{"id":2269,"date":"2015-06-19T21:17:21","date_gmt":"2015-06-19T21:17:21","guid":{"rendered":"https:\/\/courses.candelalearning.com\/masterymacro1xngcxmaster\/?post_type=chapter&#038;p=2269"},"modified":"2018-05-31T21:29:34","modified_gmt":"2018-05-31T21:29:34","slug":"policy-implications-dampening-business-cycles-vs-laissez-faire","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/chapter\/policy-implications-dampening-business-cycles-vs-laissez-faire\/","title":{"raw":"Policy Implications: Dampening Business Cycles vs. Laissez-Faire","rendered":"Policy Implications: Dampening Business Cycles vs. Laissez-Faire"},"content":{"raw":"<div class=\"textbox learning-objectives\">\r\n<h3>Learning Objectives<\/h3>\r\n<ul>\r\n \t<li>Compare and contrast Keynesian and Neoclassical policy responses to business cycles<\/li>\r\n<\/ul>\r\n<\/div>\r\n<h2 id=\"m48759-ch26mod02_02\">Policy Responses to Business Cycles<\/h2>\r\nIn this course, we've focused on three goals for macroeconomics: full employment, stable prices (low inflation), and economic growth. We know that the economy tends to growth over time as a result of increases in the quantity and quality of labor and capital and improvement<span style=\"color: #333333;\">s in technology. We also know that the path of the economy can be disturbed by shocks to aggregate demand or aggregate supply.\u00a0We have learned about the limits to fiscal and monetary policy in the real world. Taking those into account,\u00a0what policies\u00a0would Keynesian and Neoclassical economists be likely to propose to promote those goals? That is the subject of this section.<\/span>\r\n\r\n<span style=\"color: #333333;\">Recall that neoclassical economists are predisposed towards market outcomes and are suspicious of using aggregate demand to manage the economy. By contrast, Keynesian economists are suspicious of market outcomes and lean towards demand management policies, both fiscal and monetary policy to try to improve market outcomes.<\/span>\r\n\r\n<span style=\"color: #333333;\">Let\u2019s take another look at business cycles. As explained earlier\u00a0in the module on Macroeconomic Measures, unemployment can be divided into two categories: cyclical unemployment<em class=\"glossterm no-emphasis\">\u00a0<\/em>and the natural rate of unemployment, which is the sum of frictional and structural unemployment. Cyclical unemployment results from fluctuations in the business cycle and is created when the economy is producing below potential GDP\u2014giving potential employers less incentive to hire, since there is less demand for their products. When the economy is producing at potential GDP, cyclical unemployment will be zero.<\/span>\r\n\r\n[caption id=\"attachment_9643\" align=\"aligncenter\" width=\"750\"]<img class=\"wp-image-9643 size-full\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/2043\/2015\/06\/07042225\/6848699792_85daaa89cc_o.jpg\" alt=\"Plaque reading &quot;...no country, however rich, can afford the waste of its human resources. Demoralization caused by vast unemployment is our greatest extravagance. Morally, it is the greatest menace to our social order.&quot;\" width=\"750\" height=\"231\" \/> <strong>Figure 1.<\/strong> <strong>The Franklin D. Roosevelt Memorial in Washington D.C.<\/strong>\u00a0This memorial quotes a portion of FDR's radio \"fireside chat\" during the Great Depression in September 1934. \"No country, however rice, can afford the waste of its human resources.\"[\/caption]\r\n\r\nBecause of the dynamics of the labor mark<span style=\"color: #333333;\">et, in which people are always entering or exiting the labor force, the unemployment rate never falls to 0%, not even when the economy is producing at or even slightly above potential GDP. Due to\u00a0imperfect information, it takes time for job seekers and employers to find each other. This search time causes frictional unemployment and is socially efficient when it puts people in the right jobs for them.\u00a0Probably the best we can hope for is for the number of job vacancies to equal the number of job seekers.<\/span>\r\n\r\nMost economists do not consider frictional unemployment to be a \u201cbad\u201d thing. After all, there will always be workers who are unemployed while looking for a job that is a better match for their skills. There will always be employers that have an open position, while looking for a worker that is a better matc<span style=\"color: #333333;\">h for the job. Ideally, these matches happen quickly, but even when the economy is very strong there will be some frictional unemployment.\u00a0Structural unemployment, where job seekers lack marketable skills, is a more serious matter, requiring deliberate policies to address.<\/span>\r\n<h2>Keynesian Perspective on Business Cycles<\/h2>\r\nA decrease in aggregate demand causes a recessionary gap with increased unemployment. The question is what to do about it. If the economy is self-correcting, the unemployment and lack of sales will, over time, cause wages and prices to fall. shifting the AS curve to the right and returning the economy to full employment and potential GDP. Keynesian economists worry about the loss of jobs and income that may persist over time. For this reason, their preference is to stimulate aggregate demand to speed up the recovery and get people back to work. Additionally, Keynesians prefer increases in government spending to tax cuts. The former lead directly to increased aggregate demand, while the latter can be less effective if individuals and businesses don't spend all of their tax cuts.\u00a0The deeper the recession, the more resources are unemployed and the less crowding out will result from expansionary fiscal policy. So Keynesians believe it makes sense to try to reduce the depth and duration of recessions.\r\n\r\nSimilarly, Keynesians argue for contractionary fiscal and monetary policy to offset an inflationary gap. As we explained in the Macroeconomic Measures module, inflation has both distributional and real costs as well. Keynesians hope a more active policy will reduce those social costs.\r\n\r\nBoth of these scenarios are shown in Figure 2 below.\r\n\r\n[caption id=\"attachment_9477\" align=\"aligncenter\" width=\"406\"]<img class=\"wp-image-9477 size-full\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/2043\/2015\/06\/27024910\/keynesshift.jpg\" alt=\"The graph shows three possible downward-sloping AD curves, an upward-sloping AS curve, and a vertical, straight potential GDP line.\" width=\"406\" height=\"417\" \/> <strong>Figure 2.\u00a0The Keynesian Approach to Fighting Recession and Inflation.<\/strong> If an economy is in recession, with an equilibrium at Er, then the Keynesian response would be to enact a policy to shift aggregate demand to the right from ADr toward ADf. If an economy is experiencing inflationary pressures with an equilibrium at Ei, then the Keynesian response would be to enact a policy response to shift aggregate demand to the left, from ADi toward ADf.[\/caption]\r\n<h2>Neoclassical Perspective on Business Cycles<\/h2>\r\nThe neoclassical view of unemployment tends to focus attention away from the problem of cyclical unemployment\u2014that is, unemployment caused by recession\u2014while putting more attention on the issue of the unemployment that prevail<span style=\"color: #0000ff;\">s<\/span> even when the economy is operating at potential GDP.\u00a0Neoclassicals think that given the real world complications of fiscal and monetary policy discussed above, it is too difficult to get them right. Better to simply let the economy adjust back to potential output on its own.\r\n\r\n<span style=\"color: #333333;\">The neoclassical view of unemployment tends to focus on how public policy can be used to reduce the natural rate of unemployment. Such policy changes might involve redesigning unemployment and welfare programs so that they support those in need, but also offer greater encouragement for job-hunting. It might 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 flow of information about jobs and the mobility of workers, to hel<\/span>p bring workers and employers together more quickly. For those workers who find that their skills are permanently no longer in demand (for example, the structurally unemployed), policy can provide opportunities for retraining so that these workers can reenter the labor force and seek employment.\u00a0Note that Keynesian economists also support improved labor market functioning and retraining for the structurally unemployed.\r\n\r\nNeoclassical economists will not tend to see aggregate demand as a useful tool for reducing unemployment; after all, if economic output is at or near potential, then aggregate demand has no significant effect on unemployment. This is shown by the vertical aggregate supply curve. Instead, neoclassical economists believe that aggregate demand should be allowed to expand only to match the gradual shifts of aggregate supply to the right\u2014keeping the price level much the same and inflationary pressures low.\u00a0That\u2019s a job for monetary policy, with the supply of money growing at a stable rate, say the Neoclassicals.\r\n\r\nIf aggregate demand rises rapidly in the neoclassical model, in the long run it leads only to inflationary pressures. Figure 3 shows a vertical long-run AS curve and three different levels of aggregate demand, rising from AD<sub>0<\/sub> to AD<sub>1<\/sub> to AD<sub>2<\/sub>. As the macroeconomic equilibrium rises from E<sub>0<\/sub> to E<sub>1<\/sub> to E<sub>2<\/sub>, the price level rises, but real GDP does not budge; nor does the rate of unemployment, which adjusts to its natural rate. Conversely, reducing inflation has no long-term costs, either. Think about Figure 2 in reverse, as the aggregate demand curve shifts from AD<sub>2<\/sub> to AD<sub>1<\/sub> to AD<sub>0<\/sub>, and the equilibrium moves from E<sub>2<\/sub> to E<sub>1<\/sub> to E<sub>0<\/sub>. During this process, the price level falls, but, in the long run, neither real GDP nor the natural rate of unemployment is changed.\r\n\r\n[caption id=\"attachment_7408\" align=\"aligncenter\" width=\"390\"]<img class=\"wp-image-7408 size-full\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/2043\/2015\/06\/12034110\/plevellongrun.jpg\" alt=\"The graph shows three aggregate demand curves that all intersect with the vertical potential GDP line at around 62 on the x-axis, but at different price levels.\" width=\"390\" height=\"350\" \/> <strong>Figure 3. How Aggregate Demand Determines the Price Level in the Long Run.<\/strong> As aggregate demand shifts to the right, from AD<sub>0<\/sub> to AD<sub>1<\/sub> to AD<sub>2<\/sub>, real GDP in this economy and the level of unemployment do not change. However, there is inflationary pressure for a higher price level as theequilibrium changes from E<sub>0<\/sub> to E<sub>1<\/sub> to E<sub>2<\/sub>.[\/caption]\r\n\r\n<div class=\"textbox tryit\">\r\n<h3>Try It<\/h3>\r\nhttps:\/\/assessments.lumenlearning.com\/assessments\/7670\r\nhttps:\/\/assessments.lumenlearning.com\/assessments\/7671\r\n\r\n<\/div>\r\n<div class=\"textbox key-takeaways\">\r\n<h3>Policy in Practice<\/h3>\r\n<span style=\"color: #333333;\">The recessions of 1990 and 2001 were each so short that had the government attempted fiscal or monetary stimulus, the economy would have been already recovering when the stimulus kicked in, creating an inflationary boom. Neoclassical policies would have been the right call. <\/span>\r\n\r\n<span style=\"color: #333333;\">During the recession of 1982-83,\u00a0however, letting the economy fix itself would have made a long and deep recession even worse. This recession was caused by a serious monetary contraction, which successfully wrung inflation out of the system. Inflation has been under control in the U.S. since then. In the early 1980s, the Reagan administration conducted a series of significant tax cuts over the period 1981-83. This was followed by an increase in defense spending which raised overall Federal spending. While the purpose of this fiscal expansion was ideological, rather than to counter the recession, the effects did in fact do so, leading to the longest peacetime expansion in modern U.S. history. Monetary policy was also accommodating during this time.\u00a0<\/span>\r\n\r\n<span style=\"color: #333333;\">The Obama administration's response to the Great Recession (2007-2009), as we have noted before, was explicitly expansionary. The consensus of most macroeconomists is that fiscal and monetary stimulus helped end the recession; indeed, some argue the stimulus should have been greater.<\/span>\r\n\r\n<\/div>\r\n<div class=\"section\" title=\"Summary of Neoclassical Economics versus Keynesian Economics\">\r\n<div class=\"titlepage\">\r\n<div>\r\n<div>\r\n<h2 id=\"m48759-ch26mod02_05\"><span class=\"cnx-gentext-section cnx-gentext-t\">Summary of Neoclassical Economics versus Keynesian Economics<\/span><\/h2>\r\n<\/div>\r\n<\/div>\r\n<\/div>\r\nTable\u00a01 summarizes the key differences between the two schools of thought.\r\n<div id=\"m48759-ch24mod02_tab03\" class=\"table\">\r\n<table id=\"ch24mod02_tab03\" summary=\"The table shows the key differences between Neoclassical Economics and Keynesian Economics. Column 1 lists a Summary of key economic considerations. Column 2 lists the stance of Neoclassical Economics. Column 3 lists the stance of Keynesian Economics. Focus: Long term or short term; Long-term (Neoclassical Economics); Short-term (Keynesian Economics). Prices and wages: sticky or flexible?; Flexible (Neoclassical Economics); Sticky (Keynesian Economics). Economic output: Primarily determined by aggregate demand or aggregate supply?; Aggregate supply (Neoclassical Economics); Aggregate demand (Keynesian Economics). Aggregate supply: vertical or upward-sloping?; Vertical (Neoclassical Economics); Upward-sloping (Keynesian Economics). Phillips curve vertical or downward-sloping; Vertical (Neoclassical Economics); Downward sloping (Keynesian Economics). Is aggregate demand a useful tool for controlling inflation?; Yes (Neoclassical Economics); Yes (Keynesian Economics). What should be the primary area of policy emphasis for reducing unemployment?; Reform labor market institutions to reduce natural rate of unemployment (Neoclassical Economics); Increase aggregate demand to eliminate cyclical unemployment (Keynesian Economics). Is aggregate demand a useful tool for ending recession?; At best, only in the short-run temporary sense, but may just increase inflation instead (Neoclassical Economics); Yes (Keynesian Economics).\"><caption>Table\u00a01. Neoclassical versus Keynesian Economics<\/caption>\r\n<thead>\r\n<tr>\r\n<th>Summary<\/th>\r\n<th>Neoclassical Economics<\/th>\r\n<th>Keynesian Economics<\/th>\r\n<\/tr>\r\n<\/thead>\r\n<tbody>\r\n<tr>\r\n<td>Focus: long-term or short term<\/td>\r\n<td>Long-term<\/td>\r\n<td>Short-term<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Prices and wages: sticky or flexible?<\/td>\r\n<td>Flexible<\/td>\r\n<td>Sticky<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Economic output: Primarily determined by aggregate demand or aggregate supply?<\/td>\r\n<td>Aggregate supply<\/td>\r\n<td>Aggregate demand<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Aggregate supply: vertical or upward-sloping?<\/td>\r\n<td>Vertical<\/td>\r\n<td>Upward-sloping<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Phillips curve vertical or downward-sloping<\/td>\r\n<td>Vertical<\/td>\r\n<td>Downward sloping<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Is aggregate demand a useful tool for controlling inflation?<\/td>\r\n<td>Yes<\/td>\r\n<td>Yes<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>What should be the primary area of policy emphasis for reducing unemployment?<\/td>\r\n<td>Reform labor market institutions to reduce natural rate of unemployment<\/td>\r\n<td>Increase aggregate demand to eliminate cyclical unemployment<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Is aggregate demand a useful tool for ending recession?<\/td>\r\n<td>At best, only in the short-run temporary sense, but may just increase inflation instead<\/td>\r\n<td>Yes<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n<\/div>\r\n<div class=\"table\">\r\n<div class=\"textbox tryit\">\r\n<h3>Try It<\/h3>\r\nThese questions allow you to get as much practice as you need, as you can click the link at the top of the first question (\u201cTry another version of these questions\u201d) to get a new set of questions. Practice until you feel comfortable doing the questions.\r\n\r\n[ohm_question]153120-153122-154532[\/ohm_question]\r\n\r\n<\/div>\r\n<\/div>\r\n<\/div>","rendered":"<div class=\"textbox learning-objectives\">\n<h3>Learning Objectives<\/h3>\n<ul>\n<li>Compare and contrast Keynesian and Neoclassical policy responses to business cycles<\/li>\n<\/ul>\n<\/div>\n<h2 id=\"m48759-ch26mod02_02\">Policy Responses to Business Cycles<\/h2>\n<p>In this course, we&#8217;ve focused on three goals for macroeconomics: full employment, stable prices (low inflation), and economic growth. We know that the economy tends to growth over time as a result of increases in the quantity and quality of labor and capital and improvement<span style=\"color: #333333;\">s in technology. We also know that the path of the economy can be disturbed by shocks to aggregate demand or aggregate supply.\u00a0We have learned about the limits to fiscal and monetary policy in the real world. Taking those into account,\u00a0what policies\u00a0would Keynesian and Neoclassical economists be likely to propose to promote those goals? That is the subject of this section.<\/span><\/p>\n<p><span style=\"color: #333333;\">Recall that neoclassical economists are predisposed towards market outcomes and are suspicious of using aggregate demand to manage the economy. By contrast, Keynesian economists are suspicious of market outcomes and lean towards demand management policies, both fiscal and monetary policy to try to improve market outcomes.<\/span><\/p>\n<p><span style=\"color: #333333;\">Let\u2019s take another look at business cycles. As explained earlier\u00a0in the module on Macroeconomic Measures, unemployment can be divided into two categories: cyclical unemployment<em class=\"glossterm no-emphasis\">\u00a0<\/em>and the natural rate of unemployment, which is the sum of frictional and structural unemployment. Cyclical unemployment results from fluctuations in the business cycle and is created when the economy is producing below potential GDP\u2014giving potential employers less incentive to hire, since there is less demand for their products. When the economy is producing at potential GDP, cyclical unemployment will be zero.<\/span><\/p>\n<div id=\"attachment_9643\" style=\"width: 760px\" class=\"wp-caption aligncenter\"><img loading=\"lazy\" decoding=\"async\" aria-describedby=\"caption-attachment-9643\" class=\"wp-image-9643 size-full\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/2043\/2015\/06\/07042225\/6848699792_85daaa89cc_o.jpg\" alt=\"Plaque reading &quot;...no country, however rich, can afford the waste of its human resources. Demoralization caused by vast unemployment is our greatest extravagance. Morally, it is the greatest menace to our social order.&quot;\" width=\"750\" height=\"231\" \/><\/p>\n<p id=\"caption-attachment-9643\" class=\"wp-caption-text\"><strong>Figure 1.<\/strong> <strong>The Franklin D. Roosevelt Memorial in Washington D.C.<\/strong>\u00a0This memorial quotes a portion of FDR&#8217;s radio &#8220;fireside chat&#8221; during the Great Depression in September 1934. &#8220;No country, however rice, can afford the waste of its human resources.&#8221;<\/p>\n<\/div>\n<p>Because of the dynamics of the labor mark<span style=\"color: #333333;\">et, in which people are always entering or exiting the labor force, the unemployment rate never falls to 0%, not even when the economy is producing at or even slightly above potential GDP. Due to\u00a0imperfect information, it takes time for job seekers and employers to find each other. This search time causes frictional unemployment and is socially efficient when it puts people in the right jobs for them.\u00a0Probably the best we can hope for is for the number of job vacancies to equal the number of job seekers.<\/span><\/p>\n<p>Most economists do not consider frictional unemployment to be a \u201cbad\u201d thing. After all, there will always be workers who are unemployed while looking for a job that is a better match for their skills. There will always be employers that have an open position, while looking for a worker that is a better matc<span style=\"color: #333333;\">h for the job. Ideally, these matches happen quickly, but even when the economy is very strong there will be some frictional unemployment.\u00a0Structural unemployment, where job seekers lack marketable skills, is a more serious matter, requiring deliberate policies to address.<\/span><\/p>\n<h2>Keynesian Perspective on Business Cycles<\/h2>\n<p>A decrease in aggregate demand causes a recessionary gap with increased unemployment. The question is what to do about it. If the economy is self-correcting, the unemployment and lack of sales will, over time, cause wages and prices to fall. shifting the AS curve to the right and returning the economy to full employment and potential GDP. Keynesian economists worry about the loss of jobs and income that may persist over time. For this reason, their preference is to stimulate aggregate demand to speed up the recovery and get people back to work. Additionally, Keynesians prefer increases in government spending to tax cuts. The former lead directly to increased aggregate demand, while the latter can be less effective if individuals and businesses don&#8217;t spend all of their tax cuts.\u00a0The deeper the recession, the more resources are unemployed and the less crowding out will result from expansionary fiscal policy. So Keynesians believe it makes sense to try to reduce the depth and duration of recessions.<\/p>\n<p>Similarly, Keynesians argue for contractionary fiscal and monetary policy to offset an inflationary gap. As we explained in the Macroeconomic Measures module, inflation has both distributional and real costs as well. Keynesians hope a more active policy will reduce those social costs.<\/p>\n<p>Both of these scenarios are shown in Figure 2 below.<\/p>\n<div id=\"attachment_9477\" style=\"width: 416px\" class=\"wp-caption aligncenter\"><img loading=\"lazy\" decoding=\"async\" aria-describedby=\"caption-attachment-9477\" class=\"wp-image-9477 size-full\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/2043\/2015\/06\/27024910\/keynesshift.jpg\" alt=\"The graph shows three possible downward-sloping AD curves, an upward-sloping AS curve, and a vertical, straight potential GDP line.\" width=\"406\" height=\"417\" \/><\/p>\n<p id=\"caption-attachment-9477\" class=\"wp-caption-text\"><strong>Figure 2.\u00a0The Keynesian Approach to Fighting Recession and Inflation.<\/strong> If an economy is in recession, with an equilibrium at Er, then the Keynesian response would be to enact a policy to shift aggregate demand to the right from ADr toward ADf. If an economy is experiencing inflationary pressures with an equilibrium at Ei, then the Keynesian response would be to enact a policy response to shift aggregate demand to the left, from ADi toward ADf.<\/p>\n<\/div>\n<h2>Neoclassical Perspective on Business Cycles<\/h2>\n<p>The neoclassical view of unemployment tends to focus attention away from the problem of cyclical unemployment\u2014that is, unemployment caused by recession\u2014while putting more attention on the issue of the unemployment that prevail<span style=\"color: #0000ff;\">s<\/span> even when the economy is operating at potential GDP.\u00a0Neoclassicals think that given the real world complications of fiscal and monetary policy discussed above, it is too difficult to get them right. Better to simply let the economy adjust back to potential output on its own.<\/p>\n<p><span style=\"color: #333333;\">The neoclassical view of unemployment tends to focus on how public policy can be used to reduce the natural rate of unemployment. Such policy changes might involve redesigning unemployment and welfare programs so that they support those in need, but also offer greater encouragement for job-hunting. It might 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 flow of information about jobs and the mobility of workers, to hel<\/span>p bring workers and employers together more quickly. For those workers who find that their skills are permanently no longer in demand (for example, the structurally unemployed), policy can provide opportunities for retraining so that these workers can reenter the labor force and seek employment.\u00a0Note that Keynesian economists also support improved labor market functioning and retraining for the structurally unemployed.<\/p>\n<p>Neoclassical economists will not tend to see aggregate demand as a useful tool for reducing unemployment; after all, if economic output is at or near potential, then aggregate demand has no significant effect on unemployment. This is shown by the vertical aggregate supply curve. Instead, neoclassical economists believe that aggregate demand should be allowed to expand only to match the gradual shifts of aggregate supply to the right\u2014keeping the price level much the same and inflationary pressures low.\u00a0That\u2019s a job for monetary policy, with the supply of money growing at a stable rate, say the Neoclassicals.<\/p>\n<p>If aggregate demand rises rapidly in the neoclassical model, in the long run it leads only to inflationary pressures. Figure 3 shows a vertical long-run AS curve and three different levels of aggregate demand, rising from AD<sub>0<\/sub> to AD<sub>1<\/sub> to AD<sub>2<\/sub>. As the macroeconomic equilibrium rises from E<sub>0<\/sub> to E<sub>1<\/sub> to E<sub>2<\/sub>, the price level rises, but real GDP does not budge; nor does the rate of unemployment, which adjusts to its natural rate. Conversely, reducing inflation has no long-term costs, either. Think about Figure 2 in reverse, as the aggregate demand curve shifts from AD<sub>2<\/sub> to AD<sub>1<\/sub> to AD<sub>0<\/sub>, and the equilibrium moves from E<sub>2<\/sub> to E<sub>1<\/sub> to E<sub>0<\/sub>. During this process, the price level falls, but, in the long run, neither real GDP nor the natural rate of unemployment is changed.<\/p>\n<div id=\"attachment_7408\" style=\"width: 400px\" class=\"wp-caption aligncenter\"><img loading=\"lazy\" decoding=\"async\" aria-describedby=\"caption-attachment-7408\" class=\"wp-image-7408 size-full\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/2043\/2015\/06\/12034110\/plevellongrun.jpg\" alt=\"The graph shows three aggregate demand curves that all intersect with the vertical potential GDP line at around 62 on the x-axis, but at different price levels.\" width=\"390\" height=\"350\" \/><\/p>\n<p id=\"caption-attachment-7408\" class=\"wp-caption-text\"><strong>Figure 3. How Aggregate Demand Determines the Price Level in the Long Run.<\/strong> As aggregate demand shifts to the right, from AD<sub>0<\/sub> to AD<sub>1<\/sub> to AD<sub>2<\/sub>, real GDP in this economy and the level of unemployment do not change. However, there is inflationary pressure for a higher price level as theequilibrium changes from E<sub>0<\/sub> to E<sub>1<\/sub> to E<sub>2<\/sub>.<\/p>\n<\/div>\n<div class=\"textbox tryit\">\n<h3>Try It<\/h3>\n<p>\t<iframe id=\"lumen_assessment_7670\" class=\"resizable\" src=\"https:\/\/assessments.lumenlearning.com\/assessments\/load?assessment_id=7670&#38;embed=1&#38;external_user_id=&#38;external_context_id=&#38;iframe_resize_id=lumen_assessment_7670\" frameborder=\"0\" style=\"border:none;width:100%;height:100%;min-height:400px;\"><br \/>\n\t<\/iframe><br \/>\n\t<iframe id=\"lumen_assessment_7671\" class=\"resizable\" src=\"https:\/\/assessments.lumenlearning.com\/assessments\/load?assessment_id=7671&#38;embed=1&#38;external_user_id=&#38;external_context_id=&#38;iframe_resize_id=lumen_assessment_7671\" frameborder=\"0\" style=\"border:none;width:100%;height:100%;min-height:400px;\"><br \/>\n\t<\/iframe><\/p>\n<\/div>\n<div class=\"textbox key-takeaways\">\n<h3>Policy in Practice<\/h3>\n<p><span style=\"color: #333333;\">The recessions of 1990 and 2001 were each so short that had the government attempted fiscal or monetary stimulus, the economy would have been already recovering when the stimulus kicked in, creating an inflationary boom. Neoclassical policies would have been the right call. <\/span><\/p>\n<p><span style=\"color: #333333;\">During the recession of 1982-83,\u00a0however, letting the economy fix itself would have made a long and deep recession even worse. This recession was caused by a serious monetary contraction, which successfully wrung inflation out of the system. Inflation has been under control in the U.S. since then. In the early 1980s, the Reagan administration conducted a series of significant tax cuts over the period 1981-83. This was followed by an increase in defense spending which raised overall Federal spending. While the purpose of this fiscal expansion was ideological, rather than to counter the recession, the effects did in fact do so, leading to the longest peacetime expansion in modern U.S. history. Monetary policy was also accommodating during this time.\u00a0<\/span><\/p>\n<p><span style=\"color: #333333;\">The Obama administration&#8217;s response to the Great Recession (2007-2009), as we have noted before, was explicitly expansionary. The consensus of most macroeconomists is that fiscal and monetary stimulus helped end the recession; indeed, some argue the stimulus should have been greater.<\/span><\/p>\n<\/div>\n<div class=\"section\" title=\"Summary of Neoclassical Economics versus Keynesian Economics\">\n<div class=\"titlepage\">\n<div>\n<div>\n<h2 id=\"m48759-ch26mod02_05\"><span class=\"cnx-gentext-section cnx-gentext-t\">Summary of Neoclassical Economics versus Keynesian Economics<\/span><\/h2>\n<\/div>\n<\/div>\n<\/div>\n<p>Table\u00a01 summarizes the key differences between the two schools of thought.<\/p>\n<div id=\"m48759-ch24mod02_tab03\" class=\"table\">\n<table id=\"ch24mod02_tab03\" summary=\"The table shows the key differences between Neoclassical Economics and Keynesian Economics. Column 1 lists a Summary of key economic considerations. Column 2 lists the stance of Neoclassical Economics. Column 3 lists the stance of Keynesian Economics. Focus: Long term or short term; Long-term (Neoclassical Economics); Short-term (Keynesian Economics). Prices and wages: sticky or flexible?; Flexible (Neoclassical Economics); Sticky (Keynesian Economics). Economic output: Primarily determined by aggregate demand or aggregate supply?; Aggregate supply (Neoclassical Economics); Aggregate demand (Keynesian Economics). Aggregate supply: vertical or upward-sloping?; Vertical (Neoclassical Economics); Upward-sloping (Keynesian Economics). Phillips curve vertical or downward-sloping; Vertical (Neoclassical Economics); Downward sloping (Keynesian Economics). Is aggregate demand a useful tool for controlling inflation?; Yes (Neoclassical Economics); Yes (Keynesian Economics). What should be the primary area of policy emphasis for reducing unemployment?; Reform labor market institutions to reduce natural rate of unemployment (Neoclassical Economics); Increase aggregate demand to eliminate cyclical unemployment (Keynesian Economics). Is aggregate demand a useful tool for ending recession?; At best, only in the short-run temporary sense, but may just increase inflation instead (Neoclassical Economics); Yes (Keynesian Economics).\">\n<caption>Table\u00a01. Neoclassical versus Keynesian Economics<\/caption>\n<thead>\n<tr>\n<th>Summary<\/th>\n<th>Neoclassical Economics<\/th>\n<th>Keynesian Economics<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td>Focus: long-term or short term<\/td>\n<td>Long-term<\/td>\n<td>Short-term<\/td>\n<\/tr>\n<tr>\n<td>Prices and wages: sticky or flexible?<\/td>\n<td>Flexible<\/td>\n<td>Sticky<\/td>\n<\/tr>\n<tr>\n<td>Economic output: Primarily determined by aggregate demand or aggregate supply?<\/td>\n<td>Aggregate supply<\/td>\n<td>Aggregate demand<\/td>\n<\/tr>\n<tr>\n<td>Aggregate supply: vertical or upward-sloping?<\/td>\n<td>Vertical<\/td>\n<td>Upward-sloping<\/td>\n<\/tr>\n<tr>\n<td>Phillips curve vertical or downward-sloping<\/td>\n<td>Vertical<\/td>\n<td>Downward sloping<\/td>\n<\/tr>\n<tr>\n<td>Is aggregate demand a useful tool for controlling inflation?<\/td>\n<td>Yes<\/td>\n<td>Yes<\/td>\n<\/tr>\n<tr>\n<td>What should be the primary area of policy emphasis for reducing unemployment?<\/td>\n<td>Reform labor market institutions to reduce natural rate of unemployment<\/td>\n<td>Increase aggregate demand to eliminate cyclical unemployment<\/td>\n<\/tr>\n<tr>\n<td>Is aggregate demand a useful tool for ending recession?<\/td>\n<td>At best, only in the short-run temporary sense, but may just increase inflation instead<\/td>\n<td>Yes<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<div class=\"table\">\n<div class=\"textbox tryit\">\n<h3>Try It<\/h3>\n<p>These questions allow you to get as much practice as you need, as you can click the link at the top of the first question (\u201cTry another version of these questions\u201d) to get a new set of questions. Practice until you feel comfortable doing the questions.<\/p>\n<p><iframe loading=\"lazy\" id=\"ohm153120\" class=\"resizable\" src=\"https:\/\/ohm.lumenlearning.com\/multiembedq.php?id=153120-153122-154532&theme=oea&iframe_resize_id=ohm153120&show_question_numbers\" width=\"100%\" height=\"150\"><\/iframe><\/p>\n<\/div>\n<\/div>\n<\/div>\n\n\t\t\t <section class=\"citations-section\" role=\"contentinfo\">\n\t\t\t <h3>Candela Citations<\/h3>\n\t\t\t\t\t <div>\n\t\t\t\t\t\t <div id=\"citation-list-2269\">\n\t\t\t\t\t\t\t <div class=\"licensing\"><div class=\"license-attribution-dropdown-subheading\">CC licensed content, Original<\/div><ul class=\"citation-list\"><li>Modification, adaptation, and original content. <strong>Provided by<\/strong>: Lumen Learning. <strong>License<\/strong>: <em><a target=\"_blank\" rel=\"license\" href=\"https:\/\/creativecommons.org\/licenses\/by\/4.0\/\">CC BY: Attribution<\/a><\/em><\/li><\/ul><div class=\"license-attribution-dropdown-subheading\">CC licensed content, Shared previously<\/div><ul class=\"citation-list\"><li>The Phillips Curve. <strong>Authored by<\/strong>: OpenStax College. <strong>Located at<\/strong>: <a target=\"_blank\" href=\"https:\/\/cnx.org\/contents\/vEmOH-_p@4.40:H_swtuep@5\/The-Phillips-Curve\">https:\/\/cnx.org\/contents\/vEmOH-_p@4.40:H_swtuep@5\/The-Phillips-Curve<\/a>. <strong>License<\/strong>: <em><a target=\"_blank\" rel=\"license\" href=\"https:\/\/creativecommons.org\/licenses\/by\/4.0\/\">CC BY: Attribution<\/a><\/em>. <strong>License Terms<\/strong>: Download for free at http:\/\/cnx.org\/contents\/bc498e1f-efe9-43a0-8dea-d3569ad09a82@4.4<\/li><li>The Policy Implications of the Neoclassical Perspective. <strong>Authored by<\/strong>: OpenStax College. <strong>Located at<\/strong>: <a target=\"_blank\" href=\"https:\/\/cnx.org\/contents\/vEmOH-_p@4.39:33A-gaO1@6\/The-Policy-Implications-of-the\">https:\/\/cnx.org\/contents\/vEmOH-_p@4.39:33A-gaO1@6\/The-Policy-Implications-of-the<\/a>. <strong>License<\/strong>: <em><a target=\"_blank\" rel=\"license\" href=\"https:\/\/creativecommons.org\/licenses\/by\/4.0\/\">CC BY: Attribution<\/a><\/em>. <strong>License Terms<\/strong>: Download for free at http:\/\/cnx.org\/contents\/bc498e1f-efe9-43a0-8dea-d3569ad09a82@4.4<\/li><li>FDR Memorial - Washington DC. <strong>Authored by<\/strong>: Tim Evanson. <strong>Provided by<\/strong>: Flickr. <strong>Located at<\/strong>: <a target=\"_blank\" href=\"https:\/\/www.flickr.com\/photos\/timevanson\/6848699792\/in\/photolist-brcnQU-aUYVKV-8UEAhr-7aDqBg-rM4nvq-ougFDL-aUZ2Pc-84HzWd-7AFvKc-aJnxQK-p2Zvd6-aUZybk-8QQZUV-bahSsD-gqmyD7-aNBY5p-aacgen-XV1zRf-9hr3UW-SKXw6W-aUZWKc-aXosz8-ougXcB-5sfurc-ougun7-JVY1eN-aUZcMT-eEu9L7-5zd2cK-aUZt9F-Wteq2m-d5pPe-aspUyh-aUZceg-6CHAWE-cw8Zk5-8WvXvH-7XfdtK-2thVWa-7Uyjgr-bqaG3X-ajQGaM-7vdF28-6puBPn-ajQGBe-ej3kR3-bofVTS-na5Eiw-fS6Jvk-dBR2VD\">https:\/\/www.flickr.com\/photos\/timevanson\/6848699792\/in\/photolist-brcnQU-aUYVKV-8UEAhr-7aDqBg-rM4nvq-ougFDL-aUZ2Pc-84HzWd-7AFvKc-aJnxQK-p2Zvd6-aUZybk-8QQZUV-bahSsD-gqmyD7-aNBY5p-aacgen-XV1zRf-9hr3UW-SKXw6W-aUZWKc-aXosz8-ougXcB-5sfurc-ougun7-JVY1eN-aUZcMT-eEu9L7-5zd2cK-aUZt9F-Wteq2m-d5pPe-aspUyh-aUZceg-6CHAWE-cw8Zk5-8WvXvH-7XfdtK-2thVWa-7Uyjgr-bqaG3X-ajQGaM-7vdF28-6puBPn-ajQGBe-ej3kR3-bofVTS-na5Eiw-fS6Jvk-dBR2VD<\/a>. <strong>License<\/strong>: <em><a target=\"_blank\" rel=\"license\" href=\"https:\/\/creativecommons.org\/licenses\/by-sa\/4.0\/\">CC BY-SA: Attribution-ShareAlike<\/a><\/em><\/li><\/ul><\/div>\n\t\t\t\t\t\t <\/div>\n\t\t\t\t\t <\/div>\n\t\t\t <\/section>","protected":false},"author":74,"menu_order":13,"template":"","meta":{"_candela_citation":"[{\"type\":\"cc\",\"description\":\"The Phillips Curve\",\"author\":\"OpenStax College\",\"organization\":\"\",\"url\":\"https:\/\/cnx.org\/contents\/vEmOH-_p@4.40:H_swtuep@5\/The-Phillips-Curve\",\"project\":\"\",\"license\":\"cc-by\",\"license_terms\":\"Download for free at http:\/\/cnx.org\/contents\/bc498e1f-efe9-43a0-8dea-d3569ad09a82@4.4\"},{\"type\":\"cc\",\"description\":\"The Policy Implications of the Neoclassical Perspective\",\"author\":\"OpenStax College\",\"organization\":\"\",\"url\":\"https:\/\/cnx.org\/contents\/vEmOH-_p@4.39:33A-gaO1@6\/The-Policy-Implications-of-the\",\"project\":\"\",\"license\":\"cc-by\",\"license_terms\":\"Download for free at http:\/\/cnx.org\/contents\/bc498e1f-efe9-43a0-8dea-d3569ad09a82@4.4\"},{\"type\":\"original\",\"description\":\"Modification, adaptation, and original content\",\"author\":\"\",\"organization\":\"Lumen Learning\",\"url\":\"\",\"project\":\"\",\"license\":\"cc-by\",\"license_terms\":\"\"},{\"type\":\"cc\",\"description\":\"FDR Memorial - 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