Key Terms
Neoclassical answer
Supply. Demand just follows.
Recessionary gap
Actual GDP falls below potential GDP. The economy is in equilibrium, but with unemployment.
Inflationary gap
Aggregate demand pushes the economy past potential. Output can't actually expand beyond potential; the result is inflati
Positive gap
Economy is underperforming. Unemployment above natural rate.
Recession (positive GDP gap)
Expansionary fiscal policy. Tax cuts or increased government spending shift AD right toward potential GDP.
Inflationary boom (negative GDP gap)
Contractionary fiscal policy. Tax increases or spending cuts shift AD left back toward potential GDP.
Two building blocks
1. Long-run output is determined by potential GDP.
Policy implication
Hands off. Focus on long-run growth and low inflation, not short-run stabilization.
Implication
It doesn't matter where AD is. Prices adjust until AD intersects LRAS at potential GDP.
Rational expectations
People use all available information to form the most accurate possible predictions about the future. If everyone has ra
Adaptive expectations
People look at past experience and gradually update beliefs. Adjustment happens, but slowly, in incremental steps over t
Result
Fiscal stimulus hits an economy that's already recovering, causing inflation instead of curing unemployment. Active poli
What neoclassical economists do support
Stable low inflation, low stable tax rates, policies that increase long-run potential GDP (physical capital, human capit
Keynesian strengths
Explains recessions, cyclical unemployment, and why economies get stuck. Useful for policy prescriptions in downturns.
Keynesian weaknesses
Not great at explaining long-run growth; ignores natural rate of unemployment; risks overlooking supply-side constraints