Chapter 11. Classical and Keynesian Economics

Chapter 11Classical and Keynesian Economics11-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter ObjectivesSay’s lawClassical equilibriumReal balance, interest rate, and foreign exchange effectsAggregate demandAggregate supply in the long run and short run11-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter ObjectivesThe Keynesian critique of the classical systemEquilibrium at varying price levelsDisequilibrium and equilibriumKeynesian policy prescriptions11-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Part I: The Classical Economic SystemThe centerpiece of classical economics is Say’s lawSay’s law states, “Supply creates its own demand”This means that somehow, what we produce – supply – all gets sold11-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Why Does Anybody Work?People work because they want money to buy thingsPeople who produce things are paid. They spend this money on what other people produceAs long as everyone spends everything that he or she earns, the economy is OKBut, the economy begins to have problems when people save part of their incomesPeople do save, and saving is crucial to economic growthWithout saving, we could not have investment – the production of plant, equipment, and inventory11-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Think of production as consisting of two products: consumer goods and invest-ment goods (for now, we’re ignoring government goods)The money spent on consumer goods is designated by the letter CThe money spent on investment goods is designated by the letter IConsumer Goods and Investment Goods11-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.11-7Consumer Goods and Investment GoodsIf we think of GDP as total spending, then GDP would be C + IIf we think of GDP as income received, then GDP would be C + SCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.11-8Consumer Goods and Investment Goods(Continued)If we think of GDP as total spending, then GDP would be C + IIf we think of GDP as income received, then GDP would be C + SGDP = C + IGDP = C + SCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.11-9Consumer Goods and Investment Goods(Continued)GDP = C + IGDP = C + SAnd since things equal to the same thing are equal to each other, we haveC + I = C + S Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.11-10Consumer Goods and Investment Goods(Continued)GDP = C + IGDP = C + SThings equal to the same thing are equal to each otherC + I = C + S Next, we can subtract the same thing from both sides of the equation. In this case we subtract CI = SCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Say’s Law Revisited11-11HouseholdsHouseholdsFirms7.0The economy produces a supply of consumer goods and investment goods (Aggregate Supply = AS)ASCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Say’s Law Revisited11-12HouseholdsHouseholdsFirms7.0AS=The people who produce these goods (Households) spend part of their incomes on consumer goodsC=6.5They save the restS=0.5Their savings are borrowed by investors who spend this money on investment goodsI=0.5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Say’s Law Revisited11-13HouseholdsHouseholdsFirms7.0AS=C=6.5S=0.5I=0.5GDP = C + IGDP = 6.5 + 0.5GDP = 7.0GDP = 7.0 = Aggregate Demand (AD)I = SWe can see that Say’s law holds up, at least in accordance with classical analysis. Supply does create its own demand. Everything produced is sold. (AS = GDP=AD)Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Supply and Demand Revisited11-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The curves cross at a price of $7.30 and a quantity of 6Supply and Demand Revisited11-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Loanable Funds MarketThe demand and supply curves cross at an interest rate of 15 percentSupply and Demand Revisited11-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Market for Hypothetical ProductIf the quantity supplied is greater than the quantity demanded at a certain price (in this case $8), the price will fall to the equilibrium level ($6), at which quantity demanded is equal to quantity supplied.Supply and Demand Revisited11-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Labor MarketIf the wage rate is set too high ($9 an hour),the quantity of labor supplied exceeds the quantity of labor demanded. The wage rate falls to the equilibrium level of $7; at that wage rate, the quantity of labor demanded equals the quantity suppliedThe Classical Equilibrium: Aggregate Demand Equals Aggregate SupplyOn the micro level, when quantity demanded equals quantity supplied, we’re at equilibriumOn the macro level, when aggregate demand equals aggregate supply, we’re at equilibriumThe classical economist believed our economy was either at, or tending toward , full employmentSo at classical equilibrium – the GDP at which aggregate demand was equal to aggregate supply – we were at full employment11-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Aggregate Demand CurveAggregate demand is the total value of real GDP that all sectors of the economy are willing to purchase at various price levels11-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Aggregate Demand Curve (in trillions of dollars)The level of aggregate demand varies inversely with the price level. As the price level declines, people are willing to purchase more and more output. Alternatively, as the price level rises, the quantity of output purchased goes downThere are three reasons why the quantity of goods and services purchased declines as the price level increasesAn increase in the price level reduces the wealth of people holding money, making them feel poorer and reducing their purchasesThis is called the real balance effect11-20The Aggregate Demand CurveCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The higher price level pushes up the interest rate, which leads to a reduction in the purchase of interest-sensitive goods, such as cars and housesThis is called the interest rate effect11-21The Aggregate Demand CurveCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Net exports decline as foreigners buy less from us and we buy more from them at the higher price levelThis is called the foreign purchases effect11-22The Aggregate Demand CurveCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Real Balance EffectThe real balance effect is the influence of a change in your purchasing power on the quantity of real GDP that you are willing to buyA decrease in the price level increases the quantity of real moneyThe larger the quantity of real money, the larger the quantity of goods and services demandedAn increase in the price level decreases the quantity of real moneyThe smaller the quantity of real money, the smaller the quantity of goods and services demanded11-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Interest Rate EffectA rising price level pushes up interest rates, which in turn lower the consumption of certain goods and services and also lower investment in new plant and equipmentA rising price level pushes up interest rates and lowers both consumption and investmentA declining price level pushes down interest rates and encourages both consumption and investment 11-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Foreign Purchases EffectWhen the price level in the United States rises relative to the price levels in other countriesAmerican goods become more expensive relative to foreign goodsAmerican imports rise (foreign goods are cheaper)American exports decline (American goods are more expensive)Thus, American net exports (exports minus imports) component of GDP declinesWhen the price level declines, the net exports component (and GDP) rises11-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Long-Run Aggregate Supply Curve11-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Long-Run Aggregate Supply curve (in trillions of dollars)Why is the curve a vertical line? The classical economists made two assumptions: (1) In the long run, the economy operates at full employment; (2) In the long run, output is independent of pricesAggregate Demand and Long-Run Aggregate Supply11-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Aggregate Demand and Long-Run Aggregate Supply (in trillions of dollars)The long-run equilibrium of real GDP is $6 trillion at a price level of 100The Short-Run Aggregate Supply Curve11-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Short-Run Aggregate Supply Curve (in trillions of dollars) Why does the short-run aggregate supply curve sweep upward to the right? Because business firms will supply increasing amounts of output as prices riseAggregate Demand, Long-Run and Short-Run Aggregate Supply11-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Aggregate Demand, Long-Run and Short-Run Aggregate Supply (in trillions of dollars)The long-run aggregate supply curve, the short-run aggregate supply curve, and the aggregate demand come together at full-employment The Keynesian Critique of the Classical System Until the Great Depression, classical economics was the dominant school of economic thoughtAdam smith, credited by many as the founder of classical economics believed the government should intervene in economic affairs as little as possibleJohn Maynard Keynes asked, “If supply creates its own demand, why are we having a worldwide depression?”John Maynard Keynes advocated massive government intervention to bring an end to the Great Depression11-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Keynesian Critique of the Classical SystemKeynes asked the question. “What if savings and investment were not equal?”If savings were greater than investment, there would be unemploymentNot everything being produced would be purchased11-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Keynesian Critique of the Classical SystemKeynes disputed the view that the interest rate would equilibrate savings & investmentKeynes maintained thatSaving and investment are done by different people for different reasonsMost saving is done by individuals for big ticket itemsInvesting is done by those who run a business and are trying to make a profitThey will invest only when there is a reasonably good profit outlookEven when interest rates are low, business firms won’t invest unless it is profitable for them to do so11-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Keynesian Critique of the Classical SystemKeynes questioned whether wages and prices were downwardly flexible, even during a severe recessionStudies have indicated that prices are seldom lowered and that wage cuts (even as the only alternative to massive layoffs) are seldom acceptedKeynes pointed out that even if wages were lowered, this would lower worker’s incomes, consequently lowering their spending on consumer goods11-33Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Keynesian Critique of the Classical SystemKeynes concluded that the economy was not always at, or tending toward a full employment equilibriumKeynes believed three possible equilibriums existedBelow full employmentAt full employmentAbove full employment11-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.11-35The Keynesian Critique of the Classical SystemCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Modified Keynesian Aggregate Supply CurveAs an economy works its way out of a depression, output can be raised without raising prices, so the aggregate supply curve is flat.11-36The Keynesian Critique of the Classical SystemCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Modified Keynesian Aggregate Supply CurveHowever, as resources becomes more fully employed and bottlenecks develop, costs and prices begin to rise. When this happens the aggregate supply curve begins to curve upward.11-37The Keynesian Critique of the Classical SystemCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Modified Keynesian Aggregate Supply CurveWhen we reach full employment (at a real GDP of $6 trillion), output cannot be raised any further11-38The Keynesian Critique of the Classical SystemCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Three Aggregate CurvesAD1 represents aggregate demand during a recession or depressionAD2 crosses the long-run aggregate supply curve at full employmentAD3 represents excessive demandThe Keynesian SystemKeynes stood Say’s law on its headKeynesian theory can be summarized with the statement, “ Demand creates its on supply” Keynes maintained that aggregate demand is the prime mover of the economyAggregate demand determines the level of output and employmentBusiness firms produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners will plan to buy11-39Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.11-40The Ranges of the Aggregate Supply CurveThe Keynesian Aggregate Expenditure Model11-41The Consumption and Saving FunctionsCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.When consumption (C) is greater than disposable income (DI), savings is negativeWhen disposable (DI) income is greater than consumption (C), savings is positiveThe Keynesian Aggregate Expenditure Model11-42The Investment SectorCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Real GDP (in trillions of dollars)When C + I represents aggregate demand, how much is equilibrium GDPAnswer: Approximately $7.0 trillionAggregate Demand Exceeds Aggregate SupplyWhen aggregate demand exceeds aggregate supply the economy is in disequilibriumOutput is increased in responseEventually, the economy approaches full capacity followed by price increasesIt appears that there are two ways to raise aggregate supplyBy increasing outputBy increasing pricesBy doing this, aggregate supply is raised relative to aggregate demand and equilibrium is restored11-43Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Aggregate Supply Exceeds Aggregate DemandWhen aggregate supply exceeds aggregate demand the economy is in disequilibriumInventories rise and output is decreasedWorkers are laid off, further depressing aggregate demand as these workers cut back on their consumptionEventually, inventories are sufficiently depletedIn the meantime, aggregate supply has fallen back into equilibrium with aggregate demand11-44Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Summary: How Equilibrium Is AttainedWhen the economy is in disequilibrium, it automatically moves back into equilibriumIt is always aggregate supply that adjustWhen aggregate demand is greater than aggregate supply, aggregate supply risesWhen aggregate supply is greater than aggregate demand, aggregate supply declines11-45Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Summary: How Equilibrium Is AttainedAggregate demand (C + I) must equal the level of production (aggregate supply) for the economy to be in equilibriumWhen the two are not equal, aggregate supply must adjust to bring the economy back into equilibrium11-46Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Keynesian Policy PrescriptionsThe Classical position summarizedRecessions are temporary because the economy is self-correctingDeclining investment will be pushed up again by falling interest ratesIf consumption falls, it will be raised by falling prices and wagesBecause recessions are self-correcting, the role of government is to stand back and do nothing 11-47Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Keynesian Policy PrescriptionsKeynes’s position was that recessions are not necessarily temporaryThe self-correcting mechanisms of falling interest rates and falling prices and wages might be insufficient to push investment and consumption back up againTherefore it is necessary for the government to intervene by spending moneyHow 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 would have prescribed lowering aggregate demand to bring down inflation 11-48Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.