Transcript The Self Regulating Economy

Ch. 8: The Self Regulating
Economy
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
Classical Economists’ Views
• Say’s Law: Supply creates its own demand.
• Implied in Say’s Law: there cannot be either a
general overproduction of goods or a general
underproduction of goods.
• Even in a money economy, where individuals
sometimes spend less than their full incomes,
Say’s Law still holds. This argument was partly
based on the assumption of interest rate flexibility.
Classical Economists’ Views
• For Say’s Law to hold in a money economy, funds
saved must give rise to an equal amount of funds
invested.
• In a money economy, according to classical
economists, interest rates will adjust to equate
saving and investment.
• Any fall in consumption (and consequent rise in
saving) will be matched by an equal rise in
investment.
Classical Economists on Markets
• Classical economists
believed most, if not
all, markets are
competitive.
• Prices will adjust
quickly to any
surpluses or shortages
and equilibrium will
be quickly
reestablished.
Q&A
• Explain Say’s law in terms of a barter
economy.
• According to classical economists, if saving
rises and consumption spending falls, will
total spending in the economy decrease?
Explain your answer.
• What is the classical position on prices and
wages?
Real GDP and Natural
Real GDP: Three
Possibilities
A. Recessionary Gap: Real GDP
is less than the Natural Real
GDP
B. Inflationary Gap: Real GDP is
Greater than Natural Real GDP
C. Long-Run Equilibrium: Real
GDP is Equal to Natural Real
GDP
The Labor Market and The Three
States of the Economy
• Recessionary Gap: the unemployment rate
is higher than the natural unemployment
rate.
• Inflationary Gap: the unemployment rate is
lower than the natural unemployment rate.
• Long-Run Equilibrium: the unemployment
rate is equal to the natural unemployment
rate.
Can the Unemployment Rate be Less
than the Natural Employment Rate?
• Given these two PPFs, the
Institutional PPF has
institutional constraints:
anything that prevents
economic agents from
producing the maximum Real
GDP physically possible.
• An economy can never
operate beyond its physical
PPF, but it is possible for it to
operate beyond it’s
institutional PPF.
• The economy is operating at
it’s lowest unemployment
rate at the institutional PPF.
Q&A
• What is a recessionary gap?
• What is an inflationary gap?
• What is the state of the labor market when
the economy is in a recessionary gap? In an
inflationary gap?
• If the economy is in an inflationary gap,
locate its position in terms of the two PPFs
discussed in this section.
What happens if the Economy is
in a Recessionary Gap?
• The unemployment rate is higher than the
natural unemployment rate.
• This implies that unemployment is
relatively high and that as old wage
contracts expire, business firms will
negotiate contracts that pay workers lower
wage rates.
What Happens if the Economy is
in a Recessionary Gap?
What Happens to the Economy in
an Inflationary Gap?
• The unemployment
rate is lower than the
natural unemployment
rate.
What Happens to the Economy in
an Inflationary Gap?
Self-Regulating Economy:
A Recap
• Flexible wages (and
other resource prices)
play a critical role in
the story of the selfregulating economy.
• Macroeconomists
want to know if the
economy has a natural
resting place.
Policy Implications of Believing
the Economy is Self-Regulating
• Laissez-faire: A public
policy of not interfering
with market activities in
the economy.
• In the view of some
economists, the
government does not have
an economic management
role to play.
Changes in the Economy:
Short-Run & Long-Run
• If the economy is self regulating, an increase in aggregate
demand can raise the price level and Real GDP in the short
run, but in the long run the only effect of an increase in
aggregate demand is an increase in price level.
Changes in the Economy:
Short-Run & Long-Run
• If the economy is self-regulating, a decrease in aggregate
demand can lower the price level and Real GDP in the
short run, but in the long run the only effect of a decrease
in aggregate demand is a lower price level.
Q&A
• If the economy is self-regulating, what happens in
a recessionary gap?
• If the economy is self-regulating, what happens in
an inflationary gap?
• Give an example to illustrate how the economy
can operate below the natural unemployment rate.
• If the economy is self-regulating, how do changes
in aggregate demand affect the economy in the
long run?