Department of Economics University of Calgary Economics 303 Dr. R.

Kneebone

Lecture Note #1: Basic Concepts Used in Macroeconomics

This set of notes is intended to supplement your reading of Chapters 1 and 2 of the text. These notes and the two chapters in the text are complements, not substitutes, for one another.

What is Macroeconomics? What is Macroeconomic Policy?

Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment, the distribution of income and economic growth. Macroeconomic policy involves government making choices that affect economy-wide phenomena such as inflation, unemployment, the distribution of income and economic growth. Economists who study macroeconomics ask what questions like; What determines the level and movements in macroeconomic variables? What choices are available to policy-makers to affect the level and movement in macroeconomic variables? Why do -makers make the choices they do?

Increasingly, macroeconomic policy is about government getting microeconomic choices correct. That is, establishing tax and expenditure programs with the correct set of incentives and about income redistribution. In recent years there has also been a growing recognition of the importance of economists recognizing that macroeconomic policy must be made in a world of politics. Thus macroeconomic policy involves trade-offs, not only with other macroeconomic variables, but also with concerns the policy-maker has about re-election. Finally, much of modern macroeconomics is about the establishment of rules of behaviour for policy-makers; Given this set of circumstances, I will do this. The establishment of rules is in contrast to the use of discretion; Given this set of circumstances, I may do this, or I may do that, or I may do that something else. The reason for macroeconomists preferring rules to discretion is one of the key things about which you will learn in macroeconomics.

Why Do Macroeconomists Use Models?

A question professors often here is the following; Why do I have to study the theory behind questions of economics (or anthropology, or sociology, or physics, ....)? Why can't we just let the facts speak for themselves? To understand the importance of theory, consider the following example. Suppose one wanted to discover why motorists were suddenly waiting in line for gasoline, often for several hours, during the winter of 1973-74. The first thing to do, perhaps, is to gather some facts. Consider the following list of facts. 1. Many oil-producing nations embargoed oil to North America in the fall of 1973. 2. The GDP of Canada rose, in nominal terms, by 10 percent from 1972 to 1973.

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3. Gasoline and heating oil are petroleum distillates. 4. Wage and price controls were in effect on the oil industry during that time. 5. The average fuel efficiency achieved by cars in North America has decreased due to the growing use of anti-pollution devices. 6. The price of food rose dramatically in this period. 7. Rents rose during this time, but not as fast as food prices. 8. The price of tomatoes in Regina was 39 cents per kilogram on September 14, 1968. 9. Most of the pollution in the Toronto metropolitan area is due to fixed, rather than moving sources. The list goes on indefinitely because there are an infinite number of facts. Most of us can probably conclude fact #8 is irrelevant and, indeed, most of the infinite number of facts that might have been listed is irrelevant. But why? How was this conclusion reached? Can fact #8 be rejected solely on the basis that most of us would agree to reject it? What about facts #4 and #5? There may be less than perfect agreement on the relevance of some of these facts. Facts, by themselves, do not explain events. Without some set of axioms, propositions, or theories about the nature of the phenomena we are seeking to explain, there is simply no way in which to sort out the relevant from the irrelevant facts. Those who summarily reject fact #8 as irrelevant to the events occurring during the energy crisis must have had some behavioural relations in mind that suggested that the tomato market in 1968 was not a determining factor. Such a notion, however rudimentary, is the start of a theory. A theory, in any empirical science, is a set of explanations or predictions about the real world. When analysing anything as large and complex as an entire industrialized economy, it is necessary to abstract from most of the important institutional details of production and exchange. We hope to represent or simulate the behaviour of the more important aspects of the workings of such economies by studying the behaviour of model economies. These model economies are designed to be optimal simplifications of reality. What makes them optimal simplifications is that the assumptions imbedded in the model do not seriously impact the models predictions. We try to closely portray the end results of market interactions rather than trying to closely mimic the processes in which these outcomes occur. In the words of Nobel Laureate Robert Solow; All theory depends on assumptions which are not quite true. This is what makes it theory. The art of successful theorizing is to make the inevitable simplifying assumptions in such a way that the final results are not very sensitive. -- Robert Solow Such models are the tools of the trade in macroeconomics. They can generally be presented in several equivalent representations. Such representations include diagrammatic representations, mathematical representations, and verbal descriptions. Most of our analyses in this course will be conducted by means of graphical representation and verbal descriptions. As you continue you training in economics, you begin to rely more heavily on mathematical representations. This adds a degree of precision not possible with graphical representations and verbal descriptions. As long as our modelling is done carefully and correctly, all three tools of analysis give consistent answers to economic problems and all are essential elements of the economists toolkit.

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In our models we attempt to simulate the effects of events on the economic variables that are of interest to us. These events include changes in policy settings but are mainly changes in the economic environment; changes such as technological advances, political events, wars and tsunamis, waves of optimism or pessimism, etc. Our fundamental aim is to present models as mappings between sets of assumptions and sets of conclusions in the form of specific effects of disturbances on economic variables. Our hope is that the models we study will help us to understand interrelationships between different groups of markets and different groups of economic agents. We also hope to shed light on historical patterns of relationships between observable economic time series. We hope, finally, to be able to generate recommendations for the effective conduct of macroeconomic policy.

The Structure of Economic Models

Economic models can be described by either a set of equations or by a collection of diagrams. These two methods of representing models are exactly equivalent and we will be using both in our sessions. Graphical representations of models are limited to two dimensions (three dimensional diagrams are devilishly difficult to draw) and are therefore generally less useful. It turns out, however, that this is not a serious restriction for many purposes at the intermediate level of analysis. As you progress in your economics training, more and more use of mathematics will be used. Nonetheless, a skilful economist will be able to explain the results generated by even the most sophisticated of mathematical models in simple graphical or intuitive terms. Indeed, given that our ultimate goal is to influence the way in which people, firms and governments relate to one another and with the environment, it is important that economists be able to explain their complicated theories and results in ways that can be appreciated by non-experts. The representation of an economic model -- be it mathematical or graphical -- requires that we relate the behaviour of economic agents (households, firms, governments) to levels or changes in economic variables. We must also define equilibrium for our model. Equilibrium exists when there is no reason for any model element to change in value. An example of an equilibrium condition is demand (D) = supply (S) in the market for a commodity. Finally, all models must contain an explanation of how variables change outside of equilibrium. In the economic model describing the demand and supply for a commodity, the price variable is described as changing in the market if demand does not equal supply. In particular, when D > S, the price of the good will be bid up. If D < S, the price will be bid down. Only when D = S is there no reason for price to change. All economic models must contain such an explanation of how variables change outside of equilibrium. These stories relate the process of dynamic adjustment. Since adjustment from equilibrium to equilibrium will often occur over time (though some adjustments we will talk about will be assumed to occur instantaneously) and since disturbances that affect markets are occurring continuously, these dynamic adjustment stories are very important for our understanding of what we observe in the real world.

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Any model (in economics and in any other science) contains parameters and variables. A variable is something with a value that is, well, variable. Thus in a macroeconomic model, the amount that a household spends on consumer goods is usually classified as being a variable because we expect consumer expenditures to change from time to time. A parameter is something with a value that we do not expect to change. The choice of whether something is a variable or a parameter depends on the model being considered and is a choice made by the economic modeller. An example here is the marginal propensity to consume. The MPC measures the amount by which consumption changes should income change, all else equal. We generally assume in our macroeconomic models that the MPC is constant: Regardless of ones income, an extra dollar of income will always cause us to spend an additional $x where x is the value of the MPC. It is important to understand that whether or not something is defined as a parameter or as a variable is up to the economic modeller. Thus in some models I might want to assume that the MPC is a parameter. However, in other models I might classify the MPC as a variable determined by other considerations. For example, we might imagine cases where the value of the MPC varies with the state of the stock market or the likelihood of recession In any model there are two types of variables; exogenous variables and endogenous variables. Exogenous and endogenous variables are, of course, both variables by which we mean their values can change. They differ in the reasons why their values can change. A variable is classified as being endogenous if its value changes in response to changes in the value other variables. A variable is classified as being exogenous if its value is unaffected by changes in the value other variables. Whether a variable is classified as being endogenous or exogenous is up to the economic modeller. To give you an example, in most of the models we will look at in this course, we will treat the dollar amount of government spending on goods and services as an exogenous variable. Thus although we will allow the dollar amount of government spending to change (it is a variable) this amount will not be affected by changes in other variables in the model. It would not be difficult, however, to specify that government responds to changes in other variables in the model. We could specify, for example, that when GDP falls in value, government responds by increasing its spending on goods and services. In this case, government spending is endogenous because it is responding to the change in GDP. It is important to understand that whether or not a variable is endogenous or exogenous is a choice made by the economic modeller (you). As we will see later on, we can build a model and examine its predictions under one set of assumptions regarding which variables are endogenous and which are exogenous and then derive a whole new set of predictions simply by changing our assumption regarding the endogeneity and exogeneity of variables.

Short-Run versus Long-Run in Macroeconomics

In microeconomics we say we are in the short-run when one factor of production (usually the capital stock) is in fixed supply. The long-run is a period of time over which neither factor of production (i.e. neither labour nor capital) is in fixed supply. In macroeconomics the distinction between long-run and short-run is different. The distinction of whether capital is in fixed supply

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determines whether the macroeconomic model at hand is a growth model (the size of the capital stock, the level of technology and the size of the labour force are all changing) or a business cycle model (the size of the capital stock, the level of technology and the size of the labour force are all assumed to be constant). Growth models are sometimes characterized as describing the very long run. As this characterization suggests, these models are designed to explain economic events over several decades. Within business cycle models, we distinguish between the short-run and the long-run in the following way. In a business cycle model, the long-run is characterized by the condition that all markets are in equilibrium. The short-run in a business cycle model then, is a period of time during which some or all markets are not in equilibrium. In business cycle models, the long-run is often referred to as full equilibrium. In macroeconomics, we identify two reasons why markets might be prevented from moving into full equilibrium; the existence of rigidities and the existence of misperceptions. An example of a rigidity is a government-imposed rent-control in the market for rental accommodations. Rent controls prevent landlords from collecting the maximum rent that renters are willing to pay for the landlord's rental accommodation. Hence rent controls prevent the price of rental accommodations from adjusting to their equilibrium level where demand = supply. Rigidities and misperceptions result in sticky-wages and sticky-prices that prevent markets from adjusting to full equilibrium. They are, then, the reason why the economy remains away from full equilibrium for extended periods of time; as we will see, they are the reason business cycles occur.

Two Types of Macroeconomic Models

I referred in the previous section to two types of macroeconomic models; business cycle and growth models. Macroeconomists use models to investigate two different types of questions. Not surprisingly, they use different models to investigate these different questions. The first general question macroeconomists ask is: Why does output tend to grow over time? Why, for example, did Canada's GDP grow by about 5 to 6% per year during the 1950s and 1960s while in the 1970s and 1980s it grew at only about 2 or 3% per year before speeding up again to 4% during the early 2000s? Why is China currently growing at 8 to 10% per year and what is the likelihood of that continuing? To answer questions like these, macroeconomists employ growth models and hence employ assumptions that describe the very long run. A distinguishing feature of growth models is that they attempt to describe and explain trends. It is important for you to understand and appreciate that such models ignore deviations from long term trends; deviations as reflected in business cycles. The second general question macroeconomists ask is: Why do recessions/booms occur? That is, why did the Canadian economy go into recession in 1982, again in 1991, and again in 2008? To answer questions like these economists employ their model of the business cycle and so employ assumptions that describe the macroeconomic short-run and long-run. A distinguishing feature of this type of model is that the quantity of capital and the level of technology are assumed to be fixed. These models thus abstract from trend rates of growth and leave the explanation of trends to growth

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models. These business cycle models focus on the deviations from long term trends that growth models ignore. The difference between these two types of models can be illustrated with the use of the diagram below showing Canadian real GDP per person from 1870 to 2003. Over time, real output tends to grow but it is not a steady rate of growth; output tends to fluctuate up and down about a long term trend. Growth models are designed to try to explain the slope of the trend line. Business cycle models are designed to try to explain the deviations from the trend line; the booms and busts that cause living standards, unemployment, inflation, and etcetera to temporarily rise above or fall below trend. When we choose to focus on the issue of what causes business cycles that is, why do business cycles (recessions and booms) occur we will be trying to explain the deviations of GDP from its long-term trend. Given this focus, we will often find it convenient to assume the trend rate of growth is zero. In terms of the graph, this will mean we will be assuming the trend line is horizontal. Clearly, nothing is lost with this assumption because our interest is only in explaining deviations from the trend line.

Real GDP per Person (thousands of 1997 dollars)

Canada's Real GDP per Person, 1870-2003 2.1% Annual Real Grow th on Average

1981-82 recession

Recession of 1919-1920 Wheat Boom 1895-1905

1990-91 recession

The Great Depression

1870

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

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Comparative Statics and the Assumption of Stability

Previously, we defined equilibrium as a condition where there is no incentive for change. In some sense then, a model is static when it is in equilibrium. When we perform comparative static experiments we are comparing equilibriums. When we perform comparative static exercises, we are implicitly assuming the model is stable or convergent. A model is said to be stable if, when it is disturbed out of equilibrium, it adjusts in such a way as to bring it back into a new equilibrium. If, when disturbed out of equilibrium, a model does not adjust to a new equilibrium, that model is said to be unstable or non-convergent.
P S D
B

P1

D'

P1

D' D Q Graph #1 Graph #2 Q

To judge whether a model is stable or not, we have to understand the dynamics which underlies the model at hand. For example, consider the market for tomatoes that is represented in Graph #1. In demand and supply models like this one, the underlying dynamic adjustment story obeys the laws of supply and demand. Suppose we are initially in equilibrium at point A. Then, for some reason there occurs a demand shock (that is, a change in the value of some exogenous variable that affects demand) and as a consequence demand shifts to D. Clearly, point A is no longer an equilibrium point. At price P1 the demand for tomatoes now exceeds the supply of tomatoes. The laws of supply and demand dictate that the price of tomatoes will increase in this situation. Notice that this dynamic adjustment story is leading us toward the new equilibrium point B. Experimenting with a negative demand shock and with positive and negative supply shocks shows that this conclusion is true for any shock. This model, then, is said to be stable. The market depicted in Graph #2 is unstable. To see this, start again with equilibrium at point A. Now suppose a shock causes demand to shift from line D to D'. At the initial price P1, there is now an excess demand for tomatoes. By the laws of supply and demand, the price of tomatoes must rise. From our diagram we see that an increase in price moves us away from the new equilibrium (point B). This model, then, is said to be unstable or non-convergent because once shocked from equilibrium, it never returns to equilibrium.

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It should be obvious that it makes sense for us to perform comparative static experiments (i.e., to compare equilibriums) only if the model is stable. It makes no sense to compare equilibriums A and B in Graph #2 precisely because the nature of the market is such that we could never adjust from A to B. This insight suggests there is a correspondence between investigations of stability (or convergence) and the results of comparative static experiments. That is, for the results of comparative static experiments to make sense, the model must be stable. When we infer the sign of comparative static results we must therefore ensure that those signs are consistent with the requirements for convergence. This Correspondence Principle plays an important role in macroeconomic models.

A Little Bit of Mathematics

Suppose that the value of variable y is determined by the values of variables x and w. In the language of mathematics, we represent this idea by writing; y = y(x, w) which is read; the value of variable y is a function of the values of variables x and w. Nothing about this relationship tells us about the nature of the relationship between y, x and w. Some such information is contained in the functions partial derivatives. A partial derivative of the function above measures the change in the value of variable y resulting from an infinitesimally small change in the value of one of the elements of the function, holding values of the other elements of the function constant. Thus in our example, there are two partial derivatives; one showing the change in y resulting from an infinitesimally small change in x, holding w constant, and one showing the change in y resulting from an infinitesimally small change in w, holding x constant. We identify these partial derivatives with the following notation;
y/ x and y/ w

By assigning signs to these partial derivatives (positive or negative), we describe more precisely the relationship between variable y and variables x and w. For example, if we indicate that y/ x > 0, we are saying that when variable x increases in value, holding the value of variable w constant, then so too does variable y. Similarly, if we indicate that y/ w < 0, we are saying that when variable w increases in value, holding the value of variable x constant, then the value of variable y falls. This description of the partial derivative should make you think about the concept of slope. Think again of the demand curve for some commodity. By convention, demand curves are drawn in two dimensional diagrams with price (P) on the vertical axis and quantity (Q) on the horizontal axis. The demand curve shows the relationship between P and Q holding all other determinants of demand (income, the price of substitutes and complements) constant. The slope of a demand curve, then, is P/ Q; a partial derivative. A partial differential is closely related to a partial derivative in that it shows what happens to the value of variable y when one of x or w changes, holding the other constant (thus it is a partial

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measure). The difference is that here the change in x (or w) is not restricted to be infinitesimally small. The partial differential showing the change in y for a non-infinitesimal change in x, holding w constant, is described by the following notation; dy = ( y/ x)dx The first term on the RHS of the equal sign measures the influence on y of an infinitesimally small change in x. This is multiplied by dx, which measure a non-infinitesimally small change in x. The result is a non-infinitesimally small change in y (dy). You might think of the partial derivative y/ x as measuring the effect on y of a one-unit change in x. Multiplying this by the actual number of units by which x changes (dx) yields the total change in y. In a similar way, we can write the other partial differential as; dy = ( y/ w)dw A total differential is similar to a partial differential in that it describes the effect on the value of y of non-infinitesimal changes in x and w. It is, however, not a partial measure because it allows both elements of the function to change simultaneously. So long as the elements of the function, x and w in our example, are themselves not affected by changes in one another (that is, so long as x and w are exogenous variables so that x/ w = w/ x = 0), then the total differential of our function is simply the sum of the partial differentials; dy = ( y/ x)dx + ( y/ w)dw Since they play an important part of what we do in economics it is worthwhile to explore more fully the idea of a total differential. That is the subject of the next section.

Linear Approximations
Theory usually goes a long way toward telling us the answer to questions like, What determines consumption spending? Theory is generally less useful telling us of whether consumption a linear or some kind of non-linear function of income. As a result, economists are often loath to make assumptions regarding functional form. For the most part, this is not a serious problem in macroeconomics because much of what we do involves solving for comparative static results. That is, we are interested in answering questions like, How does consumption spending change if income changes? To see why doing comparative statics saves us from being specific about functional form, consider an example. Suppose we know that consumption spending (C) is some positive function of income (Y). Thus we can write a consumption function of the form; C = C(Y) (1)

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Note that we have not indicated if this relationship is linear or non-linear. Lets suppose the true relationship between C and Y is given by the curved line in the diagram below. Also suppose that income is currently Yo and consumption is Co and that we know everything there is to know about the consumption function at point A only. The characteristics of the rest of the consumption function are a mystery to us. We can see from the diagram that if we did know the true shape of the consumption function then should income increase to Y1 consumption would increase to C1 as given by point F. However, suppose we dont know the true shape of the consumption function. If we have been told that income has increased to Y1 what would be our guess about what has happened to consumption spending?

C
C1
F

C1
A

C0

Y0

Y1

An easy guess would be C1 = Co. This guess is represented by point B. This assumes the true consumption function has zero slope. This is a lousy guess since we know the slope of the function at point A. Making use of that information an improvement on our guess would be;
C1 C0 C [Y1 Y0 ] Y

(2) This

where C/ Y is the first derivative (slope) of the consumption function at point A. calculation gives us point E in the diagram.

A further improvement of this guess would involve making use of the second derivative of the function at point A. The second derivative would indicate the function is not only increasing at point A, but is increasing at an increasing rate. Still further improvements could be had by using still higher derivatives of the function at point A. If we added these additional terms to (2) above, we would have what is known as a Taylor series expansion. If we limit ourselves to just the first two expressions in the Taylor series -- so that all we have is (2) -- it is said that we are limiting our attention to a linear approximation of the Taylor series. Note that using just the first two terms of

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the Taylor series as our guess at the value of the function when Y = Y1 yields a guess of C1 . The true answer, of course, is C1 so that an error equal to the distance E to F -- is involved. Now, subtract C0 from both sides of (2) and define dC = [C1 - Co] and dY = [Y1 - Yo]. We now write (2) -- the linear approximation of (1) -- as; dC = ( y/ x)dy which is, of course, simply the total differential of (1). In a similar way, we can calculate the total differential of functions containing more than one element. For example the total differential of the following slightly more complicated consumption function, C = C(Y, W), is simply
dC C C dY dW Y W

This has the same interpretation as the simpler case. That is, it measures the linear approximation of the relationship between C and its determinants; Y and W. As a linear approximation, it is accurate only for small changes in Y and W (unless, of course, the function C = C(Y, W) is indeed linear, in which case it is exactly accurate). To sum up: Because most of what we do in macroeconomics is performing comparative static experiments, we are most interested in knowing how the change in the value of one variable is related to a change in the value of another variable. Total differentials of functions provide us with just this information. Since we do not need to know the exact functional form of a function in order to calculated its total differential, we do not need to take a stand on functional forms -- something economists are generally loathe to do. The discussion of Taylor Series was intended to show you that a total differential is simply a linear approximation. We noted that using a linear approximation as our guess of the value of the function at Y = Y1 involved an error equal to the distance between E and F. This leaves us with an important warning about comparative static results: If the true functional form is indeed non-linear, the degree of accuracy declines the larger is the proposed change in the independent variable (variable Y in this case). Thus it can be seriously misleading to use comparative static results, which rely on the use of linear approximations, to make statements about the likely effect of large changes in independent variables.1 In Economics 303, we will be relying on the use of linear approximations to simplify how we write equations. Thus when we want to formalize our discussion of the relationship between consumption expenditures (C) and income (Y), we will simply assume a linear relationship of the following sort; C = a + bY

An interesting example of this problem is the on-going effort to evaluate the likely impact of the recent very large increases in government spending and money supply that have accompanied efforts to stabilize the world economy in the face of the financial crisis which struck in 2008. Almost all economic models are built on the assumption of linear approximations and so there is a danger of using them to evaluate what will be the impact of, say, the US government increasing its spending by 20% or the US Federal Reserve increasing the US money supply by 30 or 40%..

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where a and b are parameters and b is a partial derivative relating changes in consumption to changes in income.

Aggregation Issues
Is macroeconomics just microeconomics where we add up the choices of individuals and firms? Do we need macroeconomics or is microeconomics enough? While some macroeconomists might suggest that the answer to the first statement is yes most would say the answer is no. The majority emphasize that the choices made by persons or firms in aggregate can differ in fundamental ways from the choices they make as individuals. Indeed, it requires some strong assumptions about the properties of utility and production functions to cause the utility and profit maximizing choices of aggregations of individuals and firms to look like those of individuals. An implication of this is that the specification of an equation describing the behaviour of an individual (or firm) may differ considerably from an equation describing the behaviour of an aggregation of individuals (or firms). You will see evidence of this as we develop relationships describing how aggregations of individuals respond to other variables. We will typically start by describing how an individual might behave but after doing so we will describe a more general form of a relationship which macroeconomists have deemed an appropriate description of how aggregations of individuals behave.

Keynesian vs. Classical Economists

As already noted, scientists find it useful to construct abstract models of what may be complicated realities. In all sciences, there are disagreements over what the appropriate model should look like. In physics, for example, Einstein sparked a revolution by suggesting light should be modelled as a particle rather than a wave; that is, he suggested a different model to be tested and examined by physicists. Macroeconomists also differ in their opinions about the appropriate form of economic model to use to try to understand the real world. This difference in opinion, however, is relatively basic. The classical approach emphasizes the insights of Adam Smith; how by each of us acting in our own self interest we behave in ways that make all of us better off. Households and firms, he wrote, were guided as though by an invisible hand to a socially optimal outcome even though no individual tries to attain that result. The implication of this understanding is that left to its own devices, the economy of millions and millions of individuals and firms will resolve difficulties and deal with unexpected events in ways the maximize their own (and so societys) own self interests. Government, then, has no real role to play when it comes to dealing with economic fluctuations. (This is not to say it does retain a role to redistribute income in ways that citizens deem to be fair and equitable). The Keynesian approach -- named after John Maynard Keynes, a British economist of the early to mid 1900s departs from the classical approach by emphasizing the existence of rigidities and misperceptions that prevent households and firms from being able to respond to unexpected

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events in ways that maximize their well-being. Examples here include wage contracts that obligate workers to receive, and firms to pay, a certain wage for a certain period of time. An unexpected event may cause the contracted wage to be less than optimal for one side or the other. If so, they are stuck in a less than preferred situation for as long as the contract has force. Similarly, firms typically contract with customers to provide goods at a certain price for a certain period of time. Once again, the state of the world that made that contract desirable may unexpectedly change trapping the firm in a less than preferred outcome. The differences between Classical and Keynesian macroeconomists therefore comes down to the question of whether our abstract descriptions of the real world are best modelled as one in which prices and wages adjust very quickly to unexpected events (the Classical view) or adjust only slowly to unexpected events (the Keynesian view). If the Classical view is correct, then government has very little role to play in responding to macroeconomic events; private households and firms will adjust if profit and utility maximizing ways without the need for government action. If the Keynesian view is correct, then unexpected events will leave households and firms trapped in undesirable positions for what may be a long period of time. If so, there may be a case for asking governments to intervene in the economy and speed up the process of adjustment back toward preferred outcomes. If this description of classical versus Keynesian views sounds like the debate in the US between Republicans (particularly Tea Party types) on the one hand and Democrats on the other, then you can appreciate the importance of this difference in modelling strategies. Should our abstract model of the economy assume a very fast adjustment of prices and wages when unexpected events occur or should it assume prices and wages adjust relatively slowly? It turns out that this difference of opinion is at the heart of very different macroeconomic policy recommendations.

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