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History: Classical Model

Definition- The classical model is a macroeconomic model that explains the long-run behavior of the overall economy.

This model was developed in the late 1800s and earlier 1900s

Attempted to explain a key observation

If we view the economy over a long stretch of time, we see that it operates reasonably close to its potential output

Adam Smith called this invisible hand

Classical Model Results

There is no monetary policy in the model

In other words, monetary policy does no impact real variables

This result comes from the classical dichotomy, money neutrality, and quantity equation definitions

Model Implication- Monetary policy won't lessen a recession

The government can not increase output during a recession or depression by increasing government deficit spending

In this model, government deficit spending is financed through federal government borrowing which drives up the interest rates and decreases business investment

This result comes from the crow-out effect of government spending in the closed classical model

Model Implication- Government spending won't increase output during a recession

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History: Keynesian Model

The prevailing view of classical economists was that nothing needed to be done after the financial crash of 1929. The market would take care of itself

President Herbert Hoover listened. The result was that output was stuck far below its potential for nearly 10 years

In 1936, John Maynard Keynes provided an alternate theory to explain the poor global economic performance caused by the Great Depression

8 years after the depression began

Keynes recognized that the classical model did a good job of explaining the long run behavior of the economy. However he also understood that the long run could take a long time to arrive

Keynes's famous quote, "In the long run we are all dead"0

Definition- The Keynesian Model is a macroeconomic model that explains how changes in spending can affect real GDP in the short-run

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Economic Fluctuation

Economic activity is measured using the 3 big economic indicators: real GDP, the unemployment rate, and the inflation rate measured using CPI

There are also many other indicators used to determine economic activity, but these are the 3 big ones

Economic activity varies from year to year

In other words, sometimes economic activity is increasing while at other times economic activity is decreasing

On average in the US economic activity expands annually due to increases in the labor force, increases in capital stock

The annual average expansion is between 2%-3% annually (the long-run natural rate of real GDP growth)

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Recession vs Depression

Definition- A recession is a period of declining real incomes and rising unemployment

Unofficially a recession is two consecutive quarters of declining real gdp

Definition- A depression is a severe recession

if the period of declining economic activity is relatively mild, it is called a recession. If the period of declining economic activity is more severe it is called a depression

The entity responsible for monitoring and dating recessions and depressions is the National Bureau of Economic Analysis (NBER)

3 Key Facts about Economic Fluctuations

Fluctuations are irregular and unpredictable

Most Macroeconomics Variables Fluctuate Together

As output falls, unemployment rises

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Fluctuations are Irregular and Unpredictable

Definition- The business cycle refers to fluctuations in the economy

Economy fluctuations are not regular or easy to predict with accuracy

Sometimes recessions are close together like the back to back recessions of 1980 and 1982

Sometimes recessions are further apart

the longest recession free period in the US was the 1991 to 2001 period

Things to notice

In the first half of the 20th century, US real GDP growth was much more volatile than it is today

The economy went through periods of very high growth rates and very low growth rates

When you compare the change in real GDP growth during the Great Depression and the Great Recession, you can see that the economic contraction was much more sever during the Great Depression

Also, notice that during the time period called The Great Depression there were 2 severe economic contractions

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Most Macroeconomics Variables Fluctuate Together

The most commonly used measure of economic fluctuations is real GDP

However, when monitoring short-run economic fluctuations, it doesn't really matter which indicator is used, This is due to the fact that most macroeconomic variables move together

For example, if real GDP falls, personal income, corporate profits, consumer spending, investment spending industrial production, retail sales, home sales, and auto sales also fall

While many macroeconomics variable do fluctuate together, they typically fluctuate by different amounts

For example, investment spending (I) accounts for 14% of total real GDP, However, during economic recessions, reductions in investment spending (I) account for nearly 2/3 of the decline in real GDP

Things to Notice

Both Real GDP growth and Investment Expenditures growth move in the same direction

If real GDP decreases, investment expenditures decreases

If real GDP increases, investment expenditures increases

Investment expenditures is more volatile than real GDP

If real GDP decreases, investment expenditures decreases by a larger percentage

If real GDP increases, investment expenditures increases by a larger percentage

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