Economics Today 17th Edition by Miller

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Chapter 11
Classical and Keynesian Macro Analyses

◼ Overview
The purpose of this chapter is to lay the foundation for macroeconomic theory and policy. Definitions,
assumptions, and terminology used during the next eight chapters are introduced. The classical model is
introduced first, where the short-run equilibrium real GDP and the price level is developed. Then the
basics of the Keynesian model are presented, introducing the language and key relationships necessary
for an understanding of the “Keynesian” macroeconomic model of national income and employment
determination. The focus is on the short run using the AS-AD model. In the Keynesian model, the concept
of the short-run aggregate supply curve, SRAS, is shown and used to show short-run equilibrium. The
factors that shift the LRAS, SRAS, and AD curves are identified, and the effects of aggregate demand and
supply shocks are introduced. Finally, inflation and the causes of variations in the inflation rate in the short
run are shown.

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102 Miller • Economics Today, Seventeenth Edition

◼ Learning Objectives
After studying this chapter, students should be able to
• Discuss the central assumptions of the classical model.
• Describe the short-run determination of equilibrium real GDP and the price level in the classical model.
• Explain circumstances under which the short-run aggregate supply curve may be either horizontal or
upward sloping.
• Understand what factors cause shifts in the short-run and long run aggregate supply curves.
• Evaluate the effects of aggregate demand and supply shocks on equilibrium real GDP in the short run.
• Determine the causes of short-run variations in the inflation rate.

◼ Outline
I. The Classical Model: This model, which traces its origins to the 1770s, was the first systematic
attempt to explain the determinants of the price level and the national levels of output, income,
employment, consumption, saving, and investment.
A. Say’s Law: Supply creates its own demand, or desired aggregate expenditures will equal actual
aggregate expenditures. People only produce more goods than they want because they want to
trade them for other goods. It follows that full employment of labor and other resources would
be the normal state of affairs in such economies. (See Figure 11-1.)

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B. Assumptions of the Classical Model: Supply creates its own demand, or desired expenditures
will equal actual expenditures. There are four major assumptions:
1. Pure Competition Exists: No single buyer or seller of a commodity or an input can affect
its price.
2. Wages and Prices Are Flexible: Prices, wages, and interest rates are free to move to the
level dictated by supply and demand in the long run.
3. People Are Motivated by Self-Interest: Businesses want to maximize their profits and
households want to maximize their economic well-being.
4. People Cannot Be Fooled by Money Illusion: Buyers and sellers react to changes in
relative prices, not to changes in money prices when relative prices stay unchanged.
C. Equilibrium in the Credit Market: When income is saved, it is not reflected in product demand.
Consumption expenditures can fall short of total output when saving occurs. The classical
economists argued that each dollar saved would be invested by businesses. In the credit market,
the interest rate equates the quantity of credit demanded with the quantity of credit supplied,
and thus planned investment equals planned saving. Saving represents the supply of credit, and
investment represents the demand for credit. (See Figure 11-2.)
1. The Relationship Between Saving and Investment: The classical economists believed that
each dollar saved would be invested by business.
2. The Equilibrium Interest Rate: Equilibrium between the saving plans of consumers
and investment plans of businesses occurs at the interest rate that is determined by the
intersection of the desired saving and desired investment curves. (See Figure 11-2.)
D. Equilibrium in the Labor Market: In the classical model, if an excess quantity of labor
is supplied at a particular wage level, the wage level is too high, and some workers are
unemployed. By accepting lower wages, unemployed workers will be put back to work.
Only structural and frictional unemployment will exist in this model; that is, there is a
natural rate of unemployment. (See Figure 11-3.)
1. The Relationship Between Employment and Real GDP: The level of employment in an
economy determines, other things held constant, it is real GDP. (See Table 11-1.)
E. Classical Theory, Vertical Aggregate Supply, and the Price Level: In the classical model,
long-term involuntary unemployment is impossible. Say’s law, coupled with flexible interest
rates, prices, and wages, tends to keep workers fully employed so the aggregate supply curve
(LRAS) is vertical at full employment. Full employment is the amount of employment that
would be produced year in and year out in an economy with full information and full adjustment
of wages and prices. (See Figure 11-4.)
1. Effect of an Increase in Aggregate Demand in the Classical Model: There will be an
increase in the price level as wages rise in response to an increase in the demand for labor
that is at full employment. Other input prices will also rise. The level of real GDP will
remain unchanged on the LRAS curve. (See Figure 11-4.)
2. Effect of a Decrease in Aggregate Demand in the Classical Model: There will be a
decrease in the price level as wages fall due to a decrease in the demand for labor, which
causes workers to bid down wages in response to an increase in unemployment. Other
input prices will fall. The level of real GDP will remain unchanged on the LRAS curve.
(See Figure 11-5.)
II. The Keynesian Short-Run Aggregate Supply Curve: A horizontal short-run aggregate supply
curve is called the Keynesian short-run aggregate supply curve. According to Keynes, the existence
of unions and long-term contracts between workers and employers in and outside of unionized
environments can explain downward inflexibility of nominal wage rates. Such “stickiness” of wages
makes involuntary unemployment of labor a possibility. Even in situations of excess capacity and

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104 Miller • Economics Today, Seventeenth Edition

large amounts of unemployment, the price level may not fall. There may be continuing unemployment
and a reduction in the equilibrium level of real GDP per year. (See Figure 11-6.)

III. Output Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing
Price Levels in the Short Run: An increase in aggregate demand using the Keynesian SRAS
curve results in real GDP increasing by the amount of the increase in aggregate demand. When the
price level can vary, that is the SRAS curve is upward sloping, then real GDP increases by less than
the increase in aggregate demand because part of the increase in nominal GDP is a result of an
increase in the price level. (See Figure 11-7.)
A. Reasons for Upward-Sloping Short-Run Aggregate Supply
1. Flexibility of Hours and Work: Employers can require workers to work more hours and to
work harder.
2. Existing Capital Can Be Used More Intensively.
3. Profits Rise If Prices Go Up But Wage Rates Do Not: Firms will produce more as profits rise.

IV. Shifts in the Aggregate Supply Curve: There is a core class of events that causes a shift in both
the short-run and long-run aggregate supply curves. (See Table 11-2.)
A. Shifts in Both Short- and Long-Run Aggregate Supply: Any change in the endowments of
the factors of production and any change in the level of technology or knowledge shifts the
aggregate supply curve. (See Figure 11-8.)
B. Shifts in SRAS Only: The most obvious occurrence that causes a shift in SRAS is a temporary
change in input prices. (See Figure 11-9.)

V. Consequences of Changes in Aggregate Demand: Aggregate demand shocks are any unanticipated
shocks that cause the aggregate demand curve to shift inward or outward. Aggregate supply shocks
are any unanticipated shocks that cause the aggregate supply curve to shift inward or outward.
A. When Aggregate Demand Falls While Aggregate Supply Is Stable: A decrease in AD will
decrease the price level and real GDP. If equilibrium real GDP is less than full employment real
GDP on LRAS, the difference between full employment real GDP and equilibrium real GDP is
defined as a recessionary gap. (See Figure 11-9.)
B. Short-Run Effects When Aggregate Demand Increases: The price level and real GDP
increase. If equilibrium real GDP is greater than full employment real GDP on LRAS, the
difference between full employment and actual real GDP is defined as an inflationary gap.
(See Figure 11-10.)

VI. Explaining Short-Run Variations in Inflation

A. Demand-Pull versus Cost-Push Inflation: Inflation caused by increases in AD that are not
matched by increases in aggregate supply is demand-pull inflation. Inflation caused by decreases
in the SRAS curve, ceteris paribus, is cost-push inflation. (See Figure 11-11.)
B. Aggregate Demand and Supply in an Open Economy: The effect of exchange rates and trade
with the rest of the world has an impact on both the aggregate supply and the aggregate demand
curves.
1. How a Weaker Dollar Affects Aggregate Supply: A weaker dollar increases the dollar
price of imported inputs and shifts the SRAS to the left. (See Figure 11-12(a).)
2. How a Weaker Dollar Affects Aggregate Demand: A weaker dollar increases the dollar
price of imports and decreases the price of exports in terms of foreign currency. Thus U.S.
exports increase and imports decrease; that is, net exports increase, and the aggregate
demand curve shifts to the left. (See Figure 11-12(b).)

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3. The Net Effects on Inflation and Real GDP: An increase in aggregate demand and a
decrease in aggregate supply will have an indeterminate effect on real GDP. If AD increases
by more than SRAS decreases, then real GDP will increase. If AD increases by less than
SRAS decreases, then real GDP will decrease. What is clear is that the price level will
increase.

◼ Points to Emphasize
The Classical Model
The classical model predicted that capitalism contained mechanisms that were capable of ensuring full
employment of labor and other resources. Pre-Great Depression economists felt that wants were unlimited
and that inadequate aggregate demand would be unlikely. The classical economists believed that the
market value of final goods and services generates income identical to the value of the goods produced.
Thus production will always create enough purchasing power to buy the goods and services produced,
and supply creates its own potential demand according to Say’s law. The classical economists admitted
that saving was potentially a trouble spot since saving is a situation in which people earn income from
producing goods and services but do not spend that income. There could be a contraction in the economy
with resulting unemployment. Increased saving, if not offset by increased investment, will lead to
unemployment. The economic effect of investment is that people receive purchasing power (income) for
producing capital goods, but there are no corresponding increases in the output of consumer goods in the
short run. Thus, the economic effect of investment is precisely the opposite of saving. This was not likely
to be a problem in most cases because the interest rate and changes in it would lead to all saving being
invested. Planned saving is directly related to the interest rate, while planned investment is inversely
related to the interest rate, other things held constant. Surpluses or shortages of saving will lower or raise
the interest rate until planned saving and planned investment are equated in the credit market and a price
stable, full employment equilibrium is reached. A theory of the interest rate is established as a byproduct.

The classical economists had another argument to back up the prediction of full employment under
capitalism. This other mechanism was wage-price flexibility. Unemployment is synonymous with a
surplus of labor. If a surplus of anything occurs, prices will fall and induce increases in quantity demanded
and decreases in quantity supplied. Labor is no exception, so the wage falls until the quantity of labor
supplied equals the quantity of labor demanded. Any unemployment is voluntary.

The interest rate equates planned saving and planned investment and, therefore, ensures that a full
employment output will be purchased, and wage-price flexibility eliminates surpluses and shortages
of labor and ensures that a full employment output will be produced.

Keynes’s Criticisms of the Classical Model

First, Keynes pointed out, price-wage flexibility does not exist in modern capitalist societies, given unions,
welfare states, and monopolistic corporate power. Second, he noted that neither saving nor investment
were primarily determined by the rate of interest. Planned saving and consumption are primarily
determined by income, while investment is primarily determined by the interaction of profit expectations
and the interest rate. If saving and investment are primarily determined by different variables, then the
interest rate cannot be expected to bring them to equality. The interest rate can fluctuate drastically and
planned saving and planned investment will still not be equal, leading to the possibility of unemployment.

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The Keynesian Range of the Aggregate Supply Curve

Keynes argued that people react to changes in real variables, not to changes in nominal ones. During
the Great Depression there were high levels of unemployment. Keynes assumed that because so much
unemployed labor and capital existed, increases in aggregate demand would not lead to price increases.
More labor and capital could be employed without bidding their prices up. If costs of production did not
rise, then the price level would not rise. Therefore, real GDP would increase by the amount of any increase
in aggregate demand. Keynes could ignore the effects of price level changes and concentrate on real
variables. Since there was no difference between real and nominal variables, the aggregate supply curve
would be horizontal.

The Effect on an Open Economy

It is relatively easy to see the effect of a weaker dollar on aggregate demand. Students can relate to the fact
of higher dollar prices on imported consumer goods resulting from a dollar depreciation because most of
them buy some imported goods. They may need an example of the effect of a weaker dollar on aggregate
supply. The effect on the price of an imported input—such as a machine tool—of a dollar depreciation is
clear. Assume that a German machine tool costs 50,000 euros and the exchange rate is $1.00 =  2.00. The
machine tool costs $25,000 in the United States. If the dollar depreciates to $1.00 =  1.00, then the machine
tool costs $50,000. This higher priced input will decrease the willingness of firms that buy these machines
to increase output at each price level because it will not be profitable for them to do so. The buyers of
other imported inputs will respond in the same way, and the SRAS curve will shift to the left.

◼ For Those Who Wish to Stress Theory

The Classical Aggregate Supply Curve
The conclusions from the analysis in the classical model lead logically to a vertical aggregate supply
curve. In the classical model, aggregate demand determines the price level only. The level of full
employment is determined in the labor market by the intersection of the supply and demand curves for
labor. Associated with this level of employment and a given stock of capital is a given level of real
national output. This level of real national output is independent of the price level. Equilibrium real
national output is independent of the level of aggregate demand.

Wage-Price Flexibility
The classical economists argued that wage and price flexibility would assure full employment. Keynes
pointed out that if both the money wage and the price level fell because of declining labor costs, it is not
certain that the real wage would fall. Money wages would have to fall faster than the price level. In the
short run, it is likely that money wages and prices would fall proportionately. Thus nominal wage cuts
would be unlikely to move the economy to full employment in the short run. The classical economists
responded with what is now called the real balance effect. A decline in money wages and prices leads to an
increase in the real value of money balances. There will thus be an increase in aggregate demand sufficient
to cause prices to fall by less than wages and in the long run, the economy will return to full employment
if the money supply does not change.

Keynes and the Classical Economists: Short Run versus the Long Run
Much of the debate between Keynes and the classical economists revolves around the issue of the speed of
adjustment. Because of rigidities in the economy it takes time for changes in AD to affect the level of real
GDP, the price level, and employment. Keynes stated that “in the long run, we are all dead,” meaning that
the speed of adjustment was very slow. The classical economists believed that the adjustment process was
much faster. The policy of the classical economists was laissez-faire since when a depression occurred the

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economy would adjust to long-run equilibrium rapidly. All that an increase in AD would do in the long run
is to raise the price level. In Keynes’s system, unemployment could exist for a long period of time. Thus
an increase in AD could reduce unemployment and have little if any effect on the price level. The debate
over the speed of adjustment is still going on today in macroeconomics.

◼ Further Questions for Class Discussion

1. How can the existence of a minimum wage contribute to a Keynesian SRAS curve? If a minimum
wage is above the equilibrium wage, then employers are legally prohibited from paying a lower wage
even if workers are willing to accept one. Thus some workers will be involuntarily unemployed.

2. Suppose that the value of the dollar gets weaker, i.e., depreciates. Explain the effect on the SRAS
and AD curves. What will happen to the price level and to real GDP? In this case, the weaker dollar
makes foreign inputs more expensive in terms of dollars. The SRAS curve shifts to the left. The
weaker dollar makes imported consumer goods more expensive in dollars so U.S. consumers buy
less of them. U.S. exports are less expensive in terms of foreign currency, so foreigners buy more
U.S. exports. Net exports increase and AD increases. The price level increases since an increase in
AD and a decrease in SRAS cause the price level to increase. The effect on real GDP is indeterminate.

3. The Obama administration strongly supports the idea of increasing U.S. marginal tax rates on high
incomes. If these tax cuts were to be implemented, what would be likely to happen to equilibrium real
GDP and the price level? Explain. Higher marginal tax rates would decrease the incentive to save and
invest. The effect would be to decrease investment and the incentive to work and thus decrease the
labor supply. The effect would be to shift the LRAS and SRAS curves to the right. In addition, the
higher tax rates would decrease aggregate demand. Thus a decrease in aggregate demand and a
decrease in aggregate supply would cause equilibrium real GDP to decrease. The effect on the price
level would be indeterminate from the information given.

4. Suppose that the federal government decides to increase spending, helping qualified lower-income
students, who otherwise could not afford to go to college, to attend one. Explain the effect on the
SRAS curve and the short-run equilibrium level of real GDP and the price level, ceteris paribus.
More students would attend college, and thus, there would be an increase in education. The SRAS
curve would shift outward to the right, and the equilibrium level of real GDP would increase and the
price level would decrease.

5. In the 2008 presidential race, the Democrats argued that increasing U.S. barriers to international trade
were desirable to protect the jobs of U.S. workers from “unfair foreign competition.” Based on what
you know about the factors that shift the SRAS curve, would such a tactic be likely to prevent the loss
of currently existing American workers’ jobs, that is, keep unemployment from increasing in the
short run? No. An increase in international trade barriers would cause SRAS to shift to the left.
Equilibrium real GDP would decrease and the level of employment in the U.S. economy would
decrease.

◼ Answers to Questions for Critical Analysis

Have Inflation-Adjusted U.S. Wages Been “Too High”? (p. 236)
A sustained increase in the inflation rate reduces the real wage rate if the nominal wage rate stays fixed at
a given level. Because the quantity of labor supplied and the quantity of labor demanded respond to the

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108 Miller • Economics Today, Seventeenth Edition

real wage rate, any existing surplus in the labor market and thus labor unemployment will reduce if the
real wage rate falls.

Australia’s Short-Run Aggregate Supply Hit by a Locust Plague (p. 239)

The long-run aggregate supply curve shifts leftward if there is any change in the endowments of the
factors of production, such as labor, capital or technology. Because the locusts’ damage to crops and their
effects on livestock production are only temporary, the short-run aggregate supply curve shifted without
any effect on the long-run aggregate supply curve.

◼ You Are There

Worried about Shocks to Aggregate Supply—and Demand (p. 244)
1. Increases in health care costs and fuel costs raise the costs of production at each level of real GDP per
year. To cover those increased costs, a higher price level is needed. This is the effect of a leftward
shift of the LRAS curve while the position of the AD curve remains unchanged.

2. People would respond to an unexpected increase in the quantity of money that they hold by spending
at least some of it. Aggregate demand would increase as a result. Other things being equal, a
rightward shift in the AD curve would lead to a higher price level.

◼ Issues and Applications

Gauging Financial Sources of Aggregate Demand Shocks (p. 245–246)
1. The financial crisis in 2008 and significant reductions in household wealth during that period led to a
decrease in aggregate demand. A decrease in aggregate demand would reduce the price level, ceteris
paribus.

2. Figure 11-13 shows that not all jumps in the VIX index are associated with reductions in aggregate
demand that induce recession. The VIX index is a measure of financial market volatility, which does
not always significantly affect aggregate demand.

◼ Answers to Even-Numbered Problems

11-2. a. Desired investment increases, so the equilibrium interest rate rises.

b. There is no effect on current equilibrium real GDP because in the classical model the vertical
long-run aggregate supply curve always applies.
c. A change in desired investment does not directly affect the demand for labor or the supply of
labor in the classical model, so equilibrium employment does not change.
d. The decrease in the equilibrium interest rate generates a rightward and upward movement
along the supply curve of saving. Consequently, equilibrium saving increases.
e. The rise in current investment implies greater capital accumulation. Other things being equal,
this will imply increased future production and higher equilibrium real GDP in the future.

11-4. a. A decline in nominal wages is one factor. A decrease in the cost of any other important input,
such as energy, is another.

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 Chapter 11 Classical and Keynesian Macro Analyses 109

b. A technological improvement is one factor. Greater capital accumulation and increase labor-
force participation are others.

11-6. To prevent a short-run increase in the price level from taking place after the temporary rise in oil
prices shifts the SRAS curve leftward, policymakers should decrease the quantity of money in
circulation. This will shift the AD curve leftward and prevent the equilibrium price level from
rising in the short run.

11-8. In light of the answers to problems 11-10 and 11-11, it is not possible for policymakers to
stabilize both the price level and real GDP simultaneously in response to a temporary increase in
oil prices. Stabilizing the price level requires reducing the quantity of money, but stabilizing real
GDP required increasing the quantity of money.

11-10. A reduction in total planned real expenditures by most U.S. residents at any given price level
implies a leftward shift in the position of the aggregate demand curve along the short-run
aggregate supply curve. The predicted effects are decreases in both the equilibrium U.S. price
level and equilibrium U.S. Real GDP. Keynesian theory indicates that a consequence would be a
short-term recessionary gap between expenditures on real GDP in the short run and expenditures
on real GDP that would be consistent with long-run equilibrium.

11-12. Domestic producers purchase few imported inputs, so the effect on the short-run aggregate supply
curve will be minimal. Because foreign residents are key consumers of domestically produced
goods, however, the fall in foreign incomes will depress aggregate demand. The equilibrium price
level will decline, and equilibrium real GDP will decrease.

◼ Selected References
Cochran, James L., Macroeconomics Before Keynes, Glenview, IL: Scott, Foresman and
Company, 1970.
Davidson, Paul and Eugene Smolensky, Aggregate Supply and Demand Analysis, New York:
Harper & Row, 1964.
Friedman, Milton, A Theory of the Consumption Function, New York: National Bureau of Economic
Research, 1957.
Gordon, Robert J., Macroeconomics, 4th ed., Boston: Little, Brown and Company, 1987.
Keynes, John M., The General Theory of Employment, Interest, and Money, New York:
Harcourt Brace, 1964.
Miller, Roger LeRoy and Robert Pulsinelli, Macroeconomics, New York: Harper & Row, 1986.

©2014 Pearson Education, Inc.