Transcript Chapter 11 - McGraw Hill Higher Education

Classical and
Keynesian
Economics
Chapter 11
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives

After this chapter you should be able to :
1.
2.
3.
4.
5.
6.
7.
Discuss Say’s law.
Analyze Classical equilibrium.
Explain and discuss the real balance, interest rate, and foreign
purchases effects.
Demonstrate the interaction between aggregate demand and
aggregate supply.
Summarize the Keynesian critique of the classical system.
Describe equilibrium and disequilibrium and distinguish
between them.
Summarize and discuss the Keynesian policy prescriptions.
11-2
Two Views of the Macroeconomy
Are business cycles self-correcting?

•
Do the forces of supply and demand lead a market
economy toward full employment growth with price
stability on its own?

Or do we need active government policies during
economic downturns?

We will examine two alternative answers:
•
•
Classical Economics
Keynesian Economics
11-3
Part I: The Classical Economic System

The centerpiece of classical economics is Say’s Law.
•
•

Say’s Law states, “Supply creates its own demand.”
This means that somehow, what we produce—supply—all gets
sold (demanded).
Why?
•
•
•
•
When a seller sells a product (including his/her own labor),
she/he earns income.
This income is used to purchase other goods and services.
So, selling one product creates demand for another, until all
the income is “used up.”
If all the income is spent, all the goods and services will be
sold.
11-4
Production in a Five-Person Economy
(Table shows each
person’s production.)
Joe sells 8 bushels of tomatoes (keeping 2 to eat), and uses the
money to buy a tee shirt, 4 loaves of bread, 2 pounds of butter,
and a pair of wooden shoes.
 Sally keeps 1 tee shirt and sells the rest to buy tomatoes, bread,
butter, and shoes.
 And so on…
Question: What happens if Sally buys less bread and butter to save
for a new sewing machine?

11-5
What about Saving?

The macroeconomy begins to have problems when
people save part of their incomes.
•
•

But, saving is important for future growth.
•

If some people save, then some things that are produced will
not be sold.
Money is leaking out of the system.
Without saving, we could not have investment—the
production of plant, equipment, and inventory.
How can the system stay in balance?
•
•
•
Markets inject the savings back into the system.
Savings don’t sit in a bank vault, they are lent out to
businesses, home buyers, and others.
One person’s savings become someone else’s investment.
11-6
Consumer Goods and Investment Goods


Start with just the private sector (no government or
foreign trade).
All production (Supply) consists of:
•
•
•

Consumer goods (C).
Investment goods (I).
No G or Xn.
If we think of GDP as total spending, then
GDP = C + I.

If we think of GDP as income received, then
GDP = C + S.
11-7
Consumer Goods and Investment Goods
(continued)
GDP = C + I
GDP = C + S
Things equal to the same thing are equal to each other:
C+I=C+S
Subtract the same thing (C) from both sides of the equation:
C+I=C+S
You are left with:
I=S
S leaks out, but is
Injected back in as I.
11-8
Supply and Demand Revisited


Find equilibrium price: Approx. $7.20
Find equilibrium quantity: 6
Classical economists applied this process to financial markets
to prove that I = S.
11-9
The Loanable Funds Market




Saving supplies banks
and financial institutions
with loanable funds.
Businesses borrow
(demand) funds for
Investment.
Interest rate is the price of
loanable funds; they are
flexible.
Equilibrium interest rate is
15%.
11-10
Questions for Thought and Discussion

Why does the Saving Curve slope up like a Supply
Curve?
•

Why does the Investment Curve slope down like a
Demand Curve?
•

When would you be more likely to put money in your savings
account: when interest rates are high or low? (Hint: Think
about opportunity costs of keeping cash.)
When would businesses prefer to borrow money: when
interest rates are high or low?
If banks have too much money and not enough
borrowers, will they raise or lower interest rates?
11-11
In Classical Macroeconomics,
Unemployment is Temporary

Labor markets are no different than any other markets,
under Say’s Law.
•
•

Unemployment is due to labor surplus
(Quantity supplied > Quantity demanded).
Lower price of labor (wage), until Labor Supply equals Labor
Demand.
Conclusion: No involuntary unemployment.
•
•
Need a job? Work cheaper!
Anyone who isn’t working has decided not to work at the
equilibrium wage.
11-12
Hypothetical Labor Market

At $9 per hour, there is a labor
surplus (unemployment).

At $7 per hour:
•
Everyone who wants to work
at that rate can find a job.
• Every employer willing to hire
workers at that rate can find
as many workers as s/he
wants to hire.

There was a movement along
the Labor Supply Curve.
•
Some workers voluntarily
decided not to offer their
labor.
11-13
Modeling Classical Equilibrium

Microeconomic (Market) Equilibrium:
•

Macroeconomic Equilibrium
•

When Aggregate Demand equals Aggregate Supply.
Characteristics of Macroeconomic Equilibrium for
Classical Economists:
•
•

When quantity demanded for a product equals quantity
supplied.
Full employment of labor (no involuntary unemployment)
Full employment of resources (maxim output)
Classical Economists maintain that market
economies with flexible prices should tend toward
macroeconomic equilibrium.
11-14
The Aggregate Demand Curve

Aggregate Demand is the total value of real GDP that
all sectors of the economy (C + I + G + Xn) are willing
to purchase at various price levels.
When the price
level increases,
(inflation), people
purchase less
output.
11-15
Three Reasons why the AD Curve
Slopes Down

Real Balance Effect
•
•

Interest Rate Effect
•
•

You feel poorer, so you spend less.
Purchasing power declines with inflation.
Rising prices push up interest rates.
Lenders need higher interest rates to compensate for eroding
purchasing power of money.
Foreign Purchases Effect
•
If prices rise in the US, exports decrease and imports
increase, so Xn decreases.
11-16
Aggregate Supply Curve

Aggregate Supply is the amount of real GDP that
will be made available by sellers at various price
levels.

Aggregate Supply looks different in the Long Run
and the Short Run:
•
•

In the Long Run, classical economists assume the
economy operates at full employment (maximum output),
independent of the price level.
In the Short Run, businesses will increase supply if the
price level increases.
Let’s see what each one looks like…
11-17
Long-Run Aggregate Supply Curve (LRAS)

LRAS is vertical line at full employment level of GDP
(regardless of price level).
Real GDP = $6 trillion
at every point on LRAS.
11-18
Long-Run Macroeconomic Equilibrium
LR equilibrium of
$6 trillion in real GDP
and price level of 100.
Supply Creates Its Own Demand!
11-19
Short-Run Aggregate Supply Curve

SRAS is relatively flat at low levels of output, and
gradually approaches vertical.
Beyond full employment GDP,
expanding production is more
expensive, so firms need large
price increase output.
At low levels of output, firms
can easily expand output when
prices rise.
11-20
Short-Run Macroeconomic Equilibrium
Output may be above or
below full employment in
the SR, but should settle at
full employment GDP in LR.
11-21
Classical View of Recessions
1.
2.
3.
Economy starts at AD1: E1 at
Full employment GDP and
Price level = 140.
During recession, AD
decreases to AD2: E’ at lower
output ($4 trillion).
Surplus inventory of $2 trillion
so firms decrease prices until
sell off surplus at E2.
Conclusion: No government intervention necessary. Flexible prices
will pull economy out of recession. Economy is self-adjusting!
11-22
Part II: The Keynesian Critique of the
Classical System

Until the Great Depression, classical economics was
the dominant school of economic thought.
•


The Great Depression undermined faith in Say’s Law.
John Maynard Keynes developed alternative theory of
macroeconomics:
•
•

“Laissez-Faire”: government should intervene in economic
affairs as little as possible.
Advocated government intervention to bring an end to the
Great Depression.
Focused on boosting demand for output, not flexible prices.
These two views continue to shape policy debates.
11-23
Keynes’ Critique of Say’s Law:
S≠I

Savings and investment are not equalized by interest
rates:
•
•
Saving is not affected by interest rates. People save for future
purchases and based on income.
Businesses invest when expect demand for product. In
recession, why expand even if interest rates are low?

If S > I, not everything being produced would be
purchased.

Supply does not create its own Demand.
11-24
Keynes’ Critique of Says Law:
Prices and Wages are not Flexible

Prices are not downwardly flexible, even in a
recession.
•
•

Wages are not downwardly flexible, even in a
recession.
•
•

Big firms in concentrated industries (oligopolies) can wait out
recession without lowering prices.
They would rather temporarily reduce output.
Labor unions with long-term contracts resist wage cuts.
Lowering wages not ideal way to increase inflation because
it reduces income.
If prices and wages are not flexible, Supply does not
create its own Demand.
11-25
Keynesian View of Macroeconomic
Equilibrium

Economy was not always at, or tending toward, a full
employment equilibrium.

Three equilibriums are possible:
•
•
•

Below full employment
At full employment
Above full employment
Famous quote: “In the Long Run, we are all dead.”
•
Don’t wait for the economy to fix itself, even if it could.
11-26
Modified Keynesian Aggregate Supply
Curve
1.
2.
3.
During recession, output can
be increased without raising
prices (flat part of curve).
As approach full employment
($6 trillion), prices begin to
increase (upward sloping part
of curve).
At full employment level of
GDP, L-RAS is vertical.
Output cannot be expanded,
but price level can increase.
11-27
Keynesianism is Demand-Side Economics

Keynes stood Say’s Law on its head:
•
•

Can be summarized as, “Demand creates its own Supply.”
Business firms produce only the quantity of goods and
services they believe consumers (C), investors (I),
governments (G), and foreigners (X) will plan to buy.
Aggregate Demand is the prime mover of the
economy.
•
•
If you can expand C, I, G, and/or X (demand for goods and
services), businesses will sell surplus and continue to expand.
Level of GDP depends upon planned expenditures.
11-28
Three Possible Equilibriums
Expanding
output beyond
full
employment is
inflationary.
AD1
represents
aggregate
demand
during a
recession or
depression. It
can increase
without
inflation.
AD2 crosses
the long-run
aggregate
supply
curve at full
employment
11-29
Summary of Two Theories
Classical View
Keynesian View

Assumes flexible price


Savings depends on
interest rates
Investment depends on
interest rates
Wages flexible
Wait for Long Run







Assumes flexible demand
for output
Savings depends on
income
Investment depends on
profit expectations
Wages sticky
Fix in Short Run
Which assumptions seems more realistic to you?
11-30
Three Ranges of the Aggregate Supply
Curve

Contemporary macroeconomists
often synthesize the two
theories, suggesting that each
theory could hold true under
different economic conditions.
11-31
Part III: The Keynesian System

Keynesian Aggregate Expenditure Model puts
consumer behavior at center of analysis.
As income rises, C rises,
but not as quickly.
11-32
Equilibrium in Aggregate Expenditure Model
Note vertical axis is NOT price level.
Investment
does
not depend
on income,
so add as
fixed amount.
Equilibrium is
where AE line
crosses 45° line,
at $7 trillion.
11-33
Reaching Equilibrium

When Aggregate Demand exceeds Aggregate Supply
the economy is in disequilibrium.
•
•

When Aggregate Supply exceeds Aggregate Demand
the economy is in disequilibrium.
•
•
•

Planned inventories too low, so they are depleted.
Signals firms to boost output is increased to meet excess
demand.
Planned inventories are too high, so output is decreased.
Workers are laid off, further depressing aggregate demand as
these workers cut back on their consumption.
Eventually, inventories are sufficiently depleted and
equilibrium is restored.
Inventories send signals to firms.
11-34
Summary: How Equilibrium Is Attained

Aggregate demand (C + I) must equal the level of
production (aggregate supply) for the economy to be
in equilibrium.

When the two are not equal, aggregate supply must
adjust to bring the economy back into equilibrium.

This equilibrium does not have to be at full
employment level of GDP.
11-35
The Classical Position Summarized

Recessions are temporary because the economy is
self-correcting.
•
•

Declining investment will be pushed up again by falling
interest rates.
If consumption falls, it will be raised by falling prices and
wages.
Because recessions are self-correcting, the role of
government is to stand back and do nothing.
11-36
Keynesian Policy Prescriptions

Keynes’s position was that recessions are not
necessarily temporary.
•
•
•
•

Therefore, it is necessary for the government to intervene by
spending money.
How much money? As much money as it takes.
When the government spends more money, that’s not the
same thing as printing more money.
Generally it borrows more money and then spends it.
Keynes prescribed lowering Aggregate Demand to
bring down inflation.
•
Rather than spending money, government should reduce
spending, raise taxes, decrease money supply.
11-37
Keynesianism and the New Deal

Roosevelt's New Deal programs succeeded in
bringing about rapid economic growth 1933 to 1937.
•
•
•
•
However, Roosevelt decided to try to balance federal budget.
He raised taxes and cut government spending.
Federal Reserve sharply cut the rate of growth of the money
supply.
Output plunged and the unemployment rate soared.

Military spending during WWII brought economy out
of Great Depression.

Keynesian became the dominant macroeconomic
theory until the 1970s.
11-38
Questions for Thought and Discussion:
Keynes and Say in the 21st Century

Until the 1970s, the US was a closed economy.
•
•

Workers spent additional income on US-made goods and
services.
How has globalization changed context for Keynesian
economics?
How are the different assumptions and theories of
economists influencing current policy debates?
•
Can you find a news story that illustrates the two sides of the
discussion?
11-39