Transcript Chapter 11 Classical & Keynesian Economics What You Will Learn

Chapter 11
Classical & Keynesian Economics
What You Will Learn From This Lesson
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Theory & Principles
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Language & Methodology – New Terms
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The Depression and Classical Economics
The Fatal Flaw in Classical Thinking
The Keynesian System
Recessionary Gap
Inflationary Gap
Historical Evolution from “Laissez-faire” to significant
government economic management role
Chapter 11
Classical & Keynesian Economics
The Keynesian Critique of Classical Economics
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“If Supply creates its own Demand, why are we
having a world wide depression?”
The “Roaring Twenties”
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Electrification of America led to mass production of
consumer goods
Over the decade, however, these new markets became
saturated with products
Demand declined, Inventories increased, Supply > Demand
Point -- There can be a disconnect between the
buying side of the market and the selling side of the
market
Chapter 11
Classical & Keynesian Economics
The Keynesian Critique of Classical Economics
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Keynes posed this problem to Classical World
What if Savings and Investment were not equal?
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Then Spending would not equal production, and
The economy could experience natural periods of
unemployment or inflation, and
The economy is inherently unstable rather than stable
Spending decisions and Saving decisions are made by
different groups than Production and Investment
decisions
Prices, especially in the factor markets are not
downwardly flexible
Chapter 11
Classical & Keynesian Economics
The Keynesian System
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If there could be a “disconnect” between spending
and production in an economy, then economies are
inherently unstable
There is no reason why an economy has to come to
equilibrium at full employment, and
Even if an economy does come to a full employment
equilibrium, there is no reason why it must remain
there
These statements are not compatible with the
Classical System
Chapter 11
Classical & Keynesian Economics
The Keynesian System
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If economies are inherently unstable, then three
outcomes are possible:
The economy can come to equilibrium at a level of
production lower than full employment (Recessionary
Gap)
The economy can come to equilibrium at a level of
production at full employment, or
The economy can come to equilibrium at a level of
employment above equilibrium (Inflationary Gap)
The Ranges of the Aggregate Supply Curve
A ggregate
supply
Keynesian
range
Real GDP
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Keynesian Critique of
the Classical System
Three Aggregate Curves
AD1 represents aggregate
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demand during a recession or
depression
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L-RAS
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AD2 crosses the long-run
aggregate supply curve at full
employment
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80
AD3
60
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AD1
20
AD3 represents excessive demand
AD2
0
0
1
2
3
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Real GDP (in trillions of dollars)
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter 11
Classical & Keynesian Economics
Key Differences Between Classical & Keynes
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In the Classical World
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Free market economies are always stable
Tending toward full employment & full production equilibrium
Freely fluctuating prices in the three major macro markets ensure
this
In the Keynesian World
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Free market economies are unstable
Equilibrium yes, but no reason for full employment/full production
Demand becomes a much bigger driving force
Supply will always adjust to Demand
In a way, according to Keynes “Demand creates its own Supply”
Chapter 11
Classical & Keynesian Economics
Keynesian Policy Implications
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Under the Classical System, Government had no role in
management of the economy – “Laissez-faire” or “do nothing”
Under Keynes, Government must step in to correct the inherent
instability of the economy
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If the economy faces a recessionary gap (equilibrium at less than
full employment) Government must increase demand by spending
more; lowering taxes; lowering interest rates; increasing welfare
If the economy faces an inflationary gap (equilibrium at a level
higher than full employment), Government must reduce demand by
spending less; raise taxes; increase interest rates; reducing welfare
Chapter 11
Classical & Keynesian Economics
U.S. Federal Government Objectives for
Economy
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Full Employment (1933 & by Law 1946) – Federal Government
took responsibility to ensure the economy functions at full
employment – No more than 5% unemployment
Economic Growth (1950’s) – Federal Government took
responsibility to ensure the economy grows at a consistent and
healthy rate – Real GDP at approximately 4%/year
Price Stability (1970’s) – Federal Government took responsibility
to ensure the economy has stable prices – CPI increase at no
more than 3%/year
So, from no role prior to the great depression to comprehensive
responsibilities post depression
Chapter 11
Classical & Keynesian Economics
Review of What You Have Learned
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The Depression proved there must be a flaw in the
Classical Economic Theory
John Maynard Keynes suggested the flaw was very
fundamental – The depression proved there could be
a disconnect between Aggregate Demand and
Aggregate Supply
It is not assured that production will create its own
demand. Demand is more of a driver of economic
equilibrium
Chapter 11
Classical & Keynesian Economics
What You Have Learned
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There is no reason why the economy must come to
equilibrium at full employment.
The economy can experience recessionary gaps or
inflationary gaps
Aggregate Supply will always adjust to Aggregate
Demand, not the other way around
Therefore, Government has a role and responsibility
as a maximizing entity (well-being of citizens) to
manage the economy
The U.S. Government has accepted that responsibility