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!