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Neoclassical economists will not tend to see aggregate demand as a useful tool for reducing unemployment; after all, if economic output is determined by a vertical aggregate supply curve , then aggregate demand has no long-run effect on unemployment. Instead, neoclassical economists believe that aggregate demand should be allowed to expand only to match the gradual shifts of aggregate supply to the right—keeping the price level much the same and inflationary pressures low.

If aggregate demand rises rapidly in the neoclassical model, in the long run it leads only to inflationary pressures. [link] shows a vertical LRAS curve and three different levels of aggregate demand, rising from AD 0 to AD 1 to AD 2 . As the macroeconomic equilibrium rises from E 0 to E 1 to E 2 , 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 [link] in reverse, as the aggregate demand curve shifts from AD 2 to AD 1 to AD 0 , and the equilibrium moves from E 2 to E 1 to E 0 . During this process, the price level falls, but, in the long run, neither real GDP nor the natural rate of unemployment is changed.

How aggregate demand determines the price level in the long run

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.
As aggregate demand shifts to the right, from AD 0 to AD 1 to AD 2 , real GDP in this economy and the level of unemployment do not change. However, there is inflationary pressure for a higher price level as the equilibrium changes from E 0 to E 1 to E 2 .

Visit this website to read about how inflation and unemployment are related.

Fighting recession or encouraging long-term growth?

Neoclassical economists believe that the economy will rebound out of a recession or eventually contract during an expansion because prices and wage rates are flexible and will adjust either upward or downward to restore the economy to its potential GDP. Thus, the key policy question for neoclassicals is how to promote growth of potential GDP. We know that economic growth ultimately depends on the growth rate of long-term productivity. Productivity measures how effective inputs are at producing outputs. We know that U.S. productivity has grown on average about 2% per year. That means that the same amount of inputs produce 2% more output than the year before. We also know that productivity growth varies a great deal in the short term due to cyclical factors. It also varies somewhat in the long term. From 1953–1972, U.S. labor productivity (as measured by output per hour in the business sector) grew at 3.2% per year. From 1973–1992, productivity growth declined significantly to 1.8% per year. Then, from 1993–2014, productivity growth increased slightly to 2% per year. The neoclassical economists believe the underpinnings of long-run productivity growth to be an economy’s investments in human capital, physical capital, and technology, operating together in a market-oriented environment that rewards innovation. Promotion of these factors is what government policy should focus on.

Summary of neoclassical macroeconomic policy recommendations

Let’s summarize what neoclassical economists recommend for macroeconomic policy. Neoclassical economists do not believe in “fine-tuning” the economy. They believe that economic growth is fostered by a stable economic environment with a low rate of inflation. Similarly, tax rates should be low and unchanging. In this environment, private economic agents can make the best possible investment decisions, which will lead to optimal investment in physical and human capital as well as research and development to promote improvements in technology.

Summary of neoclassical economics versus keynesian economics

[link] summarizes the key differences between the two schools of thought.

Neoclassical versus keynesian economics
Summary Neoclassical Economics Keynesian Economics
Focus: long-term or short term Long-term Short-term
Prices and wages: sticky or flexible? Flexible Sticky
Economic output: Primarily determined by aggregate demand or aggregate supply? Aggregate supply Aggregate demand
Aggregate supply: vertical or upward-sloping? Vertical Upward-sloping
Phillips curve vertical or downward-sloping Vertical Downward sloping
Is aggregate demand a useful tool for controlling inflation? Yes Yes
What should be the primary area of policy emphasis for reducing unemployment? Reform labor market institutions to reduce natural rate of unemployment Increase aggregate demand to eliminate cyclical unemployment
Is aggregate demand a useful tool for ending recession? At best, only in the short-run temporary sense, but may just increase inflation instead Yes

Key concepts and summary

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.

References

American Statistical Association. “ASA Headlines.” http://www.amstat.org/.

Haubrich, Joseph G., George Pennacchi, and Peter Ritchken. “Working Paper 11-07: Inflation Expectations, Real Rates, and Risk Premia: Evidence from Inflation Swaps.” Federal Reserve Bank of Cleveland . Last modified March 2011. http://www.clevelandfed.org/research/workpaper/2011/wp1107.pdf.

University of Michigan: Institute for Social Research. “Survey Research Center.” http://www.src.isr.umich.edu/.

Questions & Answers

what is equillibrium
riy Reply
Equilibrium is a state of balance e.g supply equals demand then there is no oversupply or shortage of goods
Scelo
When price increases quantity demnd alway decreases
Sonu Reply
this is because when price increase,consumer can longer effort to pay as they usually do thereby leading to the fall in dd
Muafue
Explain the impact of increase price of substitude goods an equilibirum price and equilibirum quantity
Sonu
Again according to the first law of demand which state that more is demanded at higher price than at lower price.Because of this consumer believe that more can only be demand at low prices than higher prices meaning that a slide change in price will affect demand
Muafue
what are the functions of money?
Liza Reply
medium of exchange
Alhassan
Medium of exchange,store of value,standard for differ payment and unit of account
Muafue
A medium of exchange for goods and services
Allen
what is demand for labour?
Allen
boumols inventory theory?
Vyshnavi Reply
what is inflation?
Jestony Reply
the increase in general price level and the decrease in money value
Inflation can be define as the persistence rise in the general price level of goods and services in the market
Muafue
what are the three reason tgat we study economics
armaan Reply
we may be rational people, know efficient where met profit maximization, know efficient allocation
li
1.How monetary and fiscal policy create stable economy. 2. How to create fairness for all citizens. 3. Determine drivers of human economic behavior.
Mark
To know that you we need understand the demand and supply and others important matters in economics
emz
can you explain. what is the reasons for having international trade
atikah Reply
to aid productivity and efficiency, for economic growth, to help reduce dependence on local product
kunle
can someone please help differentiate between short and long run in microeconomics and macroeconomics
kunle
what is inflation in economic
Christopher Reply
a general increase price level and fall in purchasing value of money
a general increase in price level and fall in purchasing value of money
due to high supply of mony in the market the demand of goods will increase and price will high its call inflation.
Thalay
thanks
Christopher
how to calculate real and calculated unemployment rate for false information
James Reply
I think unemployment can't be calculated but I think due to economics survey that happens every year we come to know about unemployment rate and compares that with precocious year unemployment rate
are foreigners in our country helping our economy or not?
Nwabali Reply
foreign countries invest in India by two ways one for there business promotion(of their product ) through employment which employment generates in India and the 2nd is foreign aid fund means when a country suffers from flood,earthquake etc so other countries help them financial(called foreign aid)
simple answer is yes
Yes, this is through the investment as investors.
jossy
what is revenue commission?
Kelvyn Reply
is the organ which is collect tax from society for public servise
ABIYOT
Where is determination of price is done?
Vidhan Reply
when price equal with marginal cost
ABIYOT
what is demand
Fransis Reply
The willingness and ability to of a buyer to purchase a commodity
Moses
the thing that u r able to buy and which fullfill your want is called Demand
Stanzin
what u want to buy to fulfilling of yours desires is called demand
Thalay
explain manetary policy
Amina Reply
why SA is used in estimating of national income
Unique Reply
first what SA stand for?
Alhassan
SA stand for static adjustment
Unique
machenism of monetary expansion
EFAT
norther one
Unique
explain manetary policy
Amina

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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