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UNit 2.5
there are two combating schools of
theory in economics...
Classical v.
Keynesian
we must examine the assessment of economic performance according to both!
THE RATCHET EFFECT
A ratchet (socket wrench) permits you to crank a
tool bit forward but NOT backward
To understand both schools, we must first analyze and comprehend...
• If 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 • Firms must pay to change prices (ex: re-pricing items
in inventory, advertising new prices to consumers, etc.)
Like a ratchet, prices can easily move up but not down!
the ratchet effect
In reality, VERY RARELY.
Does occur very often?deflation
why?
let’s examine aggregate supply according to...
Classical
v.
Keynesian
Pric
e le
vel
GDPR
AS
Qf
AD1
1. Prices of resources (wages) are very flexible 2. A change in AD will not change output, even in the SR 3. AD can’t increase without inflation
The CLASSICAL SCHOOL of Economics
Pric
e le
vel
GDPR
AS
Qf
AD1
1. Prices of resources (wages) are very flexible 2. A change in AD will not change output, even in the SR 3. AD can’t increase without inflation
The CLASSICAL SCHOOL of Economics
AD2
Recessions caused by a fall in AD are temporary
Price level will fall and economy will fix itself
No Government Involvement Required!
If AD falls, price level will not fall because wages are sticky
Recessionary Gap must be fixed by…
AS
The KEYNESIAN SCHOOL of Economics
1. Prices of resources (wages) are STICKY 2. A FALL in AD will not LEAD TO DEFLATION B/C WAGES DON’T FALL 3. AN INCREASE IN AD WILL RESULT IN INFLATION ONLY IF THE
ECONOMY IS APPROACHING FULL CAPACITY
Pric
e le
vel
GDPRQf
THE Government BY Increasing AD!AD1
AD2Q2
AS
Horizontal[Keynesian]
Range
IntermediateRange
Vertical[Classic]Range
Pric
e le
vel
GDPRQf
examining aggregate supplybreaking down the aggregate supply curve
SHIFTING AD & AS WITH BOTH THEORIES
let’s Practice!
AS
When prices are too high, consumer spending will decline.
THIS DECREASEs AD!
FLEXIBLE PRICES! Prices change, but GDP
doesn’t change!
Pric
e le
vel
GDPRQf
AD1
AD2
aggregate Demand: classical
AS
the economy fixes itself!!!
no government needed!
Pric
e le
vel
GDPR
AD2
aggregate Demand: classical
Qf
ASPr
ice
leve
l
GDPR
aggregate Demand: keynesian
AD2 AD1When prices deflate the economy declines with it,
THIS DECREASEs AD!
sticky PRICES! gdp changes, but prices
don’t change with it!
Qf
ASPr
ice
leve
l
GDPR
aggregate Demand: keynesian
prices don’t change! government intervention is needed for gdp growth!
Qf
AD3
ASPr
ice
leve
l
GDPR
aggregate Demand: keynesian
intermediary range the portion of Ad/As we
use in most models
Qf
As AD continues to grow, both GDPr and Price increase as we approach intermediary range.
AD4
ASPr
ice
leve
l
GDPR
aggregate Demand: keynesian
Qf
We are producing at Quantity full employment with stable
prices!
Full Capacity
AD5
ASPr
ice
leve
l
GDPR
aggregate Demand: keynesian
stagflation!!! Too much stimulation beyond
full capacity is deadly!
Qf
AD6But as AD surpasses full
capacity, increases in AD only mean inflation w/o economic
growth!
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