Classical and Keynesian Economics Chapter 11 Mc Graw-Hill Irwin

Classical and Keynesian Economics Chapter 11 Mc. Graw-Hill/Irwin Copyright © 2011 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Learning Objectives v 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 aggregate supply. Summarize the Keynesian critique of the classical system. Describe equilibrium and distinguish between them. Summarize and discuss the Keynesian policy prescriptions. 11 -2

Two Views of the Macroeconomy Are business cycles self-correcting? q • Do the forces of supply and demand lead a market economy toward full employment growth with price stability on its own? q Or do we need active government policies during economic downturns? q We will examine two alternative answers: • • Classical Economics Keynesian Economics 11 -3

Part I: The Classical Economic System q The centerpiece of classical economics is Say’s Law states, “Supply creates its own demand. ” • This means that somehow, what we produce—supply—all gets sold (demanded). • q 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. q Sally keeps 1 tee shirt and sells the rest to buy tomatoes, bread, butter, and shoes. q And so on… Question: What happens if Sally buys less bread and butter to save for a new sewing machine? q 11 -5

What about Saving? q The macroeconomy begins to have problems when people save part of their incomes. If some people save, then some things that are produced will not be sold. • Money is leaking out of the system. • q But, saving is important for future growth. • q 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 q q 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. • q If we think of GDP as total spending, then GDP = C + I. q 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 q q 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 q q 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 q Why does the Saving Curve slope up like a Supply Curve? • q Why does the Investment Curve slope down like a Demand Curve? • q 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 q 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. • q 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 q At $9 per hour, there is a labor surplus (unemployment). q 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. • q There was a movement along the Labor Supply Curve. • Some workers voluntarily decided not to offer their labor. 11 -13

Modeling Classical Equilibrium q Microeconomic (Market) Equilibrium: • q Macroeconomic Equilibrium • q When quantity demanded for a product equals quantity supplied. When Aggregate Demand equals Aggregate Supply. Characteristics of Macroeconomic Equilibrium for Classical Economists: Full employment of labor (no involuntary unemployment) • Full employment of resources (maxim output) • q Classical Economists maintain that market economies with flexible prices should tend toward macroeconomic equilibrium. 11 -14

The Aggregate Demand Curve q 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 q Real Balance Effect You feel poorer, so you spend less. • Purchasing power declines with inflation. • q Interest Rate Effect Rising prices push up interest rates. • Lenders need higher interest rates to compensate for eroding purchasing power of money. • q Foreign Purchases Effect • If prices rise in the US, exports decrease and imports increase, so Xn decreases. 11 -16

Aggregate Supply Curve q Aggregate Supply is the amount of real GDP that will be made available by sellers at various price levels. q 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. • q Let’s see what each one looks like… 11 -17

Long-Run Aggregate Supply Curve (LRAS) q 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 q 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 AD 1: E 1 at Full employment GDP and Price level = 140. During recession, AD decreases to AD 2: E’ at lower output ($4 trillion). Surplus inventory of $2 trillion so firms decrease prices until sell off surplus at E 2. 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 q Until the Great Depression, classical economics was the dominant school of economic thought. • q q “Laissez-Faire”: government should intervene in economic affairs as little as possible. The Great Depression undermined faith in Say’s Law. John Maynard Keynes developed alternative theory of macroeconomics: Advocated government intervention to bring an end to the Great Depression. • Focused on boosting demand for output, not flexible prices. • q These two views continue to shape policy debates. 11 -23

Keynes’ Critique of Say’s Law: S≠I q 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? • q If S > I, not everything being produced would be purchased. q Supply does not create its own Demand. 11 -24

Keynes’ Critique of Says Law: Prices and Wages are not Flexible q Prices 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. • q Wages are not downwardly flexible, even in a recession. Labor unions with long-term contracts resist wage cuts. • Lowering wages not ideal way to increase inflation because it reduces income. • q If prices and wages are not flexible, Supply does not create its own Demand. 11 -25

Keynesian View of Macroeconomic Equilibrium q Economy was not always at, or tending toward, a full employment equilibrium. q Three equilibriums are possible: Below full employment • At full employment • Above full employment • q 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 q 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. • q 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. AD 1 represents aggregate demand during a recession or depression. It can increase without inflation. AD 2 crosses the long-run aggregate supply curve at full employment 11 -29

Summary of Two Theories Classical View Keynesian View q Assumes flexible price q q Savings depends on interest rates Investment depends on interest rates Wages flexible Wait for Long Run q q q q 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 q 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 q 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 q When Aggregate Demand exceeds Aggregate Supply the economy is in disequilibrium. Planned inventories too low, so they are depleted. • Signals firms to boost output is increased to meet excess demand. • q When Aggregate Supply exceeds Aggregate Demand the economy is in disequilibrium. 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. • q Inventories send signals to firms. 11 -34

Summary: How Equilibrium Is Attained q Aggregate demand (C + I) must equal the level of production (aggregate supply) for the economy to be in equilibrium. q When the two are not equal, aggregate supply must adjust to bring the economy back into equilibrium. q This equilibrium does not have to be at full employment level of GDP. 11 -35

The Classical Position Summarized q 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. • q Because recessions are self-correcting, the role of government is to stand back and do nothing. 11 -36

Keynesian Policy Prescriptions q 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. • q 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 q 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. • q Military spending during WWII brought economy out of Great Depression. q Keynesian became the dominant macroeconomic theory until the 1970 s. 11 -38

Questions for Thought and Discussion: Keynes and Say in the 21 st Century q Until the 1970 s, the US was a closed economy. Workers spent additional income on US-made goods and services. • How has globalization changed context for Keynesian economics? • q 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