Textbook Media Press. CH 28 Taylor: Principles of Economics 3e 1

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1 CH 28 Taylor: Principles of Economics 3e 1

2 The Building Blocks of Neoclassical Analysis Neoclassical economics argues that in the long run, the economy will adjust back to its potential GDP level of output through flexible price levels. In the neoclassical view, potential GDP and the natural rate of unemployment are determined in the long run by market forces. Thus, the neoclassical perspective views the longrun AS curve as vertical. CH 28 Taylor: Principles of Economics 3e 2

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7 Expectations How long does it take for wage and prices to adjust, and for the economy to rebound back to its potential GDP? A rational expectations perspective argues that people have excellent information about economic events and how the economy works, and that as a result, price and other economic adjustments will happen very quickly. Adaptive expectations is a milder theory in which people have limited information about economic information and how the economy works, and so price and other economic adjustments can be slow. CH 28 Taylor: Principles of Economics 3e 7

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9 Policy Implications of the Neoclassical Perspective: Fighting Recession or Encouraging Long-Term Growth? Neoclassical economists tend to put relatively more emphasis on long-term growth than on fighting recession Because they believe that recessions will fade in a few years and long-term growth will ultimately determine the standard of living. CH 28 Taylor: Principles of Economics 3e 9

10 Policy Implications of the Neoclassical Perspective: Fighting Unemployment or Inflation? Neoclassical economists tend to focus more on reducing the natural rate of unemployment caused by economic institutions and government policies than the cyclical rate of unemployment caused by recession. CH 28 Taylor: Principles of Economics 3e 10

11 The Neoclassical View on Inflation Neoclassical economists see no social benefit to inflation. With an upward-sloping Keynesian AS curve, inflation can arise because an economy is approaching full employment. But with a vertical long-run neoclassical AS curve, inflation does not accompany any rise in output. CH 28 Taylor: Principles of Economics 3e 11

12 The Neoclassical View on Aggregate Demand If aggregate supply is vertical, then aggregate demand does not affect the quantity of output. Instead, aggregate demand can only cause inflationary changes in the price level. CH 28 Taylor: Principles of Economics 3e 12

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14 The Neoclassical Phillips Curve Trade-Off A vertical aggregate supply curve, where the quantity of output is consistent with many different price levels, also implies a vertical Phillips curve. CH 28 Taylor: Principles of Economics 3e 14

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16 Macroeconomists Riding Two Horses Many mainstream economists take a Keynesian perspective, assuming sticky wages and prices and emphasizing the power of aggregate demand, for purposes of short-run analysis and a neoclassical perspective, assuming adjustment of wages and prices and emphasizing the power of long-run supply, for purposes of long-run analysis. CH 28 Taylor: Principles of Economics 3e 16

17 Macroeconomists Riding Two Horses The Keynesian and neoclassical approaches differ in their views of government macroeconomic policy. Keynesian macroeconomic policy requires optimism about the ability of the government to recognize a situation of too little or too much aggregate demand, and to adjust aggregate demand accordingly with the right level of changes in taxes or spending, all enacted in a timely fashion. CH 28 Taylor: Principles of Economics 3e 17

18 Macroeconomists Riding Two Horses Even when neoclassical economists admit that a Keynesian increase in aggregate demand might in theory help to avoid a recession, they argue it is unlikely to work well in practice. Why? it takes government statisticians months to produce even preliminary estimates of GDP so that politicians know whether a recession is occurring, the political process can take more months to enact a tax cut or a spending increase, the amount of those tax or spending changes will be determined as much by political considerations as economic ones. CH 28 Taylor: Principles of Economics 3e 18