AP Econ - Unit 6 (Alternative Theory)

Classical View

• AS is horizontal (in the LR)

  • Always at Qf in LR

  • price/wages are flexible

• AD is stable as long as Sm is constant

Keynesian View

• gov’t policies are NECESSARY

• Horizontal AS curve

  • prices/wages are inflexible

• AD is unstable because Ig is volatile - small changes in interest rates cause big changes in Ig

Price/wage (in)flexibility

flexibility - wages change quickly to reflect the change in price levels; so when business revenue increase/decrease, their wages change the same, so profit (output) stays the same

inflexibility - wages do not change quickly due to contracts and minimum wage; because you can’t lower wages, you can’t lower the price so AS is horiz.

Monetarist View (classical)

• inappropriate USE of monetary policy causes instability

  • Sm is unstable

  • Velocity is stable

Mainstream View (Keynesian)

• Instability is due to volatile Ig and Supply shocks

  • Velocity is unstable

Equation of Exchange

MV=PQ

• M: money supply

• V: velocity

• PQ=GDP (price x quantity)

Can the economy self correct? Classical

YESSSSS!!!!!!!!

Can the economy self correct? Mainstream

NOOOOO!!!!!!

• prices and wages are inflexible

• need help from monetary and fiscal policy

Rules or Discretionary Policy? Monetarists and classical

RULES

• Monetary rule - expand Sm 3-5% per year to match GDP

• OPPOSE FISCAL POLICY - is it effective because of crowding in/out?

Rules or Discretionary Policy? Mainstream and Keynesian

DISCRETIONARY

• Monetary Policy - can’t increase Sm by the same each year because Ig is so unpredictable

• Fiscal Policy - it works and crowding in/out in minimal