Principles of Macroeconomics for AP® Courses 2e Chapter 13 Money and Banking

The Neoclassical Pe FIGURE Great Recession We can see the impact of the Great Recession in many areas of the economy that impact our daily lives , One of the most visible signs was in the housing market where many people were forced to abandon their homes and other buildings , including ones midway through construction . Credit of House by A Creative Commons , BY ) CHAPTER OBJECTIVES In this chapter , you will learn about The Building Blocks of Neoclassical Analysis The Policy Implications of the Neoclassical Perspective Balancing and Neoclassical Models Introduction to the Neoclassical Perspective BRING IT HOME Navigating Uncharted Waters The Great Recession ended in June 2009 after 18 months , according to the National Bureau of Economic Research ( The examines a variety of measures of economic activity to gauge the economy overall health . These measures include real income , wholesale and retail sales , employment , and industrial production . In the years since the official end of this historic economic downturn , it has become clear that the Great Recession was , hitting the . economy with the collapse of the housing market and the failure of the financial system credit institutions , further contaminating global economies . While the stock market rapidly lost trillions of dollars of value , consumer spending dried up , and companies began cutting jobs , economic were struggling with how to best combat and prevent a national , and even global economic collapse , In the end , used a number of controversial monetary and fiscal policies to support the housing market and domestic industries as well as to stabilize the financial sector . Some of these initiatives included

318 13 The Neoclassical Perspective Federal Reserve Bank purchase of both traditional and nontraditional assets off banks balance sheets . By doing this , the Fed injected money into the banking system and increased the amounts of funds available to lend to the business sector and consumers . This also dropped interest rates to as low as zero percent , which had the effect of dollars in the global market and boosting exports . The Congress and the President also passed several pieces of legislation that would stabilize the financial market . The Troubled Asset Relief Program ( TARP ) passed in late 2008 , allowed the government to inject cash into troubled banks and other institutions and help support General Motors and Chrysler as they faced bankruptcy and threatened job losses throughout their supply chain . The American Recovery and Reinvestment Act in early 2009 provided tax rebates to and households to encourage consumer spending . Four years after the end of the Great Recession , the economy had yet to return to its levels of productivity and growth . Annual productivity increased only between 2009 and 2012 compared to its annual growth rate between 2000 and 2007 , unemployment remained above the natural rate , and real continued to lag behind potential growth . The actions the government took to stabilize the economy were under scrutiny and debate about their effectiveness continues . In this chapter , we will discuss the neoclassical perspective on economics and compare it to the perspective , using both the Great Recession and the more recent recession as examples . In Chicago , Illinois , the highest recorded temperature was in July 1995 , while the lowest recorded temperature was below zero in January 1958 . Understanding why these extreme weather patterns occurred would be interesting . However , if you wanted to understand the typical weather pattern in Chicago , instead of focusing on extremes , you would need to look at the entire pattern of data over time . A similar lesson applies to the study of . It is interesting to study extreme situations , like the 19305 Great Depression , the Great Recession , or the recession of 2020 . Ifyou want to understand the whole picture , however , you need to look at the long term . Consider the unemployment rate . The unemployment rate has from as low as in 1969 to as high as in 1982 and in 2020 . Even as the unemployment rate rose during and declined during , it kept returning to the general neighborhood of . When the nonpartisan Congressional Budget carried out its economic forecasts in 2010 , it assumed that from 2015 to 2020 , after the recession has passed , the unemployment rate would be . In February 2020 , before the pandemic , the unemployment rate reached a historic low of and is back to below as of early 2022 . From a perspective , the economy seems to keep adjusting back to this rate of unemployment . As the name neoclassical implies , this perspective of how the works is a new View of the old classical model of the economy . The classical view , the predominant economic philosophy until the Great Depression , was that in economic activity would rather quickly , with prices , adjust back to full employment . This view of the economy implied a vertical aggregate supply curve at full employment , and prescribed a hands off policy approach . For example , if the economy were to slip into recession ( a leftward shift of the aggregate demand curve ) it would temporarily exhibit a surplus of goods . Falling prices would eliminate this surplus , and the economy would return to full employment level . No active or monetary policy was needed . In fact , the classical view was that expansionary or monetary policy would only cause , rather than increase . The deep and lasting impact of the Great Depression changed this thinking and economics , which prescribed active policy to alleviate weak aggregate demand , became the more mainstream perspective . Access for free at

The Building Blocks of Neoclassical Analysis 319 The Building Blocks of Neoclassical Analysis LEARNING OBJECTIVES By the end of this section , you will be able to Explain the importance in the long run Analyze the role of prices Interpret a neoclassical model of aggregate demand and aggregate supply Evaluate different ways for measuring the speed of adjustment The neoclassical perspective on holds that , in the long run , the economy will fluctuate around its potential and its natural rate of unemployment . This chapter begins with two building blocks of neoclassical economics ( potential determines the economy size and ( wages and prices will adjust in a manner so that the economy will adjust back to its potential level of output . The key policy implication is this The government should focus more on growth and on controlling than on worrying about recession or cyclical unemployment . This focus on growth rather than the short run in the business cycle means that neoclassical economics is more useful for analysis and economics is more useful for analyzing the short run . Let consider the two neoclassical building blocks in turn , and how we can embody them in the aggregate supply model . The Importance of Potential in the Long Run Over the long run , the level of potential determines the size of real . When economists refer to potential they are referring to that level of output that an economy can achieve when all resources ( land , labor , capital , and entrepreneurial ability ) are fully employed . While the unemployment rate in labor markets will never be zero , full employment in the labor market refers to zero cyclical unemployment . There will still be some level of unemployment due to frictional or structural unemployment , but when the economy is operating with zero cyclical unemployment , economists say that the economy is at the natural rate of unemployment or at full employment . Economists benchmark actual or real against the potential to determine how well the economy is performing . As explained in Economic , we can explain growth by increases in investment in physical capital and human capital per person as well as advances in technology . Physical capital per person refers to the amount and kind of machinery and equipment available to help people get work done . Compare , for example , your productivity in typing a term paper on a typewriter to working on your laptop with word processing software . Clearly , you will be able to be more productive using word processing software . The technology and level of capital of your laptop and software has increased your productivity . More broadly , the development of technology and Universal Product Codes ( those barcodes on every product we buy ) has made it much easier for to track shipments , tabulate inventories , and sell and distribute products . These two technological innovations , and many others , have increased a nation ability to produce goods and services for a given population . Likewise , increasing human capital involves increasing levels of knowledge , education , and skill sets per person through vocational or higher education . Physical and human capital improvements with technological advances will increase overall productivity and , thus , To see how these improvements have increased productivity and output at the national level , we should examine evidence from the United States . The United States experienced growth in the twentieth century clue to phenomenal changes in infrastructure , equipment , and technological improvements in physical capital and human capital . The population more than tripled in the twentieth century , from 76 million in 1900 to over 300 million in 2016 . The human capital of modern workers is far higher today because the education and skills of workers have risen dramatically . In 1900 , only about of the population had completed high school and just one person in 40 had completed a college degree . By 2010 , about of Americans age 25 or older had a high school degree and about 28 had a college degree as well . In 2019 , 33 age 25 or older had a college degree . The average amount of

320 13 The Neoclassical Perspective physical capital per worker has grown dramatically . The technology available to modern workers is extraordinarily better than a century ago cars , airplanes , electrical machinery , smartphones , computers , chemical and biological advances , materials science , health list of technological advances could run on and on . More workers , higher skill levels , larger amounts capital per worker , and amazingly better technology , and potential for the economy has clearly increased a great deal since 1900 . This growth has fallen below its potential and , at times , has exceeded its potential . For example from 2008 to 2009 , the economy tumbled into recession and remained below its potential until 2018 . After the recession of March and April 2020 , the economy again fell below potential and remains there as of early 2022 . At other times , like in the late or from 2018 to 2020 , the economy ran at potential even slightly ahead . Figure 132 shows the actual data for the increase in real since 1960 . The slightly smoother line shows the potential since 1960 as estimated by the nonpartisan Congressional Budget Office . Most economic and are times when the economy is below or above potential in a given year . Clearly , around potential do exist , but over the long run , the upward trend determines the size of the economy . 20 000 515 any arm ' 12 i i am arm ?

JU . Real , Nominal ( billions of dollars ) 52 ) i 1903 965 1990 2000 Year FIGURE Potential and Actual ( in 2012 Dollars ) Actual falls below potential during and after , like the of 1980 and , 2001 , and and continues below potential until 2019 , when it goes slightly above potential . In other cases , actual can be above potential for a time , as in the late 19905 . In the aggregate supply model , we show potential as a vertical line . Neoclassical economists who focus on potential as the primary determinant of real argue that the aggregate supply curve is located at potential is , we draw the aggregate supply curve as a vertical line at the level , as Figure shows . A vertical curve means that the level of aggregate supply ( or potential ) will determine the economy real , regardless of the level of aggregate demand . Over time , increases in the quantity and quality of physical capital , increases in human capital , and technological advancements shift potential and the vertical curve gradually to the right . Economists often describe this gradual increase in an economy potential as a nation economic growth . Access for free at

The Building Blocks of Neoclassical Analysis Price Level Real FIGURE A Vertical AS Curve In the neoclassical model , we draw the aggregate supply curve as a vertical line at the level of potential . If AS is vertical , then it determines he level of real output , no matter where we draw the aggregate demand curve . Over time , the curve shifts to he right as productivity increases and potential expands . The Role of Flexible Prices How does the adjust back to its level in the long run ?

What if aggregate demand increases or decreases ?

Economists base the neoclassical View of how the adjusts on the insight that even if wages and prices are sticky , or slow to change , in the short run , they are over time . To understand this better , let follow the connections from the to the equilibrium . The aggregate demand and aggregate supply diagram in Figure 134 shows two aggregate supply curves . We draw the original upward sloping aggregate supply curve ( is a or AS curve . The vertical aggregate supply curve ( is the or neoclassical AS curve , which is located at potential . The original aggregate demand curve , labeled ADO , so that the original equilibrium occurs at point , at which point the economy is producing at its potential . 135 130 125 120 115 110 105 100 95 90 I 100 200 300 400 500 600 700 800 Real ( billions of constant dollars ) Price Level ( base year 100 ) FIGURE The Rebound to Potential after AD Increases Tue original equilibrium ( at an output level of 500 and a price level of 120 , happens at the intersection of the aggregate demand curve ( ADO ) and the aggregate supply curve ( The output at is equal to potential . Aggregate demand shifts right from ADO to . The new equilibrium is , with a higher output level of 550 and an increase in the price level to 125 . With 321

322 13 The Neoclassical Perspective unemployment rates low , eager employers bid up wages , which shifts aggregate supply to the left , from to . The new equilibrium ( is at the same original level of output , 500 , but at a higher price level of 130 . Thus , the aggregate supply curve ( which is vertical at the level of potential , determines the level of real in this economy in the long run . Now , imagine that some economic event boosts aggregate demand perhaps a surge of export sales or a rise in business that leads to more investment , perhaps a policy decision like higher government spending , or perhaps a tax cut that leads to additional aggregate demand . The analysis is that the rise in aggregate demand will shift the aggregate demand curve out to the right , from ADO to , leading to a new equilibrium at point with higher output , lower unemployment , and pressure for an rise in the price level . In the neoclassical analysis , however , the chain events is just beginning . As economic output rises above potential , the level of unemployment falls . The economy is now above full employment and there is a labor shortage . Eager employers are trying to bid workers away from other companies and to encourage their current workers to exert more effort and to work longer hours . This high demand for labor will drive up wages . Most employers review their workers salaries only once or twice a year , and so it will take time before the higher wages through the economy . As wages do rise , it will mean a leftward shift in the run aggregate supply curve back to , because the price ofa major input to production has increased . The economy moves to a new equilibrium ( The new equilibrium has the same level of real as did the original equilibrium ( but there has been an increase in the price level . This description of the shift from to and the shift from to is a way of making a simple point the economy can not sustain production above its potential in the long run . An economy may produce above its level of potential in the short run , under pressure from a surge in aggregate demand . Over the long run , however , that surge in aggregate demand ends up as an increase in the price level , not as a rise in output . The rebound of the economy back to potential also works in response to a shift to the left in aggregate demand . Figure again starts with two aggregate supply curves , with showing the original upward sloping AS curve and showing the vertical neoclassical aggregate supply curve . A decrease in aggregate example , because of a decline in consumer that leads to less consumption and more the original aggregate demand curve to shift back to . The shift from the original equilibrium ( to the new equilibrium ( results in a decline in output . The economy is now below full employment and there is a surplus of labor . As output falls below potential , unemployment rises . While a lower price level ( is rare in the United States , it does happen occasionally during very weak periods of economic activity . For practical purposes , we might consider a lower price level in the model as indicative of , which is a decline in the rate . Thus , the aggregate supply curve , which is vertical at the level of potential , ultimately determines this economy real . Access for free at

The Building Blocks of Neoclassical Analysis 135 130 125 120 115 110 105 100 95 AD Price Level ( base year 100 ) AD 90 200 300 400 500 600 700 800 Real ( billions of constant dollars ) FIGURE A Rebound Back to Potential from a Shift to the Left in Aggregate Demand The original equilibrium ( at an output level of 500 and a price level of 120 , happens at the intersection of the aggregate demand curve ( ADO ) and the aggregate supply curve ( The output at is equal to potential . Aggregate demand shifts left , from ADO to . The new equilibrium is at , with a lower output level of 450 and downward pressure on the price level of 115 . With high unemployment rates , wages are held down . Lower wages are an decrease in the price of a key input , which shifts aggregate supply to the right , from to . The new equilibrium ( is at the same original level of output , 500 , but at a lower price level of 110 . Again , from the neoclassical perspective , this scenario is only the beginning of the chain of events . The higher level of unemployment means more workers looking . As a result , employers can hold down on pay perhaps even replace some of their workers with unemployed people willing to accept a lower wage . As wages stagnate or fall , this decline in the price ofa key input means that the run aggregate supply curve shifts to the right from its original ( to ) The overall impact in the long run , as the equilibrium shifts from to to , is that the level of output returns to potential , where it started . There is , however , downward pressure on the price level . Thus , in the neoclassical View , changes in aggregate demand can have a impact on output and on only a impact . In the long run , when wages and prices are , potential and aggregate supply determine real size . How Fast Is the Speed of Adjustment ?

How long does it take for wages and prices to adjust , and for the economy to rebound to its potential ?

This subject is highly contentious . economists argue that if the adjustment from recession to potential takes a very long time , then neoclassical theory may be more hypothetical than practical . In response to John Maynard Keynes immortal words , In the long run we are all dead , neoclassical economists respond that even if the adjustment takes as long as , say , ten years the neoclassical perspective remains of central importance in understanding the economy . One subset of neoclassical economists holds that wage and price adjustment in the might be quite rapid . The theory of rational expectations holds that people form the most accurate possible expectations about the future that they can , using all information available to them . In an economy where most people have rational expectations , economic adjustments may happen very quickly . To understand how rational expectations may affect the speed adjustments , think about a situation in the real estate market . Imagine that several events seem likely to push up home values in the neighborhood . Perhaps a local employer announces that it plans to hire many more people or the city announces that it will 323

324 13 The Neoclassical Perspective build a local park or a library in that neighborhood . The theory of rational expectations points out that even though none of the changes will happen immediately , home prices in the neighborhood will rise immediately , because the expectation that homes will be worth more in the future will lead buyers to be willing to pay more in the present . The amount of the immediate increase in home prices will depend on how likely it seems that the announcements about the future will actually happen and on how distant the and neighborhood improvements are in the future . The key point is that , because of rational expectations , prices do not wait on events , but adjust immediately . At a level , the theory of rational expectations points out that if the aggregate supply curve is vertical over time , then people should rationally expect this pattern . When a shift in aggregate demand occurs , people and businesses with rational expectations will know that its impact on output and employment will be temporary , while its impact on the price level will be permanent . If and workers perceive the outcome of the process in advance , and if all and workers know that everyone else is perceiving the process in the same way , then they have no incentive to go through an extended series of scenarios , like a first hiring more people when aggregate demand shifts out and then those same people when aggregate supply shifts back . Instead , everyone will recognize where this process is a change in the price then will act on that expectation . In this scenario , the expected change in the price level may happen very quickly , without a zigzag of output and employment moving one way and then the other . The theory that people and have rational expectations can be a useful , but as a statement about how people and businesses actually behave , the assumption seems too strong . After all , many people and are not especially well informed , either about what is happening in the economy or about how the economy works . An alternate assumption is that people and act with adaptive expectations they look at past experience and gradually adapt their beliefs and behavior as circumstances change , but are not perfect synthesizers of information and accurate of the future in the sense of rational expectations theory . If most people and businesses have some form of adaptive expectations , then the adjustment from the short run and long run will be traced out in incremental steps that occur over time . The empirical evidence on the speed of adjustment and wages is not . The speed of adjustment probably varies among different countries and time periods . A reasonable guess is that the initial effect ofa shift in aggregate demand might last two to years , before the adjustments in wages and prices cause the economy to adjust back to potential . Thus , one might think of the short run for applying analysis as time periods less than two to years , and the long run for applying neoclassical analysis as longer than years . For practical purposes , this guideline is frustratingly imprecise , but when analyzing a complex social mechanism like an economy as it evolves over time , some imprecision seems unavoidable . The Policy Implications of the Neoclassical Perspective LEARNING OBJECTIVES By the end of this section , you will be able to Discuss why and how economists measure expectations Analyze the impacts of and monetary policy on aggregate supply and aggregate demand Explain the neoclassical Phillips curve , noting its and unemployment Identify clear distinctions between neoclassical economics and economics To understand the policy recommendations of the neoclassical economists , it helps to start with the perspective . Suppose a decrease in aggregate demand causes the economy to go into recession with high unemployment . The response would be to use government policy to stimulate aggregate demand and eliminate the recessionary gap . The neoclassical economists believe that the response , while perhaps well intentioned , will not have a good outcome for reasons we will discuss shortly . Since the neoclassical economists believe that the economy will correct itself over time , the only advantage ofa Access for free at

The Policy Implications of the Neoclassical Perspective 325 stabilization policy would be to accelerate the process and minimize the time that the unemployed are out ofwork . Is that the likely outcome ?

policy requires some optimism about the government ability to recognize a situation of too little or too much aggregate demand , and to adjust aggregate demand accordingly with the right level of changes in taxes or spending , all enacted in a timely fashion . After all , neoclassical economists argue , it takes government statisticians months to produce even preliminary estimates of so that politicians know whether a recession is those preliminary estimates may be revised substantially later . Moreover , there is the question of timely action . The political process can take more months to enact a tax cut or a spending increase . Political or economic considerations may determine the amount of tax or spending changes . Then the economy will take still more months to put into effect changes in aggregate demand through spending and production . When economists and policy makers consider all of these time lags and political realities , active policy may fail to address the current problem , and could even make the future economy worse . The average War II recession has lasted only about a year . By the time government policy activates , the recession will likely be over . As a consequence , the only result of government will be to stimulate the economy when it is already recovering ( or to contract the economy when it is already falling ) In other words , an active policy is likely to exacerbate the cycles rather than dampen them . Some neoclassical economists believe a large part of the business cycles we observe are due to government policy . To learn about this issue further , read the following Clear It Up feature . CLEAR IT UP Why and how do economists measure inflation expectations ?

People take expectations about inflation into consideration every time they make a major purchase , such as a house or a car . As inflation fluctuates , so too does the nominal interest rate on loans to buy these goods . The nominal interest rate is comprised of the real rate , plus an expected inflation factor . Expected inflation also tells economists about how the public views the economy direction . Suppose the public expects inflation to increase . This could be the result of positive demand shock due to an expanding economy and increasing aggregate demand . It could also be the result of a negative supply shock , perhaps from rising energy prices , and decreasing aggregate supply . In either case , the public may expect the central bank to engage in monetary policy to reduce inflation , and this policy results in higher interest rates . If , however economists expect inflation to decrease , the public may anticipate a recession . In turn , the public may expect expansionary monetary policy , and lower interest rates , in the short run . By monitoring expected inflation , economists garner information about the effectiveness of policies . Additionally , monitoring expected inflation allows for projecting the direction of real interest rates that isolate for the effect of inflation . This information is necessary for making decisions about investments . Expectations about inflation may seem like a highly theoretical concept , but , in fact the Federal Reserve Bank measures , inflation expectations based upon early research conducted by Joseph , a journalist for the Philadelphia Inquirer . In 1946 , he started a survey of economists about their expectations of inflation . After death in 1969 , the Federal Reserve Bank and other economic research agencies such as the Survey Research Center at the University of Michigan , the American Statistical Association , and the National Bureau of Economic Research continued the survey . Current Federal Reserve research compares these expectations to actual inflation that has occurred , and the results , so far , are mixed . Economists forecasts , however , have become notably more accurate in the last few decades . Economists are actively researching how inflation expectations and other economic variables form and change .

326 13 The Neoclassical Perspective LINK IT UP Visit this website ( publications to read The Federal Reserve Bank of Cleveland Economic Commentary A New Approach to Gauging Expectations by Joseph for more information about how economists forecast expected . The Neoclassical Phillips Curve Tradeoff The Perspective introduced the Phillips curve and explained how it is derived from the aggregate supply curve . The short run upward sloping aggregate supply curve implies a downward sloping Phillips curve thus , there is a tradeoff between and unemployment in the short run . By contrast , a neoclassical aggregate supply curve will imply a vertical shape for the Phillips curve , indicating no long run tradeoff between and unemployment . Figure ( a ) shows the vertical AS curve , with three different levels of aggregate demand , resulting in three different equilibria , at three different price levels . At every point along that vertical AS curve , potential and the rate of unemployment remains the same . Assume that for this economy , the natural rate is . As a result , the Phillips curve relationship , in Figure ( is a vertical line , rising up from unemployment , at any level of . Read the following Work It Out feature for additional information on how to interpret and unemployment rates . 135 A 1150 , 125 A , 120 i . i I . it no i i 105 100 95 90 ' 100 200 300 400 500 600 700 Real ( billions of constant dollars ) Ra ?

The long AS curve ( by vertical Phillips Curve FIGURE From a AS Curve to a Phillips Curve ( a ) With a vertical curve , shifts in aggregate demand do not alter the level of output but do lead to changes in the price level . Because output is unchanged between the equilibria , and , all unemployment in this economy will be due to the natural rate of unemployment . If the natural rate of unemployment is , then the Phillips curve will be vertical . That is , regardless of changes in the price level , the unemployment rate remains at . Access for free at

The Policy Implications of the Neoclassical Perspective 327 Tracking Inflation and Unemployment Rates Suppose that you have collected data for years on inflation and unemployment rates and recorded them in a table , such as Table . How do you interpret that information ?

Year Inflation Rate Unemployment Rate 1970 1975 1980 1985 1990 1995 2000 TABLE Step . Plot the data points in a graph with inflation rate on the vertical axis and unemployment rate on the horizontal axis . Your graph will appear similar to Figure . Inflation Rate ( Unemployment Rate ( FIGURE Inflation Rates Step . What patterns do you see in the data ?

You should notice that there are years when unemployment falls but inflation rises , and other years where unemployment rises and inflation falls . Step . Can you determine the natural rate of unemployment from the data or from the graph ?

As you analyze the graph , it appears that the natural rate of unemployment lies at . This is the rate that the economy appears to adjust back to after an apparent change in the economy . For example , in 1975 the economy appeared to have an increase in aggregate demand . The unemployment rate fell to but inflation increased from to . By 1980 , the economy had adjusted back to unemployment and the inflation rate had returned to . In 1985 , the economy looks to have suffered a recession as unemployment rose to and inflation fell to . This would be consistent with a decrease in aggregate demand . By 1990 , the economy recovered back to unemployment , but at a lower inflation rate of . In 1995 the economy again rebounded and unemployment fell to , but inflation increased to , which is consistent with a large increase in aggregate demand . The

328 13 The Neoclassical Perspective economy adjusted back to unemployment but at a higher rate of inflation of . Then in 2000 , both unemployment and inflation increased to and , respectively . Step . Do you see the Phillips curve ( in the data ?

If we trace the downward sloping trend of data points , we could see a Phillips curve that exhibits the inverse tradeoff between higher unemployment and lower inflation rates . If we trace the vertical line of data points , we could see a Phillips curve at the natural rate of unemployment . The unemployment rate on the Phillips curve will be the natural rate of unemployment . A small increase in the price level from ADO to will have the same natural rate as a larger increase in the price level from to . The equilibrium along the vertical aggregate supply curve can occur at a variety of different price levels , and the natural rate of unemployment can be consistent with all different rates of . The great economist Milton ( summed up the neoclassical view of the Phillips curve tradeoff in a 1967 speech here is always a temporary tradeoff between and unemployment there is no permanent of In the perspective , the primary focus is on getting the level of aggregate demand right in relationship to an aggregate supply curve . That is , the government should adjust AD so that the economy produces at its potential , not so low that cyclical unemployment results and not so high that results . In the neoclassical perspective , aggregate supply will determine output at potential , the natural rate of unemployment determines unemployment , and shifts in aggregate demand are the primary determinant of changes in the price level . LINK IT UP Visit this website ( to read about the effects of economic intervention . Fighting Unemployment or Inflation ?

As we explained in , economists divide unemployment into two categories cyclical unemployment and the natural rate of unemployment , which is the sum of frictional and structural unemployment . Cyclical unemployment results from in the business cycle and is created when the economy is producing below potential potential employers less incentive to hire . When the economy is producing at , cyclical unemployment will be zero . Because of labor market dynamics , in which peop are always entering or exiting the labor force , the unemployment rate never falls to , not even when the economy is producing at or even slightly above potential . Probably the best we can hope for is for the number ofjob vacancies to equal the number ofjob seekers . We know that it takes time for job seekers and employers to each other , and this time is the cause of frictional unemployment . Most economists do not er frictional unemployment to be a bad thing . After all , there will always be workers who are unemployed while looking for ajob that is a better match for their skills . There will always be employers that have an en position , while looking for a worker that is a better match for the job . Ideally , these matches happen quickly , but even when the economy is very strong there will be some natural unemployment and this is what the natural rate of unemployment measures . The neoclassical view of unemployment tends to focus attention away from the cyclical unemployment is , unemployment caused by putting more attention on the unemployment rate issue that prevails even when the economy is operating at potential . To put it another way , the neoclassical view of unemployment tends to focus on how the government can adjust public policy to reduce the natural rate . Such policy changes might involve redesigning unemployment and welfare programs so that they support those in need , but also offer greater encouragement . It might Access for free at

The Policy Implications of the Neoclassical Perspective 329 involve redesigning business rules with an eye to whether they are unintentionally discouraging businesses from taking on new employees . It might involve building institutions to improve the of information about jobs and the mobility , to help bring workers and employers together more quickly . For those workers who that their skills are permanently no longer in demand ( for example , the structurally unemployed ) economists can design policy to provide opportunities for retraining so that these workers can reenter the labor force and seek employment . Neoclassical economists will not tend to see aggregate demand as a useful tool for reducing unemployment after all , with a vertical aggregate supply curve determining economic output , then aggregate demand has no effect on unemployment . Instead , neoclassical economists believe that aggregate demand should be allowed to expand only to match the gradual shifts of aggregate supply to the the price level much the same and pressures low . If aggregate demand rises rapidly in the neoclassical model , in the long run it leads only to pressures . Figure shows a vertical curve and three different levels of aggregate demand , rising from ADO to to . As the equilibrium rises from to to , the price level rises , but real does not budge nor does the rate of unemployment , which adjusts to its natural rate . Conversely , reducing has no costs , either . Think about Figure in reverse , as the aggregate demand curve shifts from AD to to , and the equilibrium moves from to to . During this process , the price level falls , but , in the long run , neither real nor the natural unemployment rate changes . 135 130 Price Level ( base year 100 ) I 100 200 300 400 500 600 700 800 Real ( billions of constant dollars ) FIGURE How Aggregate Demand Determines the Price Level in the Long Run As aggregate demand shifts to the right , from ADD to to , rea in this economy and the level of unemployment do not change . However , there is inflationary pressure for a price level as the equilibrium changes from to to . LINK IT UP Visit this website ( to read about how and unemployment are related . Fighting Recession or Encouraging Growth ?

Neoclassical economists believe that the economy will rebound out ofa recession or eventually contract during an expansion because prices and wage rates are and will adjust either upward or downward to restore the economy to its potential . Thus , the key policy question for is how to promote growth of potential . We know that economic growth ultimately depends on the growth rate of productivity .

330 13 The Neoclassical Perspective Productivity measures how effective inputs are at producing outputs . We know that productivity has grown on average about per year . That means that the same amount of inputs produce more output than the year before . We also know that productivity growth varies a great deal in the short term due to cyclical factors . It also varies somewhat in the long term . From , labor productivity ( as measured by output per hour in the business sector ) grew at per year . From , productivity growth declined to per year . Then , from , productivity growth increased to around per year . In recent years , it has grown less than per year , although it did pick up in 2019 and 2020 to over again . The neoclassical economists believe the underpinnings of productivity growth to be an economy investments in human capital , physical capital , and technology , operating together in a environment that rewards innovation . Government policy should focus on promoting these factors . Summary of Neoclassical Policy Recommendations Let summarize what neoclassical economists recommend for policy . Neoclassical economists do not believe in the economy . They believe that a stable economic environment with a low rate of fosters economic growth . Similarly , tax rates should be low and unchanging . In this environment , private economic agents can make the best possible investment decisions , which will lead to optimal investment in physical and human capital as well as research and development to promote improvements in technology . Summary of Neoclassical Economics versus Economics Table summarizes the key differences between the two schools of thought . Summary Neoclassical Economics Economics Focus or short term Prices and wages sticky or flexible ?

Flexible Sticky Economic output Primarily determined by aggregate demand or Aggregate supply Aggregate demand aggregate supply ?

Aggregate supply vertical or Vertical sloping ?

Phillips curve vertical or , Vertical Downward sloping sloping Is aggregate demand a useful tool for Yes Yes controlling inflation ?

What should be the primary area of Increase aggregate demand Reform labor market institutions to , policy emphasis for reducing reduce natural rate of unemployment to eliminate cyclical unemployment ?

unemployment , Is es Onym es or run , sense , but ma ust increase inflation Yes ending recession ?

instead TABLE Neoclassical versus Economics Access for free at Balancing and Neoclassical Models 331 Balancing and Neoclassical Models LEARNING OBJECTIVES By the end of this section , you will be able to Evaluate how neoclassical economists and economists react to Analyze the interrelationship between the neoclassical and economic models We can compare the balance between and Neoclassical models to the challenge of riding two horses simultaneously . When a circus performer stands on two horses , with a foot on each one , much of the excitement for the viewer lies in contemplating the gap between the two . As modern ride into the future on two one foot on the perspective and one foot on the long term neoclassical balancing act may look uncomfortable , but there does not seem to be any way to avoid it . Each approach , and neoclassical , has its strengths and weaknesses . The model , built on the importance of aggregate demand as a cause of business cycles and a degree and price rigidity , does a sound job of explaining many and why cyclical unemployment rises and falls . By focusing on the aggregate demand adjustments , economics risks overlooking the causes of economic growth or the natural rate of unemployment that exist even when the economy is producing at potential . The neoclassical model , with its emphasis on aggregate supply , focuses on the underlying of output and employment in markets , and thus tends to put more emphasis on economic growth and how labor markets work . However , the neoclassical view is not especially helpful in explaining why unemployment moves up and down over short time horizons of a few years . Nor is the neoclassical model especially helpful when the economy is mired in an especially deep and recession , like the Great Depression . economics tends to view as a price that might sometimes be paid for lower unemployment neoclassical economics tends to view as a cost that offers no offsetting gains in terms of lower unemployment . can not , however , be summed up as an argument between one group of economists who are pure and another group who are pure . Instead , many mainstream economists believe both the and neoclassical perspectives . Robert , the Nobel laureate in economics in 1987 , described the dual approach in this way At short time scales , I think , something sort of is a good approximation , and surely better than anything straight At very long time scales , the interesting questions are best studied in a neoclassical framework , and attention to the side of things would be a minor distraction . At the time scale , we have to piece things together as best we can , and look for a hybrid model that will do the job . Many modern spend considerable time and energy trying to construct models that blend the most attractive aspects of the and neoclassical approaches . It is possible to construct a somewhat complex mathematical model where aggregate demand and sticky wages and prices matter in the short run , but wages , prices , and aggregate supply adjust in the long run . However , creating an overall model that encompasses both and neoclassical models is not easy . BRING IT HOME Navigating Uncharted Great Recession and Recession of 2020 Were the policies that the government implemented to stabilize the economy and markets during the Great Recession of , and the recession of 2020 effective ?

Many economists from both the and neoclassical schools have found that they were , although to varying degrees . Great Recession , Alan Blinder of Princeton University and Mark for Moody Analytics found that , without 332 13 The Neoclassical Perspective , decline would have been more than its in 2008 followed by its decline in 2009 . They also estimated that there would have been million more job losses had the government not intervened in he market with the TARP to support the industry and key automakers General Motors and Chrysler . Federal Reserve Bank economists Carlos , Stefano , and Christian found in their study , Policy Initiatives in the Global Recession What Did Forecasters Expect ?

that once the government implemented policies , adapted their expectations to these policies . They were more likely to anticipate increases in investment due to lower interest rates brought on by monetary policy and increased economic growth resulting from . The neoclassical perspective can also shed light on the country experience with policy during the induced recession of 2020 . It was mentioned one criticism made by proponents of the neoclassical is that government policy is often too slow to react to a recession . However after the pandemic hit , the government quickly responded with aid to state and local governments , increased unemployment insurance , aid to businesses forced to shut down , and stimulus checks to boost spending . There is no doubt that the economic from the pandemic would have been much worse without these policies . Some economists even argue that he government helped too much and that the high inflation the . economy experienced starting is due the real output growing faster than potential , but it is too early ( as of early 2022 ) to tell if that argument is correct . By focusing on potential instead of demand , the neoclassical perspective also makes an important Joint about how the size of the economy determines its ability to grow . Since the pandemic hit , millions of workers wave stayed out of the labor market due to early retirement , health and safety concerns , the availability of childcare , and school closures . As mentioned in , these changes have caused labor force participation to remain its historical average . The pandemic has also made it harder for future workers to acquire skills hey need to be productive in the labor market . The longer these dynamics are at play , the more harm it will do to . Access for free at

13 Key Terms 333 Key Terms adaptive expectations the theory that people look at past experience and gradually adapt their beliefs and behavior as circumstances change expected a future rate of that consumers and firms build into current decision making neoclassical perspective the philosophy that , in the long run , the business cycle will fluctuate around the potential , or , level physical capital per person the amount and kind of machinery and equipment available to help a person produce a good or service rational expectations the theory that people form the most accurate possible expectations about the future that they can , using all information available to them Key Concepts and Summary The Building Blocks of Neoclassical Analysis The neoclassical perspective argues that , in the long run , the economy will adjust back to its potential level of output through price levels . Thus , the neoclassical perspective views the AS curve as vertical . A rational expectations perspective argues that people have excellent information about economic events and how the economy works and that , as a result , price and other economic adjustments will happen very quickly . In adaptive expectations theory , people have limited information about economic information and how the economy works , and so price and other economic adjustments can be slow . The Policy Implications ofthe Neoclassical Perspective Neoclassical economists tend to put relatively more emphasis on growth than on recession , because they believe that will fade in a few years and growth will ultimately determine the standard of living . They tend to focus more on reducing the natural rate of unemployment caused by economic institutions and government policies than the cyclical unemployment caused by recession . Neoclassical economists also see no social to . With an AS curve , can arise because an economy is approaching full employment . With a vertical neoclassical AS curve , does not accompany any rise in output . If aggregate supply is vertical , then aggregate demand does not affect the quantity of output . Instead , aggregate demand can only cause changes in the price level . A vertical aggregate supply curve , where the quantity is consistent with many different price levels , also implies a vertical Phillips curve . Balancing and Neoclassical Models The perspective considers changes to aggregate demand to be the cause of business cycle . are likely to advocate that policy makers actively attempt to reverse recessionary and periods because they are not convinced that the economy can easily return to full employment . The neoclassical perspective places more emphasis on aggregate supply . Neoclassical economists believe that long term productivity growth determines the potential level and that the economy typically will return to full employment after a change in aggregate demand . Skeptical of the effectiveness and timeliness of policy , neoclassical economists are more likely to advocate a , or fairly limited , role for active stabilization policy . While would tend to advocate an acceptable tradeoff between and unemployment when counteracting a recession , neoclassical economists argue that no such tradeoff exists . Any gains in lower unemployment will eventually vanish and the result of active policy will only be .

334 13 Questions Questions . Do rational expectations tend to look back at past experience while adaptive expectations look ahead to the future ?

Explain your answer . Legislation proposes that the government should use policy to achieve an unemployment rate of zero percent , by increasing aggregate demand for as much and as long as necessary to accomplish this goal . From a neoclassical perspective , how will this policy affect output and the price level in the short run and in the long run ?

Sketch an aggregate supply diagram to illustrate your answer Hint . revisit Figure . Would it make sense to argue that rational expectations economics is an extreme version of neoclassical economics ?

Explain . Summarize the and Neoclassical models . Review Questions . 10 . 11 . 12 . 13 . 14 . 15 . 16 . Does neoclassical economics focus on the long term or the short term ?

Explain your answer . Does neoclassical economics View prices and wages as sticky or ?

Why ?

What shape is the aggregate supply curve ?

Why does it have this shape ?

What is the difference between rational expectations and adaptive expectations ?

A neoclassical economist and a economist are studying the economy of Vineland . It appears that Vineland is beginning to experience a mild recession with a decrease in aggregate demand . Which of these two economists would likely advocate that the government of Vineland take active measures to reverse this decline in aggregate demand ?

Why ?

Do neoclassical economists tend to focus more on long term economic growth or on ?

Explain . Do neoclassical economists tend to focus more on cyclical unemployment or on ?

Explain . Do neoclassical economists see a value in tolerating a little more if it brings additional economic output ?

Explain your answer . If aggregate supply is vertical , what role does aggregate demand play in determining output ?

In determining the price level ?

What is the shape of the neoclassical Phillips curve ?

What assumptions do economists make that lead to this shape ?

When the economy is experiencing a recession , why would a neoclassical economist be unlikely to argue for aggressive policy to stimulate aggregate demand and return the economy to full employment ?

Explain your answer . If the economy is suffering through a rampant period , would a economist advocate for stabilization policy that involves higher taxes and higher interest rates ?

Explain your answer . Critical Thinking Questions 17 . 18 . If most people have rational expectations , how long will last ?

Explain why the neoclassical economists believe that the government does not need to do much about unemployment . Do you agree or disagree ?

Explain . Access for free at 13 Problems 335 19 . Economists from all theoretical persuasions criticized the American Recovery and Reinvestment Act . The Stimulus Package was arguably a measure so why would a economist be critical of it ?

Why would neoclassical economists be critical ?

20 . Is it a logical contradiction to be a neoclassical ?

Explain . Problems 21 . Use Table to answer the following questions . Price Level Aggregate Supply Aggregate Demand 90 95 100 105 110 TABLE Sketch an aggregate supply and aggregate demand diagram . What is the equilibrium output and price level ?

If aggregate demand shifts right , what is equilibrium output ?

If aggregate demand shifts left , what is equilibrium output ?

In this scenario , would you suggest using aggregate demand to alter the level of output or to control any increases in the price level ?