chapter 11b -- keynes vs classical, updated sept 12 2015 (1)

8/18/2019 Chapter 11b -- Keynes vs Classical, Updated Sept 12 2015 (1)

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Classical and

KeynesianEconomicsChapter 11

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc !ll rights reser"e#


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Learning Objectives

After this chapter you should be able to :1. Discuss Say’s law.2. Analyze Classical equilibrium.

. !"plain and discuss the real balance# interest rate# and forei$n

purchases effects.%. Demonstrate the interaction between a$$re$ate demand and

a$$re$ate supply.&. Summarize the 'eynesian critique of the classical system.(. Describe equilibrium and disequilibrium and distin$uish

between them.). Summarize and discuss the 'eynesian policy prescriptions.


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Two iews o! the "acroeconomy

Are business cycles self*correctin$+, Do the forces of supply and demand lead a mar-eteconomy toward full employment $rowth with pricestability on its own+

r do we need acti/e $o/ernment policies durin$economic downturns+

0e will e"amine two alternati/e answers:, Classical Economics, Keynesian Economics


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11-#

$art %& The Classical Economic 'ystem

he centerpiece of classical economics is 'ay(s Law ., Say’s aw states# 3 Supply creates its own demand.” , his means that somehow# what we produce4supply4all $ets

sold 5demanded6.

0hy+, 0hen a seller sells a product 5includin$ his7her own labor6#

she7he earns income., his income is used to purchase other $oods and ser/ices., So# sellin$ one product creates demand for another# until all

the income is 3used up.8, 9f all the income is spent# all the $oods and ser/ices will besold.


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*hat abo+t 'aving,

he macroeconomy be$ins to ha/e problems whenpeople sa/e part of their incomes., 9f some people sa/e# then some thin$s that are produced will

not be sold., oney is lea-in$ out of the system.

;ut# sa/in$ is important for future $rowth., 0ithout saving # we could not ha/e investment 4the

production of plant# equipment# and in/entory.


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Start with =ust the pri/ate sector 5no $o/ernment orforei$n trade6.

All production 5Supply6 consists of:, Consumer $oods 5C6.

, 9n/estment $oods 596., >o ? or @ n.

9f we thin- of ?D as total spending # then

?D B C 9.9f we thin- of ?D as income received # then

?D B C S.

Cons+mer .oods and %nvestment .oods


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Cons+mer .oods and %nvestment .oods0contin+ed

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:

9 B S

C + I = C+ S

ou are left with:S lea-s out# but is9n=ected bac- in as 9.


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Supply and Demand Ee/isited

Find equilibrium price: Appro". G).2HFind equilibrium quantity: (

Classical economists applied this process to financial mar-etsto pro/e that 9 B S.


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The Loanable 4+nds "ar5et

Sa/in$ supplies ban-sand financial institutionswith loanable funds.;usinesses borrow5demand6 funds for

9n/estment.9nterest rate is the price ofloanable fundsI they arefle"ible.!quilibrium interest rate is1&J.


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6+estions !or Tho+ght and 7isc+ssion

0hy does the Sa/in$ Cur/e slope up li-e a SupplyCur/e+

, 0hen would you be more li-ely to put money in your sa/in$saccount: when interest rates are hi$h or low+ 5


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%n Classical "acroeconomics89nemployment is Temporary

abor mar-ets are no different than any other mar-ets#under Say’s aw.

, Knemployment is due to labor surplus5Luantity supplied M Luantity demanded6.

, ower price of labor 5wa$e6# until abor Supply equals aborDemand.

Conclusion: >o in/oluntary unemployment. , >eed a =ob+ 0or- cheaperN, Anyone who isn’t wor-in$ has decided not to wor- at the

equilibrium wa$e.


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:ypothetical Labor "ar5et

At GO per hour# there is a laborsurplus 5unemployment6.

At G) per hour:, !/eryone who wants to wor-

at that rate can find a =ob., !/ery employer willin$ to hire

wor-ers at that rate can findas many wor-ers as s7hewants to hire.

here was a mo/ement alon$the abor Supply Cur/e.

, Some wor-ers /oluntarilydecided not to offer theirlabor.


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"odeling Classical E;+ilibri+m

icroeconomic 5 ar-et6 !quilibrium:, 0hen quantity demanded for a product equals quantity

supplied. acroeconomic !quilibrium

, 0hen A$$re$ate Demand equals A$$re$ate Supply.

Characteristics of acroeconomic !quilibrium forClassical !conomists:

, Full employment of labor 5no in/oluntary unemployment6, Full employment of resources 5ma"im output6

Classical !conomists maintain that mar-eteconomies with fle"ible prices should tend towardmacroeconomic equilibrium.


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The =ggregate 7emand C+rve

=ggregate 7emand is the total /alue of real ?D thatall sectors of the economy 5C 9 ? @ n 6 are willin$to purchase at /arious price le/els.

0hen the pricele/el increases#5inflation6# peoplepurchase less

output.


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>eal ?alance E!!ect, ou feel poorer# so you spend less., urchasin$ power declines with inflation.

%nterest >ate E!!ect, Eisin$ prices push up interest rates., enders need hi$her interest rates to compensate for erodin$

purchasin$ power of money.

4oreign $+rchases E!!ect, 9f prices rise in the KS# e"ports decrease and imports

increase# so @ n decreases.

Three >easons why the =7 C+rve'lopes 7own


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=ggregate '+pply C+rve

=ggregate '+pply is the amount of real ?D thatwill be made a/ailable by sellers at /arious pricele/els.

A$$re$ate Supply loo-s different in the Long >+nand the 'hort >+n :

, %n the Long >+n # classical economists assume theeconomy operates at full employment 5ma"imum output6#independent of the price le/el.

, %n the 'hort >+n # businesses will increase supply if theprice le/el increases.

et’s see what each one loo-s li-eP


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Long->+n =ggregate '+pply C+rve 0L>='EAS is /ertical line at full employment le/el of ?D

5re$ardless of price le/el6.

Eeal ?D B G( trillionat e/ery point on EAS.


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Long->+n "acroeconomic E;+ilibri+m

E equilibrium ofG( trillion in real ?Dand price le/el of 1HH.

Supply Creates 9ts wn DemandN


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'hort->+n =ggregate '+pply C+rveSEAS is relati/ely flat at low le/els of output# and$radually approaches /ertical.

At low le/els of output# firms

can easily e"pand output whenprices rise.

;eyond full employment ?D #e"pandin$ production is moree"pensi/e# so firms need lar$e

price boosts to increase output.


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'hort->+n "acroeconomic E;+ilibri+m

utput may be abo/e orbelow full employment inthe SE# but should settle atfull employment ?D in E.


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Classical iew o! >ecessions

1. !conomy starts at AD 1: ! 1 atFull employment ?D and

rice le/el B 1%H.2. Durin$ recession# AD

decreases to AD 2: !’ at loweroutput 5G% trillion6.

. Surplus in/entory of G2 trillionso firms decrease prices untilsell off surplus at ! 2.

Conclusion: 9t’s a *step process mo/in$ from !1 to !’ to !2.>o $o/ernment inter/ention necessary. Fle"ible prices will pull

economy out of recession. he economy is self*ad=ustin$N


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$art %%& The Keynesian Criti;+e o! theClassical 'ystem

Kntil the ?reat Depression# classical economics wasthe dominant school of economic thou$ht.

, 3 aissez*Faire8: $o/ernment should inter/ene in economicaffairs as little as possible.

he ?reat Depression undermined faith in Say’s aw.Qohn aynard 'eynes de/eloped alternati/e theory ofmacroeconomics:

, Ad/ocated $o/ernment inter/ention to brin$ an end to the

?reat Depression., Focused on boostin$ demand for output# not fle"ible prices.

hese two /iews continue to shape policy debates.


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Keynes( Criti;+e o! 'ay(s Law& ' @ %

Sa/in$s and in/estment are not equalized by interestrates:

, Sa/in$ is not affected by interest rates. eople sa/e for futurepurchases and based on income.

, ;usiness in/ests when it e"pects demand for their product. 50hye"pand in recessions e/en if interest rates are low+ Can’t sell.6

9f S M 9# not e/erythin$ bein$ produced would bepurchased.

Supply does not create its own Demand.


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Keynes( Criti;+e o! 'ays Law&$rices and *ages are not !leAible downward

rices are not downwardly fle"ible# e/en in arecession. 5 rices are stic-y downward.6

, ;i$ firms in concentrated industries 5oli$opolies6 can wait outrecession without lowerin$ their prices.

, hey would rather temporarily reduce output.

0a$es are not downwardly fle"ible# e/en in arecession.

, abor unions with lon$*term contracts resist wa$e cuts.

9f prices and wa$es are not fle"ible downward# Supplydoes not create its own Demand.


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Keynesian iew o! "acroeconomicE;+ilibri+m

!conomy was not always at# or tendin$ toward# a fullemployment equilibrium.

hree equilibriums are possible:, Below full employment, At full employment, Above full employment

Famous quote: 39n the on$ Eun# we are all dead.8, Don’t wait for the economy to fi" itself# e/en if it could.


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"odi!ied Keynesian =ggregate '+pplyC+rve

1. Durin$ recession# output canbe increased without raisin$prices 5flat part of cur/e6.

2. As approach full employment5G( trillion6# prices be$in toincrease 5upward slopin$ partof cur/e6.

. At full employment le/el of?D # *EAS is /ertical.

utput cannot be e"panded#but price le/el can increase.


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Keynesianism is 7emand-'ide Economics

'eynes stood Say’s aw on its head: , Can be summarized as# B7emand creates its own '+pply D, ;usiness firms produce only the quantity of $oods and

ser/ices they belie/e consumers 5C6# in/estors 596#$o/ernments 5?6# and forei$ners 5@6 will plan to buy.

A$$re$ate Demand is the prime mo/er of theeconomy.

, 9f you can e"pand C# 9# ?# and7or @ 5demand for $oods and

ser/ices6# businesses will sell surplus and continue to e"pand., e/el of ?D depends upon planned eApendit+res .


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Three $ossible E;+ilibri+ms

AD1 representsa$$re$atedemanddurin$ arecession ordepression. 9tcan increasewithoutinflation.

AD2 crossesthe lon$*runa$$re$atesupplycur/e at fullemployment

!"pandin$output beyondfullemployment is

inflationary.


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'+mmary o! Two Theories

Classical iew Assumes fle"ible price

Sa/in$s depends on

interest rates9n/estment depends oninterest rates0a$es fle"ible0ait for on$ Eun

Keynesian iew Assumes fle"ible demandfor outputSa/in$s depends on

income9n/estment depends onprofit e"pectations0a$es stic-yFi" in Short Eun

0hich assumptions seems more realistic to you+


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Three >anges o! the =ggregate '+pplyC+rve

Contemporarymacroeconomists oftensynthesize the two theories#

su$$estin$ that each theorycould hold true under differenteconomic conditions.


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$art %%%& The Keynesian 'ystem'eynesian A$$re$ate !"penditure odel putsconsumer beha/ior at center of analysis.

As income rises# C rises#but not as quic-ly.


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E;+ilibri+m in =ggregate EApendit+re "odel

9n/estmentdoes

not dependon income#so add asfi"ed amount.

>ote /ertical a"is is > price le/el.

!quilibrium iswhere A! linecrosses %&R line#at G) trillion.


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>eaching E;+ilibri+m

0hen A$$re$ate Demand e"ceeds A$$re$ate Supplythe economy is in disequilibrium., lanned in/entories too low# so they are depleted., Si$nals firms to boost output is increased to meet e"cess

demand.

0hen A$$re$ate Supply e"ceeds A$$re$ate Demandthe economy is in disequilibrium.

, lanned in/entories are too hi$h# so output is decreased., 0or-ers are laid off# further depressin$ a$$re$ate demand as

these wor-ers cut bac- on their consumption., !/entually# in/entories are sufficiently depleted and

equilibrium is restored.

9n/entories send si$nals to firms.


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'+mmary& :ow E;+ilibri+m %s =ttained

A$$re$ate demand 5C 96 must equal the le/el ofproduction 5a$$re$ate supply6 for the economy to bein equilibrium.

0hen the two are not equal# a$$re$ate supply mustad=ust to brin$ the economy bac- into equilibrium.

his equilibrium does not ha/e to be at fullemployment le/el of ?D .


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The Classical $osition '+mmari ed

Eecessions are temporary because the economy isself*correctin$., Declinin$ in/estment will be pushed up a$ain by fallin$

interest rates., 9f consumption falls# it will be raised by fallin$ prices and

wa$es.

;ecause recessions are self*correctin$# the role of$o/ernment is to stand bac- and do nothin$.


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Keynesian $olicy $rescriptions

'eynes’s position was that recessions are notnecessarily temporary.

, herefore# it is necessary for the $o/ernment to inter/ene byspendin$ money.

,


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Keynesianism and the Few 7ealEoose/elt s >ew Deal pro$rams succeeded in brin$in$

about rapid economic $rowth 1O to 1O ).,

chapter 11b -- keynes vs classical, updated sept 12 2015 (1)

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