Principles of Macroeconomics Lecture 3a THEORIES OF OUTPUT DETERMINATION

Theories of Output Determination  Two Primary Schools of Economic Thought are: 1. Classical Economics (Smith, Ricardo, Von Mises, Say, Hayek, Hazlitt, Friedman, economic conservatives). 2. Keynesian Economics (Keynes, Galbraith, economic liberals). Macroeconomics

Theories of Output Determination The Classical Model:  is based on Adam Smith’s Wealth of Nations (1776).  is the foundation for neo-classical and Austrian school economics, rational expectationism, and monetarism.  was dominant before the 1920s. Gained in popularity again since the 1980s. Macroeconomics

Theories of Output Determination Classical Economists Believe that:  Market forces (flexible prices, wages, and interest rates) correct economic problems.  Limited government involvement in the economy leads to maximum wealth and the highest standard of living.  Artificial government stimulation of the economy leads to problems in the long run. Macroeconomics

Theories of Output Determination  The Keynesian Model:  is based on the works of John Maynard Keynes (1883 – 1946).  gained acceptance during the 1930s and was supported by almost all western economists and politicians during the 1950s, 1960s, and 1970s. Macroeconomics

Keynes said: “In the long run we are all dead.” Do you agree? 1. Yes 2. No 3. Not sure 4. I don’t care (we’re all dead soon) :10 0 of 5

Theories of Output Determination Macroeconomics Keynes’s Analogy The economy is like an elevator. If it goes up, it will continue to go up for a while. If it goes down, it will go down and may hit the bottom, unless someone stops it.

Theories of Output Determination  The Keynesian Theory During a recession,  Production decreases.  Thus, layoffs increase.  Thus, incomes and demand for products fall.  Thus, production decreases even more.  Thus, layoffs increase further.  And so forth. During an expansion the opposite happens. Macroeconomics

Theories of Output Determination  The Keynesian Solution The government must intervene (stop the elevator) through: 1. Active fiscal policy 2. Active monetary policy

Theories of Output Determination Active Fiscal Policy During recessions, Keynes supports:  Increases in government spending.  Decreases in taxes. Of the two, Keynes prefers increases in government spending, because households and businesses may not spend their tax rebates.

Theories of Output Determination Active Fiscal Policy Increases in government spending and decreases in taxes lead to (Keynes):  Higher incomes  Increases in spending  Increases in production  More jobs  Higher incomes  And so forth

Theories of Output Determination Active Fiscal Policy During expansions, Keynes supports  Decreases in government spending  Increases in taxes

Theories of Output Determination  Active monetary policy During recessions, Keynes supports increases in the nation’s money supply. In the United States, the Federal Reserve Board controls the nation’s money supply.

Theories of Output Determination  Active monetary policy According to Keynes: Money supply interest rates borrowing Spending GDP Macroeconomics

Theories of Output Determination  The Keynesian Multiplier When government increases spending, total spending in the economy increases by a multiple of the increase in government spending.

Theories of Output Determination  Multiplier Example Let’s say a government spends $1 billion ($1,000 million) on the construction of a stadium. This increases construction workers’ incomes by $1 billion, compared to if the government hadn’t spent the money. What happens to this $1 billion?

Theories of Output Determination Example (cont’d) Let’s assume that the construction workers spend 80% ($800 million) of their additional income. We say that their Marginal Propensity to Consume (MPC) is 80%. Let’s say they spend it on clothes. Macroeconomics

Theories of Output Determination Example (cont’d) This generates $800 million in additional income for the clothes suppliers. What happens to the $800 million? Macroeconomics

Theories of Output Determination Example (cont’d) Let’s assume the clothes producers spend 80% of their additional income on food. This generates $640 million in additional income for food suppliers. What will the food suppliers do with the additional income? You get the picture. Macroeconomics $1,000 $800 $640 $512

Theories of Output Determination  Example (cont’d) Thus, total spending in the economy increases by (in millions): $1,000 + $800 + $640 + $512 + … = $5,000 Macroeconomics

Theories of Output Determination  Example $5,000 million is 5 times $1,000 million. $1,000 is the initial government spending change. Keynes called this factor 5 “the multiplier”. Macroeconomics

Theories of Output Determination  The Change in Total Spending in the Economy According to Keynes: The additional total spending in the economy = multiplier x the change in initial spending. Or: total spending = m x initial spending. Macroeconomics

Theories of Output Determination  The Formula for the Multiplier Multiplier = 1 / (1 – MPC) Or, Multiplier = 1 / MPS Where MPS = Marginal Propensity to Save Macroeconomics

Theories of Output Determination  Multiplier Example 1 If the MPC =.8, then m = 1 / (1 –.8) = 1/(.2) = 5. Macroeconomics

If the MPC is.9, then the multiplier is: of 5

Theories of Output Determination  Multiplier Example 2 If the MPC =.9, then m = 1 / (1 –.9) = 1/(.1) = 10. Macroeconomics

If the MPC is.75, then the multiplier is: of 5

Theories of Output Determination  Multiplier Example 3 When the MPC =.75, then m = 1 / (1 –.75) = 1/(.25) = 4. Macroeconomics

If the MPS is.2, the multiplier is: of 5

Theories of Output Determination  Multiplier Example 4 If the MPC =.75, and the government increases spending by $2,000, by how much will total spending change? Remember, total spending = m x initial spending. Thus, total spending = 4 x $2,000. Thus, total spending = $8,000. Macroeconomics

If the MPC is.9, and government increases spending by $20, what is the change in total spending in the economy? 1. $10 2. $18 3. $ $ $1, of 5

Theories of Output Determination  Recessionary and Inflationary Gaps: are the differences (negative and positive, respectively) between what GDP is now and what GDP is at full employment.

Theories of Output Determination  Recessionary and Inflationary Gaps Example By how much should the government increase government spending if current GDP is $5,000, and full employment GDP is $6,000, and the MPC =.80? Answer: $X times 5 = $1,000. $X = $200.

If current GDP is $10,000 and full employment GDP is $12,000, and the MPC is.8, by how much should government increase spending to eliminate the recessionary gap? 1. $ $ $ $ $1, $2,000 10

Theories of Output Determination  Recessionary Gaps and Inflationary Gaps Example Answer to the previous question: The equation to use is: Change in GDP = multiplier x change in government spending. So: $2,000 = 5 x $400.

Will a change in government spending cause a change in real GDP? 1. Yes, both in the short and long run 2. Yes, but only in the short run 3. Yes, but only in the long run 4. Not sure

Theories of Output Determination  Evaluation of the Keynesian Theory Let’s evaluate the effects of government spending. If the government increases spending, how does it pay for this? Macroeconomics

Theories of Output Determination  Evaluation of the Keynesian Theory The funds can come from 3 sources:  newly printed money, or  borrowed money, or  increase in taxes Macroeconomics

Theories of Output Determination Evaluation of the Keynesian Theory If the prints more money, it:  lowers interest rates in the short run. This increases borrowing and spending, and stimulates the economy in the short run.  but it causes inflation and increases interest rates, and slows down the economy in the long run. Macroeconomics

Theories of Output Determination Macroeconomics Evaluation of the Keynesian Theory Evaluation of the Keynesian Theory If the government borrows the money, it:  increases funds for the government. This increases spending in the government sector.  but it decreases funds in the private sector. This decreases private sector spending.  increases the national debt and increases future taxes. This slows down the economy in the long run.

Theories of Output Determination Macroeconomics Evaluation of the Keynesian Theory If the government increases taxes, it:  increases funds for the government. This increases spending in the government sector.  but it decreases people’s incomes in the private sector. This decreases private sector spending.  discourages people from working. This slows down the economy.

Theories of Output Determination  Evaluation of the Keynesian Theory Conclusion: Keynesian policy may help the economy in the short run, but is harmful to the economy in the long run. Macroeconomics

Theories of Output Determination  The Role of Savings Keynesian theory:  Savings are a leakage from our economy.  Only increases in consumption lead to increases in production.

Theories of Output Determination  The Role of Savings Classical Theory:  Savings are important to our economy.  Increases in savings lead to increases in funds for businesses.  Businesses use these funds for research and technology and business expansions. Macroeconomics

Theories of Output Determination The Role of Savings Investments in research and technology lead to increases in productivity. This enables businesses to pay higher real wages. This leads to real (not artificial) increases in demand. Macroeconomics

Theories of Output Determination The Role of Savings Real demand increases are made possible by greater capacities to produce, and not by artificial increases in government spending or newly printed money. Macroeconomics