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.