ECON - Lecture Notes, Part 2, Chapters 9-12 Chapter 9:...

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Lecture Notes, Part 2, Chapters 9-12 Chapter 9: Economic Fluctuations (3/17/09) The classical model: if left to its own devices , a free-market economy is self-correcting. How so? Prices and wages will adjust so that L = f L and Y = f Y . The interest rate will adjust so that f Y = C+ p I +G It is said in Chapter 9 that the classical model cannot explain short run fluctuations in output and employment.
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2 This re-enforces a message stated in Chapter 7 (p. 164): “Until the Great Depression of the 1930s, there was little reason to question these classical ideas. ……But during the Great Depression, output was stuck far below its potential for many years.” ( This is a distortion .) This is consistent with John Maynard Keynes’s criticism of the classical model: “In the long run we are all dead.” The textbook is too harsh in its treatment of the classical model, and misrepresents the lessons to be drawn from the Great Depression.
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3 Two points to note: (1)One can explain recessions in the context of the classical model. (2)Most macroeconomists have come to accept the view that the Great Depression became the “Great” Depression in large part because of bad economic policies: (a)The wrong-headed monetary policy emanating from The Federal Reserve Banking System (The Fed) helped to make the depression the “Great Depression”: (i) The Fed was created to prevent banking panics. It failed to do so, and allowed the banking system to collapse. (ii) Its policies helped to produce a recession in 1937 that thwarted the recovery from the Depression. (b)The so-called New Deal policies of the Roosevelt (FDR) administration prolonged the economic recovery. FDR did not pull the economy out of the Depression, contrary to popular myth .
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4 As noted above, classical model argues that if left to its own devices , a free-market economy is self- correcting. Points 2a and 2b suggest that the Great Depression does not provide evidence to the contrary.
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5 A “Classical” Recession Fact: In the post-WWII period up to the early 1990s there were 9 recessions. 8 of the 9 were preceded by an increase in oil prices. How can an increase in oil prices cause a recession in the classical model? Oil is a key raw material utilized in the production of output. To simplify suppose that a unit of labor requires a unit of oil in order to produce output. Then in effect, the marginal cost of labor is Marginal (real) cost of labor = the real wage + the real price of the needed oil . Conclusion: If the price of oil increases, the marginal cost of labor increases, and labor demand decreases .
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6 w, the real wage s L d L ( n e w ) f L f L (old) total hrs. Y ) ( L F Y = (new) f L f L (old) total hrs .
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7 The Classical Model and the Great Depression Do markets “work” or must government step-in to push the economy to full employment? [The following data come from:
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ECON - Lecture Notes, Part 2, Chapters 9-12 Chapter 9:...

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