Classical
Classical vs
vs Keynesian Theory
Keynesian Theory

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To sum up: What is an Equilibrium?
SHORT RUN EQUILIBRIUM:
AD = SRAS
and
IS = LM
The Labor Market need not be in equilibrium
We need not be at the potential level of GDP Y*
If Y<Y* we are in a
recession
, if Y>Y* in a
boom
LONG RUN EQUILIBRIUM:
AD = SRAS = Y* and
IS = LM = Y* and N
d
= N
s
= N*
By definition, the labor market will clear
By definition, we will move to Y*
.
2

Classical Theory

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Real Business Cycle (RBC)
Wh t
ll
d i
th
b
i
l ?
•
What really drives the business cycle?
•
Kydland and Prescott developed the RBC theory that argues that
real shocks to the economy are the primary cause of business cycle
real shocks to the economy are the primary cause of business cycle.
•
Real shocks are shocks that affect the production function, the size of
the labor force the spending and savings decisions
Nominal shocks
the labor force, the spending and savings decisions,…Nominal shocks
are shocks to money supply or demand
•
In particular the RBC theory refer to
productivity shocks
In particular the RBC theory refer to
•
The RBC theory is consistent with our IS-LM and AD-AS models. A
negative productivity shock (A decreases) has two effects:
1)
reduces MPN and hence the demand for labor and N*
2)
Decreases Y* directly
4
•
Both effects make Y* to decrease (LRAS) and hence LM has to adjust!