Friday, November 25, 2016

Keynes vs Classical Model to reach Full Employment in a Recession.

This AP Macroeconomic test topic is always a bit confusing for students AND teachers alike.  I struggled with it for a long time.

Here are some slides and in-between them some explanation. Hope it helps someone out there.
 Here is the basic AD/SRAS/LRAS showing the economy at Full-Employment.  All the curves intersect at the same sweet spot.  This is what you draw if asked on the AP FRQ portion of the test.  However....

If you are asked about the "Keynesian Range" of the SRAS curve then you have to look at it like the graph below.  The Keynesian Model assumes "Sticky Prices and Wages" (this is usually a key phrase used on the test to give a clue as to what you need to answer).

This means that even if the economy enters a recession, prices of inputs and wages of workers will not adjust downward.  This suggests the SRAS is HORIZONTAL over a long range of production.

So a recession will be the result of...

...deficient AGGREGATE DEMAND (AD).  See the graph below.  We now have a Recessionary Gap at "RGDP 1".

So what is the only way to get back to Full Employment?

Prop up AD with (1) automatic stabilizers that are already in place (unemployment compensation, food/housing assistance, etc) and (2) Fiscal Policy initiatives such as discretionary government spending and/or decreases in taxes. This would be considered "expansionary Fiscal Policy" intended to increase AD (shift to the RIGHT) in order to get back to  Full Employment.

Full Stop on the Keynesian Model. Not lets look at the Classical Model.
Let's start over with our original model seen below. Here is where you need to concentrate because the graph gets unavoidably messy.

Notice the construction of the SRAS curve in this model.  The sloping, intermediate range of the SRAS curve is essential in the Classical Model.

As you move along the Intermediate Range you notice Price Level changes are every level of RGDP.

This suggests that "Prices and Wages" are "FLEXIBLE" (Key word you are likely to see on the AP test is "flexible").

As with the Keynesian Model a recession can be caused by a deficiency in Aggregate Demand (AD).

This is shown in the graph below.  We have a Recessionary Gap at "RGDP 1", Point "B".

Notice Price Level Decreases AND unemployment INCREASES.

Here is the reasoning as to what the Classical Model suggests will happen in, but in a LONGER time frame:

   1. Input prices are flexible. When there is slack demand for available resources use in the production of goods, then those prices will DECREASE.
   2.  Wages are flexible.  When Unemployment increases then wages workers are willing to work for DECREASE.
  3.  Input prices and wages are elements for the cost of producing goods. If input prices decreases then the cost of producing decreases.
  4. When the cost of producing decreases SRAS curve shifts to the RIGHT (See Graph below).
  5. When SRAS curve shifts Right, then the economy returns to Full Employment at a LOWER Price Level and a HIGHER level of RGDP---POINT "C".
  6.  This is a longer term solution to return to Full Employment than the Keynesian approach.

That is a simple as I can make it and it will, I believe, help you get the points on the AP test for this concept.

Good Luck.
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