level, labeled PLE
Assume consumer confidence falls. Show on your graph in part (a) the
short-run impact of the change in consumer confidence and label the
new equilibrium price level and output Y1 and PL1, respectively.
Using a correctly labeled graph of the short-run and long-run Phillips
curves, show the effect of the fall in consumer confidence on inflation.
Label the initial long-run equilibrium point A and the new short-run
equilibrium point B.
If the government and the central bank do not pursue any discretionary
policy change, how does the fall in consumer confidence affect
government transfer payments in Meekland? Explain.
Draw a correctly labeled graph of the loanable funds market in
Meekland and show the effect of the change in government transfer
payments you identified in part (d) on the real interest rate.
In the absence of any changes in fiscal and monetary policies, in the long
run will the short-run aggregate supply curve shift to the left, shift to the
right, or remain unchanged as a result of the fall in consumer
confidence? Explain.
The unemployment rate in the country of Southland is greater than
the natural rate of unemployment.
A.
Using a correctly labeled graph of aggregate demand and aggregate
supply, show the current equilibrium real gross domestic product,
labeled YC, and price level in Southland, labeled PLC.
The president of Southland is receiving advice from two economic
advisers—Kohelis and Raymond—about how best to reduce
unemployment in Southland.
B.
Kohelis advises the president to decrease personal income taxes.
i.
ii.
C.
How would such a decrease in taxes affect aggregate demand? Explain.
Using a correctly labeled graph of the short-run Phillips curve, show the
effect of the decrease in taxes. Label the initial equilibrium from part (a) as
point A, and the new equilibrium resulting from the decrease in taxes as
point B.
Raymond advises the president to take no policy action.
i.
ii.
What will happen to the short-run aggregate supply curve in the long run?
Explain.
Using a new correctly labeled graph of the short-run Phillips curve, show
the effect of the change in the short-run aggregate supply you identified in
part (c)(i).
Assume that the United States economy is currently in long-run equilibrium.
A. Draw a correctly labeled graph of aggregate demand and aggregate supply and
show each of the following.
i.
ii.
B.
The long-run aggregate supply curve
The current equilibrium output and price levels, labeled as YE and PLE, respectively
Assume that the government increases spending on national defense without
raising taxes.
i.
ii.
C.
On your graph in part (a), show how the government action affects aggregate demand.
How will this government action affect the unemployment rate in the short run? Explain.
Assume that the economy adjusts to a new long-run equilibrium after the
increase in government spending.
i.
ii.
How will the short-run aggregate supply curve in the new long-run equilibrium compare
with that in the initial long-run equilibrium in part (a) ? Explain.
On your graph in part (a), label the new long-run equilibrium price level as PL2.
D.
In order to finance the increase in government spending on national defense
from part (b), the government borrows funds from the public. Using a correctly
labeled graph of the loanable funds market, show the effect of the government’s
borrowing on the real interest rate.
E.
Given the change in the real interest rate in part (d), what is the impact on each
of the following?
i.
ii.
Investment
Economic growth rate. Explain.