Combined Chapters – Chapter 11 and 12 Classical vs Keynesian Consumption Function Multiplier

Chapter 11 Classical vs. Keynesian

CLASSICAL BELIEVES: Markets will behave according to S&D. In other words. S&D will respond accordingly to “Inflationary Gap, Recessionary Gap, and long run stability when all curves intersect.

SAY’S LAW Economists agree Says law works in Barter economy and disagree about if it works in a money economy. Supply creates its own demand… baker bakes enough bread to trade for what he wants. That works. Classical economics believes it works in money economy and here is why.

The Classical Model (cont'd) Assumptions of the classical model Pure competition exists. Wages and prices are flexible. People are motivated by self-interest. People cannot be fooled by money illusion. 5

The Classical Model Consequences of The Assumptions If the role of government in the economy is minimal, If pure competition prevails, and all prices and wages are flexible, If people are self-interested, and do not experience money illusion, Then problems in the macroeconomy will be temporary and the market will correct itself. 6

Classical Theory Classical economists believed that prices, wages and interest rates are flexible. Say’s law says when economy produces a certain level of real GDP, it also generates the income needed to purchase that level of real GDP.) hence, always capable of achieving the natural level of GDP. Fallacy here: no guarantee that the income received will be used to purchase g & s.- ---some will be saved. But theory would be redeemed, if the savings goes into equal needed amounts of investment.

Classical belief on wages and prices Believed all markets competitive- (S&D * Key) – adjust to surplus and shortage…. If oversupply of labor, wage rates drop and S&D of labor will be in sinc. What holds for wages also applies to prices. Prices adjust quickly to surplus or shortages Equilibrium established again.

Key: Wage rates and prices will adjust quickly to surplus or shortage In recession- unemployment rate higher than natural rate. Surplus exists in labor market Drives down wage rate ++++++++++++++ 4) In inflationary gap, unemployment lower than natural rate 5) Shortage exists in labor market 6) Drives up the wage rate

Lower wage rate –firms hire more workers SRAS shifts to right until recessionary gap is gone.

BOTH THEORIES CLASSICAL AND KEYNESIAN DO AGREE…… TWO THINGS WE CAN DO WITH DISPOSABLE INCOME- SPEND OR SAVE! We all know that consumption is 2/3 (or more) of GDP

***Classical theorists say, the funds from aggregate savings eventually borrowed and turned into investment expenditures which are a component of real GDP BUT…. What if no or low savings? Theory breaks down here – have to have equal amounts of investment for savings. (the idea here is that savings leads to investment) This is true… but it probably won’t do it by itself. Needs assistance through monetary or perhaps fiscal policy.

The Classical View of the Credit Market In classical theory, the interest rate is flexible and adjusts so that saving equals investment. If saving increases and the saving curve shifts rightward the increase in saving eventually puts pressure on the interest rate and moves it downward. A new equilibrium is established where once again the amount households save equals the amount firms invest.

Long-run Equilibrium The condition where the Real GDP the economy is producing is equal to the Natural Real GDP and the unemployment rate is equal to the natural unemployment rate.

Economy and Labor Market

Self Regulating Economy Closing the Inflationary (Expansionary) Gap The economy is at P1 and Real GDP of $11 trillion. Because Real GDP is greater than Natural Real GDP ($10 trillion), the economy is in an inflationary gap and the unemployment rate is lower than the natural unemployment rate.

Self Regulating Economy Closing the Inflationary (Expansionary) Gap Wage rates rise, and the short-run aggregate supply curve shifts from SRAS1 to SRAS2. As the price level rises, the real balance, interest rate, and international trade effects decrease the quantity demanded of Real GDP. Ultimately, the economy moves into long-run equilibrium at point 2.

Then what happened? Why the Great Depression? 25% unemployment Banks closed Production ceased Drought hit Stocks worthless No money for purchases No jobs Bleak! AS 1 AD AS AD 1 P R I C E L V GDP

Bottom Line Classical viewpoint- not possible to overproduce goods because the production of those goods would always generate a demand that was sufficient to purchase the goods. (what would they say about the recent inventories of our auto industry?)

In 1939- per capital income was still 10% less than in 1929. Keynesian Ideas The classical approach fell into disrepute during the economic decline of the 30’s. Real GDP fell by more than 30% 1930-33 In 1939- per capital income was still 10% less than in 1929. *U.S. began to embrace John Maynard Keynes’s theory of stimulating the economy through aggregate demand (Lord Keynes) had studied classical economics and wrote his famous General Theory of Employment, Interest and Money. (which was a complete rebuttal of the classical theory)

Keynesian in a Nutshell

Keynes’s View of Say’s Law in a Money Economy According to Keynes, a decrease in consumption and subsequent increase in saving may not be matched by an equal increase in investment. Thus, a decrease in total expenditures may occur. To learn more about John Maynard Keynes, click his photo above.

The Economy Gets “Stuck” in a Recessionary Gap If the economy is in a recessionary gap at point 1, Keynes held that wage rates may not fall. The economy may be stuck in the recessionary gap.

Real GDP and the price level, 1934–1940 Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve (cont'd) Real GDP and the price level, 1934–1940 Keynes argued that in a depressed economy, increased aggregate spending can increase output without raising prices. Data showing the U.S. recovery from the Great Depression seem to bear this out. In such circumstances, real GDP is demand driven. 24

Keynesian Economics was the answer to Classical economic theories and the suggested way to “jump-start” the economy again… pull out of the depression. Idea: Government enters the economy. Stimulates the economy through Aggregate Demand. Fiscal policy would move the production engine by stimulating “spending.” increased employment, jobs would be filled, production would begin people would purchase with money they earned from jobs.

Classical vs. Keynes I

A Question of How Long It Takes for Wage Rates and Prices to Fall Suppose the economy is in a recessionary gap at point 1. Wage rates are $10 per hour, and the price level is P1. The issue may not be whether wage rates and the price level fall, but how long they take to reach long-run levels The speed at which wage rate falls is a key To whether Keynesian or Classical theory Is more valid. Answers never for sure.

Keynes rejected the classical notion of self- adjustment, ( Keynes rejected the classical notion of self- adjustment, (????) and he predicted things would get worse once a spending shortfall emerged. Example: Business expectations of future sales worsens. Business investment is cut back. Unsold capital goods begins to pile up (includes office equip. machinery, airplanes, etc.) *this is an “undesired” change… Worsened sales expectations causes decline in investment spending that shifts the AD curve to the left leading to pileups of unwanted inventory.

Example: Are the U.S. and European SRAS Curves Horizontal? New Keynesians contend that the SRAS is essentially flat. Based on research, they contend SRAS is horizontal because firms adjust their prices about once a year. If the SRAS schedule were really horizontal, how could the price level ever increase? 29

Keynesian Theory LRAS P R I C E L V AD 2 AD 3 *Price Goes up AD 1 AS Real GDP Output Keynesian Theory AD unstable, prices and wages are inflexible AD no effect on prices until LRAS

Figure 11-9 Real GDP Determination with Fixed versus Flexible Prices 31

Keynes rejected the classical notion of self- adjustment, ( Keynes rejected the classical notion of self- adjustment, (????) and he predicted things would get worse once a spending shortfall emerged. Example: Business expectations of future sales worsens. Business investment is cut back. Unsold capital goods begins to pile up (includes office equip. machinery, airplanes, etc.) *this is an “undesired” change… Worsened sales expectations causes decline in investment spending that shifts the AD curve to the left leading to pileups of unwanted inventory.

http://www.youtube.com/watch?v=d0nERTFo-Sk&feature=email

Chapter 12- Consumption, Real GDP, Multiplier

Consumption Function I The consumption function is the relationship between consumption (household sector spending) and disposable income. In the consumption function, consumption is directly related to disposable income and is positive even at zero disposable income: 35

The 45-Degree Line The 45-degree line represents all points where consumption and income are exactly equal. C = YD

U.S. Consumption and Income $7000 2000 6000 1999 C = YD 1998 1997 5000 1996 1995 1994 CONSUMPTION (billions of dollars per year) 1993 4000 1992 1991 1990 1989 1988 3000 1987 1986 1985 1984 2000 1983 1982 1981 1980 1000 Actual consumer spending 45° $1000 2000 3000 4000 5000 6000 7000 DISPOSABLE INCOME (billions of dollars per year)

Autonomous Income Have you ever known people who spend money with out any income? 2. When disposable income is 0 and consumption still exists (food, clothing, shelter- basics) this is autonomous consumption 3. Whether one has to dig into one’s savings, go on welfare, or else beg, borrow or steal, or call mom, one will spend that minimum amount

How does this work? Income is low- households tend to Dissave..(borrow from savings or borrow from other sources) Income increases- household aggregate income eventually equals and exceeds current consumption

Real Disposable Income (trillions of dollars) The Keynesian model assumes that there is a positive relationship between consumption and income. 3 6 9 Planned Consumption Expenditures (trillions of dollars) Real Disposable Income (trillions of dollars) 12 45º 45º Line Saving C Dis-saving However, as income increases, consumption increases by a smaller amount. Thus, the slope of the consumption function (line C) is less than 1 (less than the slope of the 45° line).

Disposable Income Yd= C+S If we spend… cannot save. If we spend… more activity (production) takes place in the economy… potential to increase GDP What happens if we do not save at all?

What is the deciding factor on whether you spend or not? Income Keynes felt we could learn a lot about consumption by focusing on the relationship between income and spending. He said income and consumer spending rise in tandem.. If you know how much income consumers have to spend (Yd), you can predict what they will spend

Keyne’s Consumption Function Keynes referred to this as “fundamental law” that men are disposed as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income. *1)At low levels of aggregate income, the consumption expenditures of households will exceed their disposable income (when household income is low, households dissave- they either borrow or draw from past savings to purchase consumption goods

45 Degree Line 45 Degree Line C = YD Saving Dissaving Consumption Function C = $50 + 0.75YD Dissaving B G A $50 100 150 200 250 300 350 400

Government’s taxing, spending and monetary policies are constant. Keynes Cont. As with most theories, Keynes asks us to assume away a lot of the problem. We will assume there is a specific employment level of output. NARU is present when full-employment capacity is attained. Wages and prices are completely inflexible until full employment is reached Government’s taxing, spending and monetary policies are constant.

Keynes said that the economy needs to be directed to full-employment through aggregate expenditures. (C + I + G + X-M )

A sluggish economy There are a number of ways to jump-start the economy… Fiscally: taxing & spending. Should the classical or Keynesian approach be used…. Or should an eclectic approach be used?

What really is the multiplier? The multiplier is based on two concepts already covered: GDP is the nation’s expenditure on all the final goods and services produced during the year at market prices. GDP=C+I+G+(X-M) = Aggregate Demand

Obviously if C goes up the entire GDP will go up also Obviously if C goes up the entire GDP will go up also. When there is any change in spending- it will have a multiplied effect on GDP *When money is spent by one person, it becomes someone else’s income. When someone spends a dollar, perhaps someone who received that dollar would spend 80 cents and of that 80 cents received by the next person perhaps 64 cents… If we add up all the spending generated by that one dollar, it will add up to four or five or six times that dollar… Hence, the name “multiplier.”

The multiplier tells us the extent to which the rate of total spending will change in response to an initial change in the flow of expenditure. Any change in spending (C, I, or G.) will set off a chain reaction, Leading to a multiplied change in GDP. If $1 million investment resulted in $4 million additional income, the multiplier would be 4

The Multiplier Process 3. Income reduced by $100 billion 4. Consumption reduced by $75 billion Factor markets Product markets Business firms Households 7. Income reduced by $75 billion more 8. Consumption reduced by $56.25 billion more 9. And so on 1. $100 billion in unsold goods appear 6. Further cutbacks in employment or wages 2. Cutbacks in employment or wages 5. Sales fall $75 billion

The Multiplier Principle Expenditure Stage Additional Income (Dollars) Marginal Propensity To Consume Additional Consumption (Dollars) For simplicity (here) it is assumed that all additions to income are either spent domestically or saved. Round 1 Round 2 Round 3 Round 4 Round 5 Round 6 Round 7 Round 8 Round 9 Round 10 3/4 1,000,000 750,000 750,000 562,500 562,500 421,875 421,875 316,406 316,406 237,305 237,305 177,979 177,979 133,484 133,484 100,113 100,113 75,085 75,085 56,314 All Others 225,253 168,939 Total 4,000,000 3,000,000 3/4 The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75%  3/4). Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until . . . effectively, $4 million is spent in the economy.