Question

1. Compare and contrast the short run Keynesian and long run Neoclassical views of the aggregate supply and Phillips curves?

Answer 1

Shape of long-run aggregate supply

A distinction between the Keynesian and classical view of macroeconomics can be illustrated looking at the long run aggregate supply (LRAS).

Classical view of Long Run Aggregate Supply

The Classical view is that Long Run Aggregate Supply (LRAS) is inelastic. This has important implications. The classical view suggests that real GDP is determined by supply-side factors – the level of investment, the level of capital and the productivity of labour etc. Classical economists suggest that in the long-term, an increase in aggregate demand (faster than growth in LRAS), will just cause inflation and will not increase real GDP>

Keynesian view of Long Run Aggregate Supply

The Keynesian view of long-run aggregate supply is different. They argue that the economy can be below full capacity in the long term. Keynesians argue output can be below full capacity for various reasons:

· Wages are sticky downwards (labour markets don’t clear)

· Negative multiplier effect. Once there is a fall in aggregate demand, this causes others to have less income and reduce their spending creating a negative knock-on effect.

· A paradox of thrift. In a recession, people lose confidence and therefore save more. By spending less this causes a further fall in demand.

Keynesians argue greater emphasis on the role of aggregate demand in causing and overcoming a recession.

2. Demand deficient unemployment

Because of the different opinions about the shape of the aggregate supply and the role of aggregate demand in influencing economic growth, there are different views about the cause of unemployment

· Classical economists argue that unemployment is caused by supply side factors – real wage unemployment, frictional unemployment and structural factors. They downplay the role of demand deficient unemployment.

· Keynesians place a greater emphasis on demand deficient unemployment. For example, the current situation in Europe (2014), a Keynesian would say that this unemployment is partly due to insufficient economic growth and low growth of aggregate demand (AD)

3. Phillips Curve trade-off

A classical view would reject the long-run trade-off between unemployment, suggested by the Phillips Curve.

Classical economists say that in the short term, you might be able to reduce unemployment below the natural rate by increasing AD. But, in the long-term, when wages adjust, unemployment will return to the natural rate, and there will be higher inflation. Therefore, there is no trade-off in the long-run.

Keynesians support the idea that there can be a trade-off between unemployment and inflation. See: Phillips curve

In a recession, increasing AD will lead to a fall in unemployment, though it may be at the cost of higher inflation rate.