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Purdue AGEC 21700 - The Neoclassical View
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Lecture 25Outline of Last Lecture I. Stuck Aggregate DemandA. Sticky WagesB. Sticky PricesC. Sticky Prices GraphII. Unemployment and InflationA. Phillip’s Curve Outline of Current Lecture I. Neoclassical ViewII. Aggregate Demand ShiftsA. Shifts to the RightB. Shifts to the LeftIII. Rational ExpectationsCurrent LectureThis lecture is the last one and finishes up by going through chapter 13. Chapter 13 looks at the neoclassical perspective in the long run. This view says that the standard of living comes prom potential GDP. The neoclassical view also looks at how to increase Yp, which is the long run equilibrium. Increasing Yp can be done by shifting the long run aggregate supply to the right. This doesn’t happen though, so we will instead focus on how to shift the aggregate supply and aggregate demand curves. First let’s look at what happens when the aggregate demand curve shifts to the right. We first start at the long run equilibrium, which is designated by Yp and E0. Then let’s suppose that AD shifts to the right. This moves the equilibrium to a new point. At this new point wages will start to rise. This causes the short run aggregate supply curve to shift to the left. This new shift forms a third new equilibrium. This 3rd new equilibrium puts the market back at a fuller capacity. This whole process happens fairly quickly. What happens if the aggregate demand curve shifts left though? We start off at our initial equilibrium of E0. The aggregate demand curve will shift to the left and forms a new equilibrium. This indicates higher unemployment. High unemployment causes wages to drop. This in turn makes the short run aggregate supply curve shift to the right. Another new equilibrium is formed. This equilibrium moves back to Yp. As you can see, the whole neoclassical concept is based on wages and their fluctuation. Even though during the neoclassical view we come back to Yp, the initial equilibrium is different from the final. They both do have the same output. The difference is in the prices. How can this process be expedited though, in order to bring Yp back? One theory to explain how to do this is based upon rational expectations. Rational expectation says that economic agents use all available information when making decisions. The economic agents are firms and consumers. For example, consumer will accept lower wages because they know in certain economies that prices are falling. In the same token, firms won’t fire workers AGEC 217 1nd Editionbecause they know that the economy will bounce back and they will eventually need to rehire. If everyone kept this mindset, things would move quicker. Unfortunately, this is not normally the


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Purdue AGEC 21700 - The Neoclassical View

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