Classical vs. Keynesian

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Chapter3Unit 29Business, Computers, & Information Technology

Get your white boards!

1. Explain the results of Calvin’s proposal using AS and AD.

2. Draw an Inflationary Gap.

3. Draw a Recessionary Gap.

4. Define Stagflation.5. Name 10 College

Majors.

Review

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Adam Smith1723-1790

John Maynard Keynes1883-1946 3

Classicalvs.

Keynesian

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Debates Over Aggregate SupplyClassical Theory1. A change in AD will not change output even in the short run

because prices of resources (wages) are very flexible. 2. AS is vertical so AD can’t increase without causing inflation.

Price level

Real domestic output, GDP

AS

Qf

AD

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Debates Over Aggregate SupplyClassical Theory1. A change in AD will not change output even in the short run

because prices of resources (wages) are very flexible. 2. AS is vertical so AD can’t increase without causing inflation.

Price level

Real domestic output, GDP

AS

Qf

AD

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Recessions caused by a fall in AD are temporary.

Price level will fall and economy will fix itself.

No Government Involvement Required

AD1

Debates Over Aggregate SupplyKeynesian Theory1. A decrease in AD will lead to a persistent recession because

prices of resources (wages) are NOT flexible. 2. Increase in AD during a recession puts no pressure on prices.

Price level

Real domestic output, GDP

AS

Qf

AD

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Debates Over Aggregate SupplyKeynesian Theory1. A decrease in AD will lead to a persistent recession because

prices of resources (wages) are NOT flexible. 2. Increase in AD during a recession puts no pressure on prices.

Price level

Real domestic output, GDP

AS

Qf

AD

10Q1

• “Sticky Wages” prevents wages from

falling.• We are stuck at the new

equilibrium.• Every recent U.S. recession has followed this “GDP gap but no deflation” scenario.

AD1

Debates Over Aggregate SupplyKeynesian Theory1. A decrease in AD will lead to a persistent recession because

prices of resources (wages) are NOT flexible. 2. Increase in AD during a recession puts no pressure on prices

Price level

Real domestic output, GDP

AS

Qf

AD2

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AD1

Q1

The government should increase

spending to close the gap.

When there is high unemployment, an

increase in AD doesn’t lead to higher

prices until you get close to full

employment.

AD3

The Ratchet EffectA ratchet (socket wrench)

permits one to crank atool forward but not backward.

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Like a ratchet, prices can easily move up but not down!

Does deflation (falling prices) often occur?Not as often as inflation. Why?

Output prices rarely fall because:• Fear of price wars• Firms must pay to change prices (ex: re-pricing items

in inventory, advertising new prices to consumers…)

If output prices were to fall, the cost of resources must fall or firms would go out of business.

The cost of resources (especially labor) rarely fall because:

• Labor Contracts (Unions)• Wage decrease results in poor worker

morale and lower productivity.• Minimum wage

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Three Ranges of Aggregate Supply1. Keynesian Range- Horizontal at low output2. Intermediate Range- Upward sloping3. Classical Range- Vertical at Physical Capacity

Price level

Real domestic output, GDP

AS

Qf18

Keynesian Range

IntermediateRange

ClassicalRange