Macroeconomic Theories Classical vs Keynesian Economics AD 2

Macroeconomic Theories Classical vs. Keynesian Economics AD 2

FISCAL POLICY REVIEW Economy is too slow => “hit gas” => Use Expansionary Fiscal Policy Economy is too fast => “hit brakes” => Use Contractionary Fiscal Policy

Economic Schools of Thought Classical Economics |--------------| 1800 1929 Keynesian Economics |--------------| 1936 1979 Neo. Classical Economics |----------------| 1980 2008 Housing Bubble Great Depression? Classical Economics Failed Now What? Keynesian Economics did not help here!

Reading • Read Keynesian Handout

CLASSICAL Economists Classical economists were the 1 st school of economic thought starting in 1776 Adam Smith was the founder and they believed: – – Markets are naturally self regulating No government intervention necessary Recessions are temporary Great Depression challenged Classical View

KEYNESIAN VIEW 1. Economy is inherently unstable • not self regulating 2. Recessions can be long & permanent 3. Major government intervention necessary • Became popular after Great Depression (think FDR) 4. Support welfare and government assistance 5. Stagflation challenged Keynesian view 1883 -1946

Theory – Period Challenged Classical Theory - Great Depression (1929) Keynesian Economics- Stagflation (late 1970’s) Neo-Classical Theory Great Recession (2008)

Keynesian vs. Classical • Keynesian economists felt recessions could be long/permanent – More AD was needed to “fix” economy => so cut taxes & ↑ Gov’t Spending • Classical economists felt recessions would “self regulate” because prices would fall which would lead to more jobs – SRAS shift right whenever prices adjusted lower

Classical vs. Keynesian Economy is too slow => “Do Nothing=> let prices adjust” or Help now! => use Expansionary Fiscal Policy

Keynesian vs. Classicial “Keynesian Gov’t Intervention: “Classical Self Regulation” Recession => expansionary fiscal policy • • Taxes ↓ & Gov’t Spending ↑ C ↑ + G ↑ => AD ↑ Let economy “self regulate” Prices eventually adjust => SRAS ↑ LRAS 1 Inflation E 1 AD 2 AD 1 Q 2 P 1 ----- E 1 -------- P 1 ----- LRAS 1 Inflation E 2 ---- P 2 ------- SRAS 1 P 2 -------Real GDP Q 1 E 2 Q 2 AD 1 Real GDP Compare Results: Both have Same Real GDP & Employment Keynesian leads to more debt & higher inflation SRAS 1 SRAS 2