chapter 11 classical and keynesian economics 11-1 copyright 2002 by the mcgraw-hill companies, inc....
TRANSCRIPT
Chapter 11
Classical and Keynesian Economics
11-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• Say’s law
• Classical equilibrium
• Real balance, interest rate, and foreign exchange effects
• Aggregate demand
• Aggregate supply in the long run and short run
11-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• The Keynesian critique of the classical system
• Equilibrium at varying price levels
• Disequilibrium and equilibrium
• Keynesian policy prescriptions
11-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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
11-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Why Does Anybody Work?• People work because they want money to buy
things– People who produce things are paid. They spend
this money on what other people produce
– As long as everyone spends everything that he or she earns, the economy is OK
• But, the economy begins to have problems when people save part of their incomes
– People do save, and saving is crucial to economic growth
• Without saving, we could not have investment – the production of plant, equipment, and inventory
11-5Copyright 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 C
• The money spent on investment goods is designated by the letter I
Consumer Goods and Investment Goods
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11-7
Consumer Goods and Investment Goods
If we think of GDP as total spending, then
GDP would be C + I
If we think of GDP as income received, then
GDP would be C + S
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11-8
Consumer Goods and Investment Goods
(Continued)
If we think of GDP as total spending, then
GDP would be C + I
If we think of GDP as income received, then
GDP would be C + S
GDP = C + I
GDP = C + S
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-9
Consumer Goods and Investment Goods
(Continued)
GDP = C + I
GDP = C + S
And since things equal to the same thing are equal to each other, we have
C + I = C + S
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11-10
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 Next, we can subtract the same thing from both sides
of the equation. In this case we subtract C
I = S
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Say’s Law Revisited
11-11
HouseholdsHouseholds
Firms
7.0The economy produces a supply of consumer goods and investment goods (Aggregate Supply = AS)
AS
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Say’s Law Revisited
11-12
HouseholdsHouseholds
Firms
7.0AS=
The people who produce these goods (Households) spend part of their incomes on consumer goods
C=6.5
They save the restS=0.5
Their savings are borrowed by investors who spend this money on investment goods
I=0.5
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Say’s Law Revisited
11-13
HouseholdsHouseholds
Firms
7.0AS= C=6.5
S=0.5
I=0.5
GDP = C + IGDP = 6.5 + 0.5GDP = 7.0
GDP = 7.0 = Aggregate Demand (AD)
I = S
We 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 Revisited
11-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Quantity
10
9
8
7
6D
S
2 4 6 8 10 12 14
The curves cross at a price of $7.30 and a quantity of 6
Supply and Demand Revisited
11-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Quantity of loanable funds
20
15
10
5
0
Supply ofsavings
Demand forinvestment
funds
The Loanable Funds Market
The demand and supply curves cross at an interest rate of 15 percent
Supply and Demand Revisited
11-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14
12
10
8
6
4
2
0
S
D
Quantity
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 Revisited
11-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Quantity of labor
20
18
16
14
12
10
8
6
4
2
0
Supplyoflabor
Demandfor labor
Hypothetical Labor Market
If 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 supplied
The Classical Equilibrium: Aggregate Demand Equals Aggregate Supply• On the micro level, when quantity demanded
equals quantity supplied, we’re at equilibrium• On the macro level, when aggregate demand
equals aggregate supply, we’re at equilibrium• The classical economist believed our economy
was either at, or tending toward , full employment
• So at classical equilibrium – the GDP at which aggregate demand was equal to aggregate supply – we were at full employment
11-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Aggregate Demand Curve
Aggregate demand is the total value of real GDP that all sectors of the economy are willing to purchase at various price levels
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Real GDP (in trillions of dollars)
180
160
140
120
100
80
60
40
20
0
Aggregatedemand
0 1 2 3 4 5 6 7 8 9 10
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 down
• There are three reasons why the quantity of goods and services purchased declines as the price level increases– An increase in the price level reduces the
wealth of people holding money, making them feel poorer and reducing their purchases
• This is called the real balance effect
11-20
The Aggregate Demand Curve
Copyright 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 houses– This is called the interest rate effect
11-21
The Aggregate Demand Curve
Copyright 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 level– This is called the foreign purchases effect
11-22
The Aggregate Demand Curve
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Real Balance Effect• The real balance effect is the influence of
a change in your purchasing power on the quantity of real GDP that you are willing to buy– A decrease in the price level increases the
quantity of real money• The larger the quantity of real money, the larger
the quantity of goods and services demanded
– An increase in the price level decreases the quantity of real money
• The smaller the quantity of real money, the smaller the quantity of goods and services demanded
11-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Interest Rate Effect
• A 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 equipment– A rising price level pushes up interest rates
and lowers both consumption and investment
– A declining price level pushes down interest rates and encourages both consumption and investment
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The Foreign Purchases Effect
• When the price level in the United States rises relative to the price levels in other countries– American goods become more expensive relative to
foreign goods• American imports rise (foreign goods are cheaper)
• American exports decline (American goods are more expensive)
• Thus, American net exports (exports minus imports) component of GDP declines
• When the price level declines, the net exports component (and GDP) rises
11-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Long-Run Aggregate Supply Curve
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180
160
140
120
100
80
60
40
20
0
L-RAS
Real GDP (trillions of dollars)0 1 2 3 4 5 6 7 8 9 10
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 prices
Aggregate Demand and Long-Run Aggregate Supply
11-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
180
160
140
120
100
80
60
40
20
0
Aggregatedemand
L-RAS
Real GDP (trillions of dollars)0 1 2 3 4 5 6 7 8 9 10
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 100
The Short-Run Aggregate Supply Curve
11-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
180
160
140
120
100
80
60
40
20
0
S-RAS
Full-employment GDP
Real GDP (in trillions of dollars)
0 1 2 3 4 5 6 7 8 9 10
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 rise
Aggregate Demand, Long-Run and Short-Run Aggregate Supply
11-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
180
160
140
120
100
80
60
40
20
0
Aggregatedemand
L-RAS
S-RAS
Real GDP (in trillions of dollars)0 1 2 3 4 5 6 7 8 9 10
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 thought– Adam smith, credited by many as the founder of
classical economics believed the government should intervene in economic affairs as little as possible
• John 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 Depression
11-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Keynesian Critique of the Classical System
• Keynes asked the question. “What if savings and investment were not equal?”– If savings were greater than investment,
there would be unemployment– Not everything being produced would be
purchased
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The Keynesian Critique of the Classical System
– Keynes disputed the view that the interest rate would equilibrate savings & investment
– Keynes maintained that• Saving and investment are done by different people for
different reasons
• Most saving is done by individuals for big ticket items
• Investing is done by those who run a business and are trying to make a profit
• They will invest only when there is a reasonably good profit outlook
• Even when interest rates are low, business firms won’t invest unless it is profitable for them to do so
11-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Keynesian Critique of the Classical System
– Keynes questioned whether wages and prices were downwardly flexible, even during a severe recession
– Studies have indicated that prices are seldom lowered and that wage cuts (even as the only alternative to massive layoffs) are seldom accepted
– Keynes pointed out that even if wages were lowered, this would lower worker’s incomes, consequently lowering their spending on consumer goods
11-33Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Keynesian Critique of the Classical System
– Keynes concluded that the economy was not always at, or tending toward a full employment equilibrium
– Keynes believed three possible equilibriums existed
• Below full employment
• At full employment
• Above full employment
11-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-35
The Keynesian Critique of the Classical System
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
180
160
140
120
100
80
60
40
20
0
L-RAS
Real GDP (in trillions of dollars)0 1 2 3 4 5 6 7 8 9 10
Modified Keynesian Aggregate Supply Curve
As an economy works its way out of a depression, output can be raised without raising prices, so the aggregate supply curve is flat.
11-36
The Keynesian Critique of the Classical System
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
180
160
140
120
100
80
60
40
20
0
L-RAS
Real GDP (in trillions of dollars)0 1 2 3 4 5 6 7 8 9 10
Modified Keynesian Aggregate Supply Curve
However, 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.
11-37
The Keynesian Critique of the Classical System
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
180
160
140
120
100
80
60
40
20
0
L-RAS
Real GDP (in trillions of dollars)0 1 2 3 4 5 6 7 8 9 10
Modified Keynesian Aggregate Supply Curve
When we reach full employment (at a real GDP of $6 trillion), output cannot be raised any further
11-38
The Keynesian Critique of the Classical System
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
180
160
140
120
100
80
60
40
20
0
L-RAS
AD1 AD2
AD3
Real GDP (in trillions of dollars)0 1 2 3 4 5 6 7 8 9 10
Three Aggregate Curves
AD1 represents aggregate demand during a recession or depression
AD2 crosses the long-run aggregate supply curve at full employment
AD3 represents excessive demand
The Keynesian System
• Keynes stood Say’s law on its head• Keynesian theory can be summarized
with the statement, “ Demand creates its on supply” – Keynes maintained that aggregate demand is
the prime mover of the economy• Aggregate demand determines the level of output
and employment• Business firms produce only the quantity of
goods and services they believe consumers, investors, governments, and foreigners will plan to buy
11-39Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Real GDP
Keynesianrange
Aggregatesupply
The Ranges of the Aggregate Supply Curve
The Keynesian Aggregate Expenditure Model
11-41
The Consumption and Saving Functions
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Disposable income (in trillions of dollars)
Saving
Dissaving
00
1
1
2
2
3
3
4
4
5
5
6
6
7
7
8
8
9
9
10
C
When consumption (C) is greater than disposable income (DI), savings is negative
When disposable (DI) income is greater than consumption (C), savings is positive
The Keynesian Aggregate Expenditure Model
11-42
The Investment Sector
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C + I
45û
Real GDP (in trillions of dollars)0 1 2 3 4 5 6 7 8 9 10
0
1
2
3
4
5
6
7
8
9
C
Real GDP (in trillions of dollars)
When C + I represents aggregate demand, how much is equilibrium GDP
Answer: Approximately $7.0 trillion
Aggregate Demand Exceeds Aggregate Supply
• When aggregate demand exceeds aggregate supply the economy is in disequilibrium– Output is increased in response– Eventually, the economy approaches full capacity
followed by price increases
• It appears that there are two ways to raise aggregate supply– By increasing output– By increasing prices
• By doing this, aggregate supply is raised relative to aggregate demand and equilibrium is restored
11-43Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Aggregate Supply Exceeds Aggregate Demand
• When aggregate supply exceeds aggregate demand the economy is in disequilibrium– Inventories rise and output is decreased
– Workers are laid off, further depressing aggregate demand as these workers cut back on their consumption
– Eventually, inventories are sufficiently depleted
• In the meantime, aggregate supply has fallen back into equilibrium with aggregate demand
11-44Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Summary: How Equilibrium Is Attained
• When the economy is in disequilibrium, it automatically moves back into equilibrium
• It is always aggregate supply that adjust– When aggregate demand is greater than
aggregate supply, aggregate supply rises– When aggregate supply is greater than
aggregate demand, aggregate supply declines
11-45Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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
11-46Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Keynesian Policy Prescriptions
• 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
11-47Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Keynesian Policy Prescriptions• Keynes’s position was that recessions are not
necessarily temporary– The self-correcting mechanisms of falling interest
rates and falling prices and wages might be insufficient to push investment and consumption back up again
– 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 would have prescribed lowering aggregate demand to bring down inflation
11-48Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.