economics chapter 9.4

questioned classical economists’ views that the economic system as a harmonious system will automatically tend towards employment and it shows that it is possible for economies to remain in a position of short run equilibrium for long periods of time

• in the neoclassical model all resource prices and product prices are fully flexible and respond to the forced of supply and demand

• but in long term there is an asymmetry between wage changes

• in economic expansion when aggregate demand is high unemployment is lower than the natural rate wages quickly increase

• yet in a recession gap, where AD is low and unemployment is greater than natural rate wages do not fall easily even over long periods of time due to labour market rigidities (minimum wage legislations)

  • firms will avoid lowering prices because profits will fall

  • in oligopolies in price wars firms will lower their prices to compete

• if wages and prices do not fall easily economy might be stuck in short run

• when AD decreases, monetarist new classical model predicts economy will move to b in the short run where there is recessionary gap and price is now PL2

  • and in the long run it will it will move to c with PL3 and economy would again produce at YP

• however is price levels dont fall it will move to d, the new lower AD curve

even if price level suceeds in falling to PL2, the economy moves to b

• economy may get stuck if wages do not fall (wages must fall for SRAS curve to shift to SRAS2 on the LRAS curve)

• hence is price level cannot fall, or if wages cannot fall economy is stuck in short run and unable to move into the long run where it eliminates the recessionary gap

• horizontal part of the curve is based on the Keynesian idea that wages and prices not move downward.

• in the figure the economy is in a deflationary gap and may there indefinitely unless the govt intervenes with specific policies

• keynes does agree that in a depression (extreme recession) wages and prices would evenutally begin to fall

• but this would also mean wide spread unemployment and the govt would need to intervene

section 1: GDP is low and the price level remains constant, there is a lot of unemployment resources in spare capacity (refers to availability of resources like physical capital and labour which isn't used

Section 2 is when real, GDP increases and price level increases. Output increases so there is more employment of resources and are no longer in spare capacity

section 3: wages and other resources price begin to rise hence cost of production increases. No firms washing crease output and this is done by increase in price level. GDP is fixed and can no longer increase because firms are using maximum amount of labour and all other resources in the economy