Classical and Keynesian Economics Chapter 11 Classical and Keynesian Economics 11-1 Copyright 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 11-2 Copyright 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 11-3 Copyright 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 11-4 Copyright 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 11-5 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Goods and Investment Goods 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 11-6 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 11-7 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 11-8 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 11-9 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 11-10 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Say’s Law Revisited Households Households The economy produces a supply of consumer goods and investment goods (Aggregate Supply = AS) 7.0 AS Firms 11-11 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Say’s Law Revisited S=0.5 They save the rest Households Households The people who produce these goods (Households) spend part of their incomes on consumer goods AS= 7.0 C=6.5 Firms I=0.5 Their savings are borrowed by investors who spend this money on investment goods 11-12 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Say’s Law Revisited S=0.5 Households Households GDP = C + I AS= 7.0 Firms I=0.5 GDP = 7.0 = Aggregate Demand (AD) 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) 11-13 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Supply and Demand Revisited The curves cross at a price of $7.30 and a quantity of 6 11-14 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Supply and Demand Revisited The Loanable Funds Market The demand and supply curves cross at an interest rate of 15 percent 11-15 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Supply and Demand Revisited Market for Hypothetical Product If 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. 11-16 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Supply and Demand Revisited 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 11-17 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 11-18 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Aggregate Demand Curve 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 Aggregate demand is the total value of real GDP that all sectors of the economy are willing to purchase at various price levels 11-19 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Aggregate Demand Curve 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 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Aggregate Demand Curve 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 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Aggregate Demand Curve 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 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 11-23 Copyright 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 11-24 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 11-25 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Long-Run Aggregate Supply Curve 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 11-26 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Aggregate Demand and Long-Run Aggregate Supply 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 11-27 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Short-Run Aggregate Supply Curve 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 11-28 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Aggregate Demand, Long-Run and Short-Run Aggregate Supply 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 11-29 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 11-30 Copyright 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 11-31 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 11-32 Copyright 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 11-33 Copyright 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 11-34 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Keynesian Critique of the Classical System 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. 11-35 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Keynesian Critique of the Classical System 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. 11-36 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Keynesian Critique of the Classical System Modified Keynesian Aggregate Supply Curve When we reach full employment (at a real GDP of $6 trillion), output cannot be raised any further 11-37 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Keynesian Critique of the Classical System 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 11-38 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 11-39 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Ranges of the Aggregate Supply Curve 11-40 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Keynesian Aggregate Expenditure Model The Consumption and Saving Functions When consumption (C) is greater than disposable income (DI), savings is negative When disposable (DI) income is greater than consumption (C), savings is positive 11-41 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Keynesian Aggregate Expenditure Model The Investment Sector Real GDP (in trillions of dollars) When C + I represents aggregate demand, how much is equilibrium GDP Answer: Approximately $7.0 trillion 11-42 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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 11-43 Copyright 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 11-44 Copyright 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 11-45 Copyright 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 11-46 Copyright 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 11-47 Copyright 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 11-48 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.