Glossary

26.3 Balancing Keynesian and Neoclassical Models

3 min read•june 24, 2024

Economic fluctuations are a key focus in economics. Neoclassical and Keynesian approaches offer different perspectives on what causes these ups and downs and how to handle them. Understanding both views helps make sense of the complex economic landscape.

Short-term and long-term outlooks also shape how we view economic changes. Keynesians focus on immediate demand factors, while neoclassicals emphasize long-run supply factors. Blending these insights gives a fuller picture of how economies work and grow over time.

Neoclassical and Keynesian Approaches to Economic Fluctuations

Neoclassical vs Keynesian Approaches

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  • Neoclassical approach:
    • Markets efficient and self-correcting
    • Economic fluctuations caused by external shocks (technology changes, preference shifts)
    • determine economic growth
    • Government intervention unnecessary and potentially counterproductive
  • Keynesian approach:
    • Markets not always efficient, can experience prolonged disequilibrium
    • Economic fluctuations caused by changes in (investment, consumer spending)
    • Demand-side factors determine economic growth
    • Government intervention (fiscal and monetary policies) can stabilize economy during recessions

Short-term vs Long-term Perspectives

  • Short-term perspective:
    • Focuses on business cycle and short-run economic fluctuations
    • Prices and wages sticky, don't adjust quickly to economic changes
    • Aggregate demand determines economic outcomes
    • Keynesian models (IS-LM) analyze short-run fluctuations
  • Long-term perspective:
    • Focuses on factors determining long-run growth (, )
    • Prices and wages flexible, adjust to economic changes over time
    • determines economic outcomes
    • Neoclassical models (Solow growth) analyze long-run growth

Synthesizing Neoclassical and Keynesian Insights

  • Both models provide valuable insights into economic fluctuations and growth
  • Neoclassical models:
    • Supply-side factors (productivity, technological progress) determine long-run growth
    • Market forces allocate resources efficiently
  • Keynesian models:
    • Demand-side factors (investment, consumer spending) determine short-run fluctuations
    • Market failures possible, government intervention can stabilize economy
  • Synthesizing insights:
    • Policymakers should consider both supply-side and demand-side factors
    • Short run: Keynesian policies (fiscal stimulus) can mitigate downturns
    • Long run: Neoclassical policies (investing in human and physical capital) promote sustainable growth

Key Concepts and Models

IS-LM Model

  • Keynesian model representing equilibrium in goods market (IS curve) and money market (LM curve)
  • IS curve: combinations of interest rates and output levels resulting in goods market equilibrium
    • Downward-sloping because lower interest rates stimulate investment and increase equilibrium output
  • LM curve: combinations of interest rates and output levels resulting in money market equilibrium
    • Upward-sloping because higher output levels increase money demand, leading to higher equilibrium interest rates
  • Intersection of IS and LM curves determines short-run equilibrium interest rate and output level

Solow Growth Model

  • Neoclassical model explaining long-run growth based on capital accumulation, labor growth, and technological progress
  • Output (YY) a function of capital (KK), labor (LL), and technology (AA): Y=F(K,L,A)Y = F(K, L, A)
  • Steady-state output per worker (y∗y^*) depends on saving rate (ss), population growth rate (nn), technological progress rate (gg), and depreciation rate (δδ): y∗=(sn+g+δ)11−αy^* = (\frac{s}{n + g + δ})^{\frac{1}{1-α}}
    • αα is elasticity of output with respect to capital
  • Increasing saving rate or technological progress rate leads to higher long-run growth, while higher population growth or depreciation rates reduce long-run growth

Key Terms to Review (32)

Adaptive Expectations: Adaptive expectations is a theory that explains how individuals form their expectations about future economic conditions based on past experiences and observations. It suggests that people continuously revise their expectations in response to new information and changing circumstances, gradually adapting their beliefs over time.
Aggregate Demand: Aggregate demand (AD) is the total demand for all final goods and services produced in an economy during a specific time period. It represents the sum of consumer spending, business investment, government spending, and net exports. Aggregate demand is a crucial macroeconomic concept that helps economists understand and predict the overall level of economic activity, employment, and inflation in an economy.
Aggregate Supply: Aggregate supply refers to the total quantity of goods and services that firms in an economy are willing and able to sell at various price levels during a given time period. It represents the supply-side of the economy and is a crucial component in understanding macroeconomic dynamics and the determination of national output, employment, and the price level.
Business Cycles: Business cycles refer to the periodic fluctuations in economic activity, characterized by alternating periods of expansion and contraction in the overall level of economic output, employment, and income. These cycles are a fundamental feature of market economies and have significant implications for various aspects of the economy, including labor productivity, unemployment, and the balance between Keynesian and neoclassical economic models.
Capital Accumulation: Capital accumulation refers to the process of increasing the stock of capital goods, such as machinery, equipment, and infrastructure, in an economy over time. It is a crucial driver of economic growth and development, as it enhances the productive capacity of an economy by expanding the means of production.
Downward Rigidity: Downward rigidity refers to the phenomenon where prices, wages, or other economic variables tend to be resistant to decreases or reductions, even in the face of declining demand or economic conditions. This concept is particularly relevant in the context of balancing Keynesian and neoclassical models of the economy.
Dynamic Stochastic General Equilibrium models: Dynamic Stochastic General Equilibrium (DSGE) models are a class of macroeconomic models that combine microeconomic principles with dynamic optimization to study the behavior of the entire economy. These models aim to capture the complex interactions between different sectors and agents in an economy, while accounting for the uncertainty and stochastic nature of various economic variables.
Economic Disequilibrium: Economic disequilibrium refers to a state of imbalance or instability in an economic system, where the supply and demand for goods, services, or factors of production are not in harmony. This state of disequilibrium can lead to various economic fluctuations and adjustments as the market tries to restore equilibrium.
Efficiency Wages: Efficiency wages refer to the economic theory that employers may find it profitable to pay their workers more than the minimum wage required to fill a position. The idea is that higher wages can increase worker productivity and reduce turnover, ultimately leading to greater efficiency and profitability for the firm.
Exogenous Shocks: Exogenous shocks refer to unexpected external events or changes that occur outside of an economic system and have a significant impact on its performance. These shocks can originate from various sources, such as natural disasters, political upheavals, or technological breakthroughs, and they can disrupt the normal functioning of the economy, leading to changes in economic variables like output, employment, and prices.
Federal Reserve: The Federal Reserve, commonly referred to as the Fed, is the central banking system of the United States. It is responsible for conducting monetary policy, supervising banks, maintaining financial system stability, and providing banking services to the government. The Fed's actions and decisions have far-reaching implications for the overall economy, influencing factors such as inflation, employment, and economic growth.
Fiscal Policy: Fiscal policy refers to the use of government spending, taxation, and borrowing to influence the economy. It is a macroeconomic tool that policymakers employ to promote economic growth, stabilize the business cycle, and achieve other economic objectives.
Implicit Contracts: Implicit contracts are unwritten, informal agreements that govern the relationship between employers and employees. They represent the unspoken expectations and obligations that are understood, but not explicitly stated, in the employment relationship.
Keynesian Perspective: The Keynesian perspective is an economic theory that emphasizes the role of government intervention in managing aggregate demand to achieve full employment and economic stability. It contrasts with the neoclassical perspective, which focuses on the self-regulating nature of free markets.
Long-Run Aggregate Supply Curve: The long-run aggregate supply curve represents the relationship between the overall price level and the total quantity of output supplied in an economy over the long run, when all factors of production can be adjusted. It reflects the economy's productive capacity and is generally vertical, indicating that the quantity of output supplied is not sensitive to changes in the price level in the long run.
Menu Costs: Menu costs refer to the costs associated with changing prices, such as the time and effort required to update price lists, menus, and other marketing materials. These costs can create rigidities in the pricing decisions of firms, leading to price stickiness and influencing the dynamics of inflation.
Monetary Policy: Monetary policy refers to the actions taken by a country's central bank to control the money supply and influence economic conditions. It is a crucial tool used by governments to achieve macroeconomic objectives such as price stability, full employment, and economic growth.
Multiplier Effect: The multiplier effect refers to the phenomenon where an initial change in spending or investment leads to a larger change in total economic output. This occurs because the initial change sets off a chain reaction of further spending and re-spending, amplifying the original impact.
Neoclassical Perspective: The neoclassical perspective is an economic theory that emphasizes the role of supply and demand in determining the allocation of resources and the distribution of income. It focuses on the behavior of individual economic agents, such as consumers and producers, and how they make rational decisions to maximize their utility or profits.
New Keynesian Economics: New Keynesian economics is a school of macroeconomic thought that builds on the foundations of Keynesian economics, while incorporating elements of neoclassical economics. It emphasizes the role of imperfect competition, sticky prices, and other market frictions in explaining economic fluctuations and the effectiveness of monetary and fiscal policies.
Nominal Rigidities: Nominal rigidities refer to the inability or unwillingness of certain prices and wages to adjust quickly in response to changes in economic conditions. This concept is particularly relevant in the context of balancing Keynesian and Neoclassical models, as it helps explain why markets may not always clear and why there can be persistent deviations from full employment equilibrium.
Phillips Curve: The Phillips curve is an economic model that illustrates the inverse relationship between the rate of unemployment and the rate of inflation in an economy. It suggests that as unemployment decreases, inflation tends to increase, and vice versa, providing policymakers with a tool to manage the trade-off between these two economic variables.
Price Adjustments: Price adjustments refer to the changes in the price of goods and services in response to various economic factors. This term is particularly relevant in the context of balancing Keynesian and Neoclassical models, as it highlights the dynamics of how prices adapt to market conditions and the implications for economic equilibrium.
Price Ceilings: A price ceiling is a legal maximum price set by the government on a good or service. It is implemented to make a product more affordable and accessible to consumers, typically in markets where prices have risen significantly or are deemed too high.
Price Floors: A price floor is a government-imposed minimum price that must be charged for a good or service. It creates a lower limit on the price, preventing the market price from falling below a certain level. Price floors are often implemented to protect producers and ensure a minimum income for them.
Rational Expectations: Rational expectations is an economic theory that states that economic agents (such as consumers and firms) make decisions based on their best guess of the future, using all available information. This means that people's expectations about the future are not systematically biased, and they use the information they have as efficiently as possible when making decisions.
Real Business Cycle Theory: Real Business Cycle (RBC) theory is a macroeconomic model that explains fluctuations in economic activity, such as output and employment, as the result of real (rather than monetary) shocks. It emphasizes the role of technology, productivity, and other real factors in driving business cycles.
Stagflation: Stagflation is a situation where there is slow economic growth, high unemployment, and high inflation all occurring at the same time. It is a challenging economic condition that combines the problems of stagnation (low growth and high unemployment) and inflation.
Sticky Wages: Sticky wages refer to the phenomenon where wages tend to remain relatively fixed or resistant to change, even in the face of shifts in economic conditions. This concept is particularly relevant in the context of understanding short-run changes in unemployment, the building blocks of Keynesian analysis, the Keynesian perspective on market forces, and the balancing of Keynesian and neoclassical models.
Supply-Side Factors: Supply-side factors refer to the economic conditions and policies that influence the production capacity and output of goods and services in an economy. These factors determine the overall supply of products available in the market, affecting prices, employment, and economic growth.
Technological Progress: Technological progress refers to the continuous advancements and improvements in technology, including tools, techniques, and processes, that enhance productivity, efficiency, and the overall standard of living. It is a crucial driver of economic growth and development, enabling the production of goods and services at a higher quality and lower cost.
Wage and Price Rigidity: Wage and price rigidity refers to the tendency of wages and prices to remain relatively stable or 'sticky' even in the face of changes in economic conditions. This concept is central to the understanding of Keynesian and neoclassical models, as it helps explain how markets may not always reach equilibrium through the automatic adjustment of prices and quantities.
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