New Classical

&
Keynesian
Unit 9 - Lesson 9.4

Learning outcomes:

Explain using a diagram the new classical model of LRAS is vertical at the
level of potential output and full employment because the LRAS is
independent of Price Levels.
Explain using a diagram, long-run equilibrium occurs at the full employment
level of output.
Explain why the new classical model tends toward full employment in the long
run.
Explain, using diagrams, the impacts of change in the long-run equilibrium.
Explain using a diagram that the Keynesian model has 3 sections of AS.

New Classical View - Monetarist

The LRAS is vertical at Full

Employment (Natural Rate of
Unemployment).
LRAS is also represents the
Economys Potential Output.
In the long-run, the economy will
produce potential GDP regardless
of Price Levels

http://1.bp.blogspot.com/Yo1tLfZxANE/UEWUGWz68RI/AAAAAAAAAAk/UAn4Ez4Ij4U/s1600/New+Classical+M
odel+(AS).jpg

New Classical Model Assumptions

1.

The Economy tends toward full

employment.

2.

Wages are flexible in both the

upward & downward direction.

3.

Market oriented - forces of supply

and demand prevail.

https://tamoclass.files.wordpress.com/2014/03/ad-sraslras-2.png

New Classical Model

Point A: Economy is at Full Employment & the Actual
Output of the Economy = Potential Output.
Point A - B: A change in a non-price determinant
caused an increase in AD.
Point B: Economy is in an Inflationary Gap.
Unemployment < NRU & Actual Output > Potential
Output
Point B - C: With less unemployed, workers get higher
wages thus increasing the factors of production for
firms, decreasing SRAS (AS1 - AS2). Economy returns
to Full Employment at Point C.

http://college.cengage.
com/economics/boyes_melvin/shared/faculty/images/16_
03.gif

New Classical - Monetarist

Changes in AD can only affect Real GDP in the short-run.
Only impact of changes in AD are increase or decrease of
Price Level.
Inflationary Pressure
Deflationary Pressure

Keynesian Model
Assumptions:
1.

2.

3.

Wages are inflexible in the downward directionMinimum Wage, Unions. Represented by the
horizontal section of the AS curve.
Economy does not tend toward full
employment. The economy can get stuck in
a Recessionary Gap and can remain there for
a long time.
There comes a point where an increase in AD
will only increase Price Levels and not the Real
GDP of the economy. Vertical portion of AS.

http://www.peoi.
org/Courses/Coursesen/mac/Resourc
es/Image316.gif

Three Equilibrium States

Full Employment: Potential Output = Actual Output, Unemployment =
Natural Rate of Unemployment
Recessionary (Deflationary) Gap: Actual Output < Potential Output,
Unemployment > Natural Rate of Unemployment
Inflationary Gap: Actual Output > Potential Output, Unemployment <
Natural Rate of Unemployment

Full Employment
Full Employment:
Potential Output = Actual Output
Unemployment = NRU
(Natural Rate of Unemployment)

http://www.harpercollege.edu/mhealy/ecogif/asad/adasfe.gif

Recessionary (Deflationary) Gap

A decrease in AD (Yp - Y) does not affect the

Price Level a lot, but does reduce the size of the
Real GDP within the Economy.
Price Levels are not affected greatly because of
the inflexibility of wages in the downward
direction.
Economies can remain stuck in a Recessionary
Gap for a long period of time and Fiscal and/or
Monetary Policy are necessary to move the
economy toward Full Employment.

http://blogs.swa-jkt.com/swa/11058/files/2013/03/ScreenShot-2013-03-08-at-11.38.08-PM.png

Inflationary Gaps

If the Economy is operating at beyond it Full

Potential, increases in Price Levels occur with
minimal or no increase in Real GDP.
Actual Output > Potential Output
Unemployment < NRU
Any increases in AD will eventually only lead to
increases in Price Levels and have no effect
on Real GDP (Monetarist LRAS)

New Classical - Keynesian AD view

In the New Classical Model, Increases or Decreases in AD will lead to
changes in Price Levels.
In the Keynesian Model, Increases or Decreases in AD need not lead to
changes in Price Levels.
When an economy is in a Deflationary (Recessionary) Gap, increases in
AD can lead to increases in Real GDP without changing Price Levels.