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19 - 1Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
Disputes Over Macro
Theory and Policy
C H A P T E R
19 - 2Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
CLASSICAL ECONOMICS AND KEYNES
Classical Economics
Adam Smith - 1776
Laissez-faire
The Classical View
Vertical Aggregate Supply Curve
Stable Aggregate Demand
Real Output Depends Upon…•Quantity of money possessed by
households & businesses
•Purchasing power of money is
determined by the price level
19 - 3Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
Classical Theory
P1
Q1
Price Level
Real Domestic Output
AS
AD1
19 - 4Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
Classical Theory
P1
Q1
P2
Price Level
Real Domestic Output
AS
AD1
AD2
19 - 5Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
CLASSICAL ECONOMICS AND KEYNES
Keynesian Economics
John Maynard Keynes, 1930s
The Keynesian View
Prices and Wages Downwardly
Inflexible
Active Government Policy
Required to Stabilize the
Economy
Horizontal Aggregate Supply
Curve to Full-Employment
Unstable Aggregate Demand
19 - 6Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
Keynesian View
P1
Q1
Price Level
Real Domestic Output
AS
AD1
19 - 7Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
Keynesian View
P1
Q1
Price Level
Real Domestic Output
AS
AD1
AD2
Q2
19 - 8Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
CAUSES OF MACRO INSTABILITY
Ca + Ig + Xn + G = GDP
Equation of Exchange
M V = P Q = GDP
Changes in Investment
Mainstream View
Monetarist View
Adverse Aggregate Supply
Shocks
Stable Velocity
19 - 9Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
CAUSES OF MACRO INSTABILITY
Instability of Investment is the
Main Cause of Output Changes
Monetary Policy is a
Stabilizing Factor
Mainstream View
Monetarist View
With a Stable Velocity,
Nominal GDP Depends Upon
the Money Supply
Summary
19 - 10Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
Real Business Cycle ViewReal-Business-Cycle Theory
P1
Price Level
Real Domestic Output
ASLR1
AD1
Q1
19 - 11Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
Real Business Cycle ViewReal-Business-Cycle Theory
P1
Q2
Price Level
Real Domestic Output
ASLR1
AD1
Q1
ASLR2
19 - 12Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
Real Business Cycle ViewReal-Business-Cycle Theory
P1
Q2
Price Level
Real Domestic Output
ASLR1
AD1AD2
Q1
ASLR2
Recession
With Stable
Price Levels
19 - 13Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
Real Business Cycle ViewReal-Business-Cycle Theory
P1
Q2
Price Level
Real Domestic Output
ASLR1
AD1AD2
Q1
ASLR2
Recession
With Stable
Price LevelsCoordination
Failures
Coordination
Failures
19 - 14Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
DOES THE ECONOMY SELF-CORRECT?
New Classical View
Self-Correction?
Rational Expectations Theory
Speed of Adjustment
Unanticipated Price Changes
“Price Level Surprises”
Fully Anticipated Price-Level
Changes
19 - 15Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
Q1
Price Level
Real Domestic Output
AD1
ASLR
P1
An increase in AD
AS1
Self-
Correction
a
NEW CLASSICAL VIEW OF SELF-CORRECTION
19 - 16Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
P2
Q1
Price Level
Real Domestic Output
AD2
AD1
ASLR
P1
An increase in AD
AS1
Self-
Correction
a
b
NEW CLASSICAL VIEW OF SELF-CORRECTION
19 - 17Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
P2
Q1
Price Level
Real Domestic Output
AD2
AD1
ASLR
P1
An increase in AD
AS1AS2
P3Self-
Correction
a
b
c
NEW CLASSICAL VIEW OF SELF-CORRECTION
19 - 18Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
Mainstream View
Downward Wage Inflexibility
Efficiency Wage Theory
•Greater Work Effort
•Lower Supervision Costs
•Reduced Job Turnover
Insider-Outsider Theory and
Relationships
DOES THE ECONOMY SELF-CORRECT?
19 - 19Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
RULES OR DISCRETION?
Monetary Rule
Balanced Budget
In Support of Policy Rules
In Defense of Discretionary
Stabilization Policy
Discretionary Monetary
Policy
Discretionary Fiscal Policy
Increased Macro Stability
19 - 20Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
RATIONALE FOR A MONETARY RULEFederal Reserve Increases Money Supply at
the Long-Run Growth Rate of GDP
P1
Q1
Price Level
Real Domestic Output, GDP
AD1Q2
ASLR1
Fed Increases
The Money
Supply
Resulting in…
ASLR2
P2
19 - 21Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
RATIONALE FOR A MONETARY RULEFederal Reserve Increases Money Supply at
the Long-Run Growth Rate of GDP
P1
Q1
Price Level
Real Domestic Output, GDP
ASLR2
AD2AD1
Q2
ASLR1
Growth
Without
Inflation or
Deflation
P2
19 - 22Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
RULES OR DISCRETION?
Summary of Alternative Views
Chapter Conclusions
classical view
Keynesian view
monetarism
equation of exchange
velocity
real-business-cycle theory
coordination failures
rational expectations theory
new classical economics
price-level surprises
efficiency wage
insider-outsider theory
monetary ruleENDBACKCopyright McGraw-Hill/Irwin 2002
19 - 24Copyright McGraw-Hill/Irwin, 2002
Classical Economics
and Keynes
Classical Theory
Keynesian View
Causes of Macro
Instability
Real Business Cycle
View
Does the Economy Self-
Correct?
New Classical View of
Self-Correction
Rules or Discretion
Rationale for Monetary
Rule
Key Terms
Previous
Slide
Next
Slide
End
Show
Next:
Supply
And
DemandElasticities And
Government-Set Prices
Chapter 20
