Question

In the New Keynesian Macroeconomics business cycles are driven by demand shocks, while in the New Classical Macroeconomics they are driven by supply shocks. Explain this statement using your knowledge of the AD-AS model.

(the answer should be between 1/2 page to 3/4 page preferrably, not necessary though)

Answer 1

Keynesian economics is based on two main ideas:

(1) aggregate demand is more likely than aggregate supply to be the primary cause of a short-run economic event like a recession;

(2) wages and prices can be sticky, and so, in an economic downturn, unemployment can result.

• The short-run aggregate supply, or SRAS, curve can be divided into three zones—the horizontal Keynesian zone, the vertical neoclassical zone, and the upward sloping intermediate zone in between the Keynesian and neoclassical zones.

• Keynes’ Law states that demand creates its own supply; changes in aggregate demand cause changes in real GDP and employment.

• The Keynesian zone occurs at low levels of output on the SRAS curve where it is fairly flat, so movements in aggregate demand will affect output but have little effect on the price level.

• Say’s Law states that supply creates its own demand; changes in aggregate demand have no effect on real gross domestic product or employment, only on the price level.

• Say’s Law can be shown on the vertical neoclassical zone of the aggregate supply curve. The neoclassical zone occurs at the right of the SRAS curve where it is fairly vertical, so movements in aggregate demand will affect the price level but have little impact on output.

• The intermediate zone in the middle of the SRAS curve is upward-sloping, so a rise in aggregate demand will cause higher output and price level, while a fall in aggregate demand will lead to a lower output and price level.

Keynes’ Law and Say’s Law in the AD/AS model

The aggregate demand/aggregate supply, or AD/AS, model can be used to illustrate both Say’s Law and Keynes’ Law. Say's Law states that supply creates its own demand; Keynes’ Law states that demand creates its own supply.

Take a look at the AD/AS diagram below. Notice that the short-run aggregate supply, or SRAS, curve is divided into three zones: the Keynesian zone, the neoclassical zone, and the intermediate zone.

The graph shows three aggregate demand curves to represent different zones: the Keynesian zone, intermediate zone, and neoclassical zone. The Keynesian is farthest to the left as well as the lowest; the intermediate zone is the center of the three curves; the neoclassical zone is the farthest to the right as well as the highest.

Let's focus first on the Keynesian zone, the portion of the SRAS curve on the far left which is relatively flat. If the aggregate demand, or AD, curve crosses this portion of the SRAS curve—as it does at equilibrium point Ek\text{Ek}Ekstart text, E, k, end text—we can make certain assumptions about the economic situation. In the Keynesian zone, the equilibrium level of real gross domestic product, GDP, is far below potential GDP. The economy is in recession, and cyclical unemployment is high. If aggregate demand shifts to the right or left in the Keynesian zone, it will determine the resulting level of output, and thus unemployment. However, inflationary price pressure is not much of a worry in the Keynesian zone since the price level does not vary much in this zone.

Next, we'll examine the neoclassical zone of the SRAS curve, which is the near-vertical portion on the right-hand side. If the AD curve crosses this portion of the SRAS curve where output is at or near potential GDP—as it does at equilibrium point En\text{En}Enstart text, E, n, end text—then the size of potential GDP pretty much determines the level of output in the economy. Since the equilibrium is near potential GDP, cyclical unemployment is low in this economy, although structural unemployment may remain an issue. In the neoclassical zone, shifts of aggregate demand to the right or left have little effect on the level of output or employment. The only way to increase the size of the real GDP in the neoclassical zone is for aggregate supply to shift to the right. Shifts in aggregate demand in the neoclassical zone will, however, create pressures to change the price level.

Finally, let's look at the intermediate zone of the SRAS curve. If the AD curve crosses this portion of the SRAS curve—as it does at equilibrium point like Ei\text{Ei}Eistart text, E, i, end text—then we might expect unemployment and inflation to move in opposing directions. For instance, a shift of AD to the right will move output closer to potential GDP and thus reduce unemployment, but this shift will also lead to a higher price level and upward pressure on inflation. On the other hand, a shift of AD to the left will move output further from potential GDP and raise unemployment, but the shift will also lead to a lower price level and downward pressure on inflation.

Dividing the SRAS curve into different zones, as we did above, works as a diagnostic test that can be applied to an economy—similar to a doctor checking a patient for symptoms. First, figure out which zone the economy is in and then use that information to understand economic issues, tradeoffs, and policy choices.

Some economists believe that the economy is strongly predisposed to be in one zone or another. Hard-line Keynesian economists believe that economies are in the Keynesian zone most of the time; they view the neoclassical zone as a theoretical abstraction. On the other hand, hard-line neoclassical economists argue that economies are in the neoclassical zone most of the time and that the Keynesian zone is a distraction.

• The short-run aggregate supply, or SRAS, curve can be divided into three zones—the Keynesian zone, the neoclassical zone, and the intermediate zone.

• Keynes’ Law states that demand creates its own supply; changes in aggregate demand cause changes in real GDP and employment.

• The Keynesian zone occurs at the left of the SRAS curve where it is fairly flat, so movements in aggregate demand will affect output but have little effect on the price level.

• Say’s Law states that supply creates its own demand; changes in aggregate demand have no effect on real gross domestic product or employment, only on the price level.

• Say’s Law can be shown on the vertical neoclassical zone of the aggregate supply curve. The neoclassical zone occurs at the right of the SRAS curve where it is fairly vertical, so movements in aggregate demand will affect the price level but have little impact on output.

• The intermediate zone in the middle of the SRAS curve is upward-sloping, so a rise in aggregate demand will cause higher output and price level, while a fall in aggregate demand will lead to a lower output and prise level