Self-Check Questions

Key Terms

adaptive expectations the theory that people look at past experience and gradually adapt their beliefs and behavior as circumstances change expected inflation a future rate of inflation 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 full-employment, level of output 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

13.1 The Building Blocks of Neoclassical Analysis

The neoclassical perspective argues that, in the long run, the economy will adjust back to its potential GDP level of output through flexible price levels. Thus, the neoclassical perspective views the long-run 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.

13.2 The Policy Implications of the Neoclassical Perspective

Neoclassical economists tend to put relatively more emphasis on long-term growth than on fighting recession, because they believe that recessions will fade in a few years and long-term 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 benefit to inflation. With an upward-sloping Keynesian AS curve, inflation can arise because an economy is approaching full employment. With a vertical long-run neoclassical AS curve, inflation 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 inflationary changes in the price level. A vertical aggregate supply curve, where the quantity of output is consistent with many different price levels, also implies a vertical Phillips curve.

13.3 Balancing Keynesian and Neoclassical Models

The Keynesian perspective considers changes to aggregate demand to be the cause of business cycle fluctuations. Keynesians are likely to advocate that policy makers actively attempt to reverse recessionary and inflationary periods because they are not convinced that the self-correcting 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 GDP level and that the economy typically will return to full employment after a change in aggregate demand. Skeptical of the effectiveness and timeliness of Keynesian policy, neoclassical economists are more likely to advocate a hands-off, or fairly limited, role for active stabilization policy. While Keynesians would tend to advocate an acceptable tradeoff between inflation and unemployment when counteracting a recession, neoclassical economists argue that no such tradeoff exists. Any short-term gains in lower unemployment will eventually vanish and the result of active policy will only be inflation.

Self-Check Questions

1 . Do rational expectations tend to look back at past experience while adaptive expectations look ahead to the future? Explain your answer. 2 . Legislation proposes that the government should use macroeconomic 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 demand/aggregate supply diagram to illustrate your answer. Hint: revisit Figure 13.4. 3 . Would it make sense to argue that rational expectations economics is an extreme version of neoclassical economics? Explain. 4 . Summarize the Keynesian and Neoclassical models.

Review Questions

5 . Does neoclassical economics focus on the long term or the short term? Explain your answer. 6 . Does neoclassical economics view prices and wages as sticky or flexible? Why? 7 . What shape is the long-run aggregate supply curve? Why does it have this shape? 8 . What is the difference between rational expectations and adaptive expectations? 9 . A neoclassical economist and a Keynesian 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? 10 . Do neoclassical economists tend to focus more on long term economic growth or on recessions? Explain briefly. 11 . Do neoclassical economists tend to focus more on cyclical unemployment or on inflation? Explain briefly. 12 . Do neoclassical economists see a value in tolerating a little more inflation if it brings additional economic output? Explain your answer. 13 . If aggregate supply is vertical, what role does aggregate demand play in determining output? In determining the price level? 14 . What is the shape of the neoclassical long-run Phillips curve? What assumptions do economists make that lead to this shape? 15 . 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. 16 . If the economy is suffering through a rampant inflationary period, would a Keynesian economist advocate for stabilization policy that involves higher taxes and higher interest rates? Explain your answer.

Critical Thinking Questions

17 . If most people have rational expectations, how long will recessions last? 18 . Explain why the neoclassical economists believe that the government does not need to do much about unemployment. Do you agree or disagree? Explain. 19 . Economists from all theoretical persuasions criticized the American Recovery and Reinvestment Act. The “Stimulus Package” was arguably a Keynesian measure so why would a Keynesian economist be critical of it? Why would neoclassical economists be critical? 20 . Is it a logical contradiction to be a neoclassical Keynesian? Explain.