Question from Past Macroeconomics Qualifying Exam (Fall, 2002 - Question two) at George Mason UniversityEdit

A good deal of controversy in macro theorizing revolves around the relative merits of quantity adjustment and price adjustment as providing the starting point for the analytical effort. Old Keynesians and New Keynesians both emphasize quantity adjustment, whereas Old Classicals and New Classicals emphasize price adjustment.

  • a. Using simple models, illustrate the macro significance of this distinction.
  • b. If both models have some applicability in reality, their relative importance would seem to be an empirical matter. How would you appraise the weight of the empirical evidence at this time? Use specific references to the literature in presenting your answer.



Price Adjustment: Keynesian

The understanding of the Keynesians, specifically the short-run price rigidities will force the prices to be stable in the short-run (which is a period of time that is both distinctly longer than that considered by the classicals, and indeterminate because of "getting stuck" in inefficient outcomes). The hash marks on the axis represent both the price pressure and the quantity pressure. with Nominal Price Rigidity the quantity pressure dominates, at least in the short-run (however long that is). Eventually the Keynesian best case is that demand rebounds to the original level bringing the economy back to equilibrium.

Note: highlighted in this distinction are assumptions about the Aggregate Supply curve. Follow link for more on the debate in macro about the shape and function of this concept.


Quantity Adjustment: Classicals

Since the AS has a positive slope in the short-run there is theoretically both a quantity and a price adjustment, however the classicals believe that the short-run is extremely short and that this will not last long, so they do not change output, rather there should only be deflationary pressure (the price level drops because of decrease competition for inputs macro-wide, this translates to an expansion of aggregate supply in terms of the AD-AS market). Point "1" is the starting point. Point "2" does not persist for long. Point "3" represents a price adjustment and the same aggregate output as initial.

b. The empirical evidence is weighted towards the Keynesian view

Additional info for consideration. Credited to SangHo Yoon: (mistakes are mine)
Searches for empirical evidence to support their proposition has been on going since Keynesian-Monetarists debates, and even New Classical and New Keynesian have been engages in searching for the evidence to deny or accept the existence of real rigidity in the market. Such evidences can explain that which approach would be correct to explain the business cycle that occurs at least in aggregate variables. However, both schools have been criticized for the lack of empirical evidence as their efforts have been biased toward the theoretical development for micro foundation of macroeconomics. For example, Ladler argues that empirical evidence is a research foundation in macroeconomics to criticize New Classical/Keynesian schools, and Friedman also criticized New Classical/RBC school for lack of empirical support for their theories in his interviews.
However, recent research program within New Keynesian school has made some progress in providing the empirical evidence to show the existence of real rigidity. For example, Mankiw and Romer have been engaged in testing menu cost model using cross-country data.. Moreover, Bhakar has utilized data of UK to show that most firms tend not to increase or decrease prices in booms or recessions. He also shows the importance of quantity adjustment through shift work, variation in hours, and customer rationing. Although New Classical/Keynesian still have much more work to do in testing their models, its lack of empirical support may come from biased research effort toward early stage of theoretical development for microfoundation.

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