ECON 201 Chapter 13: The Neoclassical Perspective

the philosophy that, in the long run, the business cycle will fluctuate around the potential, or full-employment, level of output

• Potential GDP determines the economy's size.
• Wages and prices will adjust in a flexible manner so that the economy will adjust back to its potential GDP level of output.

• Over the long run, the level of potential GDP determines the size of real GDP.
• "Potential GDP" is the level of output that an economy can achieve when all resources (land, labor, capital, and entrepreneurial ability) are fully employed.
• While the unemployment rate in labor markets will never be zero, full employment in the labor market refers to zero cyclical unemployment.
• Economists benchmark actual or real GDP against the potential GDP to determine how well the economy is performing.

• GDP growth can be explained by increases and investment in physical capital and human capital per person, as well as advances in technology.
• Physical capital per person - the amount and kind of machinery and equipment available to help a person produce a good or service.
• Increasing human capital involves increasing levels of knowledge, education, and skill sets per person through vocational or higher education.
• Physical and human capital improvements with technological advances will increase overall productivity and, thus, GDP.

• In the neoclassical model, we draw the aggregate supply curve as a vertical line at the level of potential GDP.
• If AS is vertical, then it determines the level of real output, no matter where we draw the aggregate demand curve.
• Over time, the LRAS curve shifts to the right as productivity increases and potential GDP expands.

•Economists base the neoclassical view of how the macroeconomy adjusts on the insight that even if wages and prices are "sticky" in the short run, they are still flexible over time.
• An economy may produce above its level of potential GDP in the short run, due to a surge in aggregate demand.
• However, the economy cannot sustain production above its potential GDP in the long run.
• Over the long run, the surge in aggregate demand ends up as an increase in the price level, not as a rise in output.

• Rational expectation - the theory that people form the most accurate possible expectations about the future that they can, using all information available to them
• In an economy where most people have rational expectations, economic adjustments may happen very quickly.
• Theorizes that everyone will recognize that the process is heading toward a change in the price level and then will act on that expectation quickly, without a drawn-out zigzag of output and employment.
• An alternate assumption is that people and firms act with adaptive expectations.
• Adaptive expectations - the theory that people look at past experience and gradually adapt their beliefs and behavior as circumstances change.
• Are not perfect synthesizers of information and accurate predictors of the future.
• If most people and businesses have some form of adaptive expectations, then the adjustment from the short run to the long run will be traced out in incremental steps that occur over time.

• Expected inflation - a future rate of inflation that consumers and firms build into current decision making. • In the Keynesian perspective, the focus is that the government should adjust AD so that the economy produces at its potential GDP.
• Not so low that cyclical unemployment results and not so high that inflation results.
• In the neoclassical perspective, aggregate supply will determine output at potential GDP.
• The natural rate of unemployment determines unemployment.
• Shifts in aggregate demand are the primary determinant of changes in the price level.

• When the economy is producing at potential GDP, cyclical unemployment will be zero.
• For neoclassical economists:
• The view of unemployment tends to focus on how the government can adjust public policy to reduce the natural rate of unemployment.
• Do not tend to see aggregate demand as a useful tool for reducing unemployment.
• Since a vertical aggregate supply curve determines economic output, then aggregate demand has no long-run effect on unemployment.
• 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.

• 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.
• The key policy question for neoclassicals is how to promote growth of potential GDP.
• Economic growth depends on the growth rate of longo-term productivity.
• Government policy should focus on promoting long-run productivity growth through:
• investments in human capital, physical capital, and technology.
• operating together in a market-oriented
environment that rewards innovation.

• Many mainstream economists believe both the Keynesian and neoclassical perspectives.
• At short-time scales (and sometimes deep
long-lasting recessions), the Keynesian model can be a good approximation.
• At very long time scales, the neoclassical framework can make more sense.