Classical vs.

Keynesian Economists

Which model best describes our economy?

Keynesian vs. Classical Approach

Stock Market suddenly falls 25%

AD1

LRAS1PriceLevel

RealGDP

SRAS1What Now?

Tax Cuts?Gov’t Spending?New Incentives?Self-Regulation?

AD2

---------------P1

Y1

E1

--------

---------P2

Y2

E2

PriceLevel

Real GDP

Keynesian Range

Intermediate Range

AS

Classical Range

AD

Economy is at Full Employment when AS turns Vertical

Economic Schools of Thought

1900 1929

Classical Economics |----------------------------|

Keynesian Economics |----------------------------|

NeoClassical Economics |--------------------------------|

1936 1979 1980 2008

Great Depression?

Prices were not flexible!What Now?

Keynesian Economics did not help here!

CLASSICAL VIEW

1. Markets are naturally self regulating

2. No government intervention necessary

3. Recessions are temporary

4. Wages & prices are flexible

5. against minimum wages, welfare, government assistance

6. Real Variables do not depend on nominal variables

7. Great Depression challenged Classical View

Classical View9-2b

FIGURE 9-1Aggregate Supply and Aggregate Demand in Classical Economics

LRAS1PriceLevel

RealGDP

AD1

Classical Model Failure: The Great Depression

AD2

Real GDP ↓ 27%

Unemployment 3% → 25%

Price Levels fell

However,Wages did not adjust

KEYNSIAN VIEW

1. Economy is inherently unstable• not self regulating

2. Recessions can be long & permanent

3. Major government intervention necessary

4. Wages and prices are sticky/fixed• AS curve is very flat or upward sloping

5. Support welfare and government assistance

6. Stagflation challenged Keynesian view

Keynesian Failure: “Oil Shock”

Quantity ofOutput

PriceLevel

0

AD

3. . . . and Price level ↑ .

2. . . . causes R-GDP to fall . . .

1. An adverse shift in the SRAS

SRAS1

LRAS

Y

AP

SRAS2

B

Y2

P2

Shifting AD would make

inflation worse!

Reconciling 2-Views

• Most economists believe classical theory describes world in the long run but not short run

• Prices, Wages & interest rates are at least somewhat sticky in the short run

• Keynesian economics focuses on AD and failed to explain the Stagflation of the late 1970’s

Adverse Shifts in SRAS

• Consider an adverse shift in short run aggregate supply: • curve shifts to the left

• Output falls below natural rate of employment

• BOTH unemployment & price level rise

Stagflation

• A period of recession and inflation.– Output falls and price level rises– Example: late 1970’s in USA (oil crisis)

• Challenge: Policymakers who can influence aggregate demand cannot offset both simultaneously

Classical Recovery

Quantity ofOutput

PriceLevel

0

SRASLRAS

AD1

AP

Y

AD2

SRAS2

1. A decrease inaggregate demand . . .

2. . . . causes output to fall in the short run . . .

3. . . . but over time, the short-runaggregate-supplycurve shifts . . .

4. . . . and output returnsto its natural rate.

CP3

BP2

Y2

Alphabet Recovery Part 2

• http://www.pbs.org/newshour/bb/business/july-dec11/makingsense_10-07.html