Transcript Keynesian Theory

Classical vs. Keynesian
One more thing???? Which is best?
Bottom line difference!
•
Classical Believes: Markets will behave
according to S&D. Leave alone and they
self-correct. Prices and wages are
flexible. Supply creates demand
•
Keynesian Believes: Prices and wages
sticky. Need government injection to
increase consumption. Only works on
AD. AS is stationary
The Classical Model (cont'd)

Classical economists—Adam Smith, J.B.
Say, David Ricardo, John Stuart Mill,
Thomas Malthus, A.C. Pigou, and
others—wrote from the 1770s to the
1930s.

They assumed wages and prices were
flexible, and that competitive markets
existed throughout the economy.
In other words. S&D will respond
accordingly to “Inflationary Gap,
Recessionary Gap, and long run stability
when all curves intersect.
Classical economists believe in Say’s Law
SAY’S LAW- Supply creates its own
demand
Economists agree Says law works in Barter
economy and disagree about if it works
in a money economy.
Baker bakes enough bread to trade for
what he wants.
That works. As long as one has a double
coincidence of wants.
Classical economics believes it works in
money economy and here is why.
The Classical Model (cont'd)

Assumptions of the classical model
• Competition exists.
• Wages and prices are flexible.
• People are motivated by self-interest.
• People cannot be fooled by money illusion.
• Money supply is fixed.
The Classical Model

Consequences of The Assumptions
• If the role of government in the economy is
minimal,
• If pure competition prevails, and all prices and
wages are flexible,
• If people are self-interested, and do not
experience money illusion,
• Then problems in the macroeconomy will be
temporary and the market will correct itself.
Classical Theory
Classical economists believed that prices, wages
and interest rates are flexible.
Say’s law says when economy produces a certain
level of real GDP, it also generates the
income needed to purchase that level of real
GDP.) hence, always capable of achieving
the natural level of GDP.
Fallacy here: no guarantee that the income
received will be used to purchase g & s.---some will be saved.
But theory would be redeemed, if the savings goes into
equal needed amounts of investment.
Classical belief on wages and prices

Believed all markets competitive- (S&D *
Key) – adjust to surplus and shortage….
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If oversupply of labor, wage rates drop
and S&D of labor will be in sync.
This also applies to prices.
Prices adjust quickly to surplus or
shortages.
Equilibrium established again. (amount
supplied = amount demanded)
Three States of the Economy.
This applies to Classical and
Keynesian
Real GDP is less than Natural Real GDP
(recessionary gap)
2.
Real GDP is more than Natural Real GDP
(inflationary gap)
3.
Real GDP is equal to Natural Real GDP.
What is Natural Real GDP?
Real GDP that is produced at the natural
unemployment rate. (which we agree around
5%)
1.
Key: Wage rates and prices will
adjust quickly to surplus or
shortage-classical view
In recession- unemployment rate higher than
natural rate.
2)
Surplus exists in labor market
3)
Drives down wage rate
++++++++++++++
4) In inflationary gap, unemployment lower than
natural rate
5) Shortage exists in labor market
6) Drives up the wage rate
1)
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Lower wage rate –firms hire more
workers
SRAS shifts to right until recessionary
gap is gone.
BOTH THEORIES CLASSICAL AND
KEYNESIAN DO AGREE……
TWO THINGS WE CAN DO WITH
DISPOSABLE INCOMESPEND OR SAVE!
We all know that consumption is 2/3 (or
more) of GDP
***Classical theorists say, the funds from
aggregate savings eventually borrowed and
turned into investment expenditures which are
a component of real GDP
BUT…. What if no or low savings?
Theory breaks down here – have to have equal
amounts of investment for savings.
(the idea here is that savings leads to investment)
This is true… but it probably won’t do it by
itself. Needs assistance through monetary or
perhaps fiscal policy.
The Classical View of the Credit
Market
In classical theory, the interest
rate is flexible and adjusts so
that saving equals investment.
If saving increases and the
saving curve shifts rightward
the increase in saving
eventually puts pressure on the
interest rate and moves it
downward.
A new equilibrium is
established where once again
the amount households save
equals the amount firms invest.
Long-run Equilibrium
The condition where the
Real GDP the economy is
producing is equal to the
Natural Real GDP and
the unemployment rate
is equal to the natural
unemployment rate.
Recessionary (Contractionary) Gap
The condition where the
Real GDP the economy is
producing is less than the
Natural Real GDP and
the unemployment rate is
greater than the natural
unemployment rate.
Recessionary (Contractionary) Gap
The economy is currently in
short-run equilibrium at a
Real GDP level of Q1.
QN is Natural Real GDP or
the potential output of the
economy.
Notice that Q1< QN. When
this condition (Q1< QN) exists,
the economy is said to be in a
recessionary gap.
Inflationary (Expansionary) Gap
The condition where the
Real GDP the economy is
producing is greater than
the Natural Real GDP
and the unemployment
rate is less than the
natural unemployment
rate.
Inflationary (Expansionary) Gap
The economy is currently
in short-run equilibrium at a
Real GDP level of Q1.
QN is Natural Real GDP or
the potential output of the
economy.
Notice that Q1>QN. When
this condition (Q1>QN) exists,
the economy is said to be in
an inflationary gap.
Economy and Labor Market
Self Regulating Economy
Closing the Inflationary (Expansionary) Gap
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The economy is at P1 and
Real GDP of $11 trillion.
Because Real GDP is
greater than Natural Real
GDP ($10 trillion), the
economy is in an
inflationary gap and the
unemployment rate is
lower than the natural
unemployment rate.
Self Regulating Economy
Closing the Inflationary (Expansionary) Gap
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Wage rates rise, and the
short-run aggregate supply
curve shifts from SRAS1 to
SRAS2.
As the price level rises, the
real balance, interest rate,
and international trade
effects decrease the quantity
demanded of Real GDP.
Ultimately, the economy
moves into long-run
equilibrium at point 2.
Policy Implication
Laissez-faire
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Classical, new classical, and monetarist economists
believe that the economy is self-regulating. For these
economists, full employment is the norm: The
economy always moves back to Natural Real GDP.
Laissez-faire
A public policy of not interfering
with market activities in the economy.
How would it automatically adjust? Classical
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Slump in output yields….
Lower prices
This increases consumer
spending.
Lower wages - eventually will occur… with lower prices
Lower interest rate
Increases investment
spending Increases employment
Excesses of supply of goods and workers would be
eliminated and return to a balanced full-employment
status.
*Production of output automatically provides the income
needed to buy the output.
This theory was prevalent until Depression of 30’s hit.
Then what happened?
25% unemployment
Banks closed
Production ceased
Drought hit
Stocks worthless
No money for purchases
No jobs
Bleak!
AS 1
AD 1
AD
P
R
I
C
E
L
E
V
E
L
GDP
AS
Bottom Line
Classical viewpointnot possible to overproduce goods
because the production of those goods
would always generate a demand that
was sufficient to purchase the goods.
(what would they say
about the recent inventories of our auto
industry?)

Keynesian Ideas
The classical approach fell into disrepute during
the economic decline of the 30’s. Real GDP
fell by more than 30% 1930-33
In 1939- per capital income was still 10% less
than in 1929.
*U.S. began to embrace John Maynard Keynes’s
theory of stimulating the economy through
aggregate demand (Lord Keynes) had studied
classical economics and wrote his famous
General Theory of Employment, Interest and
Money. (which was a complete rebuttal of the
classical theory)
Keynesian in a Nutshell
Keynes’s View of Say’s Law
in a Money Economy
According to Keynes, a
decrease in consumption
and subsequent increase in
saving may not be matched
by an equal increase in
investment. Thus, a decrease
in total expenditures may
occur.
To learn more about
John Maynard Keynes,
click his photo above.
John Maynard Keynes and the
Great Depression
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Classical Economics:
In a recession,
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Wages will fall (more
will be hired)
Prices will fall (more
will be bought)
The economy selfregulates, and
Moves back to fullemployment GDP
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Keynes’ criticism:
In a recession,
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Wages would not fall.
Prices would not fall.
Self-regulation could
not occur.
The economy could
get “stuck” with high
unemployment.
Keynes’ Prescription
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For an economy “stuck” at a high
unemployment equilibrium,
• Self-regulation was not working.
• A “jumpstart” was needed:
• An injection of new spending to get the
economy moving again.
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The only spender who could do this was
Government.
Keynesian Economics
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Works only on the AD curve
Assumes AS is stationary
Critics of Keynes:
• …But this will cause deficits!
• …But the government can’t spend that much!
The Economy Gets “Stuck” in a
Recessionary Gap
If the economy is
in a recessionary
gap at point 1,
Keynes held that
wage rates may
not fall.
The economy
may be stuck in
the recessionary
gap.
Keynesian Economics and the Keynesian
Short-Run Aggregate Supply Curve (cont'd)

Real GDP and the price level, 1934–1940
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Keynes argued that in a depressed economy,
increased aggregate spending can increase output
without raising prices.
Data showing the U.S. recovery from the Great
Depression seem to bear this out.
In such circumstances, real GDP is demand driven.
Keynesian Economics was the answer to
Classical economic theories and the suggested
way to “jump-start” the economy again… pull
out of the depression.
Idea: Government enters the economy.
Stimulates the economy through Aggregate
Demand.
Fiscal policy would move the production engine
by stimulating “spending.”
increased employment, jobs would be filled,
production would begin
people would purchase with money they earned
from jobs.
Classical vs. Keynes I
A Question of How Long It Takes for
Wage Rates and Prices to Fall
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Suppose the economy is
in a recessionary gap at
point 1.
Wage rates are $10 per
hour, and the price level
is P1.
The issue may not be
whether wage rates and
the price level fall, but
how long they take to
reach long-run levels
The speed at which wage rate falls is a key
To whether Keynesian or Classical theory
Is more valid. Answers never for sure.
Keynes rejected the classical notion of selfadjustment, (????) and he predicted things
would get worse once a spending shortfall
emerged.
Example:
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Business expectations of future sales worsens.
Business investment is cut back.
Unsold capital goods begins to pile up (includes office
equip. machinery, airplanes, etc.)
*this is an “undesired” change…
Worsened sales expectations causes decline in
investment spending that shifts the AD curve to the left
leading to pileups of unwanted inventory.
Example: Are the U.S. and European
SRAS Curves Horizontal?
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New Keynesians contend that the SRAS is
essentially flat.
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Based on research, they contend SRAS is
horizontal because firms adjust their prices
about once a year.
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If the SRAS schedule were really horizontal,
how could the price level ever increase?
Keynesian Theory
P
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AD 1
AD 2
AD 3 *Price
Goes up
L
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AS
Real GDP Output
Keynesian Theory
AD unstable, prices and wages are inflexible AD no effect on prices until LRAS
Figure 11-9 Real GDP Determination
with Fixed versus Flexible Prices
Table 11-2 Determinants of
Aggregate Supply
Consequences of Changes in
Aggregate Demand

Aggregate Demand Shock
• Any event that causes the aggregate demand
curve to shift inward or outward

Aggregate Supply Shock
• Any event that causes the aggregate supply
curve to shift inward or outward
So--- which is best? ????
Classical prefers to move the AS.
Keynesian prefers to move the AD
Both have good points, and neither is
perfect.
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