Chapter 11 Classical & Keynesian Economics What You Will Learn From This Lesson Theory & Principles  The Depression and Classical Economics  The Fatal Flaw in Classical Thinking  The Keynesian System Language & Methodology – New Terms  Recessionary Gap  Inflationary Gap Historical Evolution from “Laissez-faire” to significant government economic management role

Chapter 11 Classical & Keynesian Economics The Keynesian Critique of Classical Economics “If Supply creates its own Demand, why are we having a world wide depression?” The “Roaring Twenties”  Electrification of America led to mass production of consumer goods  Over the decade, however, these new markets became saturated with products  Demand declined, Inventories increased, Supply > Demand Point -- There can be a disconnect between the buying side of the market and the selling side of the market

Chapter 11 Classical & Keynesian Economics The Keynesian Critique of Classical Economics Keynes posed this problem to Classical World What if Savings and Investment were not equal?  Then Spending would not equal production, and  The economy could experience natural periods of unemployment or inflation, and  The economy is inherently unstable rather than stable Spending decisions and Saving decisions are made by different groups than Production and Investment decisions Prices, especially in the factor markets are not downwardly flexible

Chapter 11 Classical & Keynesian Economics The Keynesian System If there could be a “disconnect” between spending and production in an economy, then economies are inherently unstable There is no reason why an economy has to come to equilibrium at full employment, and Even if an economy does come to a full employment equilibrium, there is no reason why it must remain there These statements are not compatible with the Classical System

Chapter 11 Classical & Keynesian Economics The Keynesian System If economies are inherently unstable, then three outcomes are possible: The economy can come to equilibrium at a level of production lower than full employment (Recessionary Gap) The economy can come to equilibrium at a level of production at full employment, or The economy can come to equilibrium at a level of employment above equilibrium (Inflationary Gap)

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

11-38 The Keynesian Critique of the Classical System Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Three Aggregate Curves AD 1 represents aggregate demand during a recession or depression AD 2 crosses the long-run aggregate supply curve at full employment AD 3 represents excessive demand

Chapter 11 Classical & Keynesian Economics Key Differences Between Classical & Keynes In the Classical World  Free market economies are always stable  Tending toward full employment & full production equilibrium  Freely fluctuating prices in the three major macro markets ensure this In the Keynesian World  Free market economies are unstable  Equilibrium yes, but no reason for full employment/full production  Demand becomes a much bigger driving force  Supply will always adjust to Demand  In a way, according to Keynes “Demand creates its own Supply”

Chapter 11 Classical & Keynesian Economics Keynesian Policy Implications Under the Classical System, Government had no role in management of the economy – “Laissez-faire” or “do nothing” Under Keynes, Government must step in to correct the inherent instability of the economy  If the economy faces a recessionary gap (equilibrium at less than full employment) Government must increase demand by spending more; lowering taxes; lowering interest rates; increasing welfare  If the economy faces an inflationary gap (equilibrium at a level higher than full employment), Government must reduce demand by spending less; raise taxes; increase interest rates; reducing welfare

Chapter 11 Classical & Keynesian Economics U.S. Federal Government Objectives for Economy Full Employment (1933 & by Law 1946) – Federal Government took responsibility to ensure the economy functions at full employment – No more than 5% unemployment Economic Growth (1950’s) – Federal Government took responsibility to ensure the economy grows at a consistent and healthy rate – Real GDP at approximately 4%/year Price Stability (1970’s) – Federal Government took responsibility to ensure the economy has stable prices – CPI increase at no more than 3%/year So, from no role prior to the great depression to comprehensive responsibilities post depression

Chapter 11 Classical & Keynesian Economics Review of What You Have Learned The Depression proved there must be a flaw in the Classical Economic Theory John Maynard Keynes suggested the flaw was very fundamental – The depression proved there could be a disconnect between Aggregate Demand and Aggregate Supply It is not assured that production will create its own demand. Demand is more of a driver of economic equilibrium

Chapter 11 Classical & Keynesian Economics What You Have Learned There is no reason why the economy must come to equilibrium at full employment. The economy can experience recessionary gaps or inflationary gaps Aggregate Supply will always adjust to Aggregate Demand, not the other way around Therefore, Government has a role and responsibility as a maximizing entity (well-being of citizens) to manage the economy The U.S. Government has accepted that responsibility