Transcript Welch & Welch - Economics: Theory and Practice

Viewpoints & Models
• Classical Economics
 Popularly accepted theory prior to the
Great Depression of the 1930s.
 Says the economy will automatically adjust
to full employment.
• Classical economists assume that:
– Supply creates its own demand
(Say’s Law)
– Wages and prices are flexible
– Savings always equals investment,
Viewpoints & Models
• Classical Economics (cont.)
FIGURE 9-1
Aggregate Supply and Aggregate Demand in Classical Economics
Viewpoints & Models
• Keynesian Economics
 John Maynard Keynes,
 aggregate spending helps determine the level of
macroeconomic activity.
 Macroeconomy seeks an equilibrium output level.
• Macroeconomic Equilibrium
– Amount of total planned spending on new goods
and services equals total output in the economy.
 If aggregate spending > current production, then
output, employment, and income will all increase.
• Inventories
– Stocks of goods on hand.
– Allows for spending to exceed current
production.
http://www.youtube.com/watch?v=dOnERTFo-Sk
http://www.youtube.com/watch?v=d0nERTFo-Sk
Total
Output
Total Spending
$0.00
0.75
0.50
0.50
1.00
1.25
1.50
1.50
2.00
1.75
2.50
3.00
Injections –
Leakages
-0.50
2.25
Economic
Condition
Total
Output
Total Spending
Injections –
Leakages
Economic
Condition
$0.00
0.75
0.75
Expansion
0.50
1.00
0.50
Expansion
1.00
1.25
0.25
Expansion
1.50
1.50
0.00
Equilibrium
2.00
1.75
-0.25
Contraction
2.50
2.00
-0.50
Contraction
3.00
2.25
-0.75
Contraction
Viewpoints & Models
• Keynesian Economics (cont.)
TABLE 9-1
Total Output and Total Planned Spending (Trillions of Dollars)
3.00
2.50
2.00
1.50
1.00
0.50
0
1.00
2.00
3.00
Planned consumption
(trillions of $)
45º line
12
Saving
C
9
Dis-saving
6
3
45º
3
6
9
12
Real disposable
income
(trillions of dollars)
Savings
Consumption
Viewpoints & Models
• Keynesian Economics (cont.)
FIGURE 9-2
Equilibrium in the Macroeconomy
Viewpoints & Models
• Keynesian Economics (cont.)
 Use government expenditures and taxes to
control the level of economic activity.
• A recession could be counteracted by
increasing aggregate spending through:
– Increasing government expenditures on
goods and services
– Increasing transfer payments
– Lowering taxes
Viewpoints & Models
• Keynesian Economics (cont.)
FIGURE 9-3
Changes in Macroeconomic Equilibrium
Viewpoints & Models
• New Classical Economics
 Return to the basic classical premise that free
markets automatically stabilize themselves and that
government intervention in the macroeconomy is not
advisable.
 Brought about by what some argued to be holes in
Keynesian economics principles, which could not
explain or remedy some problems of the 1970s.
• Stagflation
– Occurs when an economy experiences high rates of both
inflation and unemployment.
 More sophisticated explanations of aggregate demand
and aggregate supply.
Viewpoints & Models
• New Classical Economics (cont.)
 Downward-sloping aggregate demand curve was
explained through:
• Interest Rate Effect
– Interest rate moves with changes in overall prices.
– An inverse relationship exists between the interest rate
and the amount people borrow and spend.
• Wealth Effect
– In order to maintain the same amount of accumulated
wealth, people spend less when prices rise and more
when prices fall.
• Foreign Trade Effect
– A direct relationship exists between changes in overall
prices in an economy and spending on imports that
diverts spending from domestically produced output.
Viewpoints & Models
• New Classical Economics (cont.)
Aggregate Demand in the New Classical Model
Viewpoints & Models
• New Classical Economics (cont.)
 Aggregate supply curve could be viewed in two ways:
• Short-run supply with three phases
– At low levels of output, the aggregate supply curve is
perfectly horizontal.
– As output increases beyond a certain point, a direct
relationship between prices and output is established.
– At high levels of output, the aggregate supply curve
becomes perfectly vertical.
• Long-run supply
– Perfectly vertical at the natural rate of unemployment,
the point to which the economy will move.
Viewpoints & Models
• New Classical Economics (cont.)
FIGURE 9-5
Aggregate Supply in the New Classical Model
Viewpoints & Models
• New Classical Economics (cont.)
 Long Run Policy Implications
• Natural Rate Hypothesis
– Over the long run, unemployment will tend toward its
natural rate, and policies to reduce unemployment below
that level will be ineffective.
• Adaptive Expectations
– Households and businesses base their expectations of
the future on past and current experiences.
• Rational Expectations
– Households and businesses base their expectations of
future policies on how they think they will be affected
by these policies.
Viewpoints
& Models
• New Keynesian Economics
 Builds on the Keynesian view that the economy does
not automatically return to full employment.
 Regards prices and wages as inflexible (or “sticky”)
downward rather than flexible as other schools
believe.
• Monetarism
 School of thought that favors stabilizing the economy
through controlling the money supply.
• Supply-Side Economics
 Policies to achieve macroeconomic goals by stimulating
the supply side of the market.
 Became popular in the 1980s.
Inflation & Unemployment
• Phillips Curve
 Curve showing the relationship between an economy’s
unemployment and inflation rates.
FIGURE 9-6
A Phillips Curve (Hypothetical Data)
Inflation & Unemployment
• Phillips Curve (cont.)
FIGURE 9-7
Annual Rates of Unemployment and Inflation in the United States
for 1960–2000 and Representative Phillips Curves
Inflation & Unemployment
• Phillips Curve (cont.)
 Three factors may help to explain shifts in the Phillips
curve:
• Structural changes in the labor force
– 1970s: Increase in the labor force participation rates
of women and teenagers who, at the time, had higher
unemployment rates than men.
– 1980s & 1990s: Rate of unemployment for women fell,
the movement of teenagers into the market reversed
itself, and an increase in the rate of involuntary parttime employment.
• Cost-push inflation
– 1970s & 1980s: Brought about by energy price
increases.
• Eligibility for government transfer payments
– Availability of transfer payments increases
unemployment, and vice versa.
Macroeconomic Viewpoints Summary
• Viewpoints Summary
 No theory is designed to explain all the complex
relationships among the players and institutions of a
macroeconomy.
 The economy is not composed of a set of simple
relationships that can be easily manipulated to neatly
solve various problems as they arise.
 Assessing economic theories would be easier if we
lived in closed economies.
• Closed Economies
– Economy where foreign influences have no effect on
output, employment, and prices.
• Open Economies
– Economy where foreign influences have an effect on
output, employment, and prices.
1.
a.
b.
c.
d.
The equilibrium level of output is:
$1 trillion.
$4 trillion.
$6 trillion.
none of the above.
2.
Injections into the spending
stream exceed leakages from the
spending stream by approximately
$0.5 trillion at an output level of:
a.
$1 trillion.
b.
$2 trillion.
c.
$6 trillion.
d.
none of the above.
3.
The classical economists believed changes in wages and
prices would help to ensure that the economy would operate at
full employment.
4.
The classical economists thought that supply creates
its own demand and investment spending always equals
saving.
5.
In the Keynesian model, total spending in the
economy will be less than total output if leakages from the
spending stream are less than injections.
6.
In the Keynesian model, if leakages from the
spending stream are greater than injections, total output
will decrease.
7.
In the new classical model, aggregate supply is upward
sloping in the short run, and perfectly vertical at the natural
rate of unemployment in the long run.