1. Aggregate Supply Keynes vs Say So….who is correct?

2. Timed Writing Consider the following scenario:  Three young boys, acting like the rascals they are, throw a rock through a bakery window. The window breaks and a crowd gathers. Everyone in the crowd cries about the tragic loss of the window. But then, someone sees a silver lining to the problem. “Ah hah!” says one optimistic observer. “ Don’t worry! The money the baker will spend on replacing the window will be used by the window maker to buy something else and then that person will use it also!” The crowd was very happy at this idea and began to agree that breaking the window was probably a good thing after all! “ Yes sir!” says the optimist, “If the window hadn’t broken, we wouldn’t be starting this economic boom!”  Why would a economist claim the reasoning of the optimistic person flawed?

3. What is Aggregate Supply? Aggregate Supply (AS) measures the volume of goods and services produced within the economy at a given overall price level  There is a positive relationship between AS and the general price level.  Rising prices are a signal for businesses to expand production to meet a higher level of Aggregate Demand (more on that later). An increase in demand should lead to an expansion of aggregate supply in the economy.

4. Classical Ecnomics There is intense disagreement between schools of economic thought about how the macroeconomy should function. The oldest of the current schools was conceptualized by Jean- Baptiste Say.  Traditionally associated with supply-side economics, Say is the inventor of the aptly named, “Say’s Law”.  Say’s Law Supply creates Demand

5. Say’s Law Explained Supply Creates Demand  It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products. (J.B. Say, 1803: p.138-9)  The act of producing creates the market for other products and therefore, the market for its own product.  Lets simplify this….

6. Classical Economics Made Simple The market (economy) works very quickly. It is a perfect, well oiled and efficient machine. It adjust quickly to problems. Surpluses in one area are balanced by shortages in other areas and so on. Case Study: The Great Depression  Read your textbooks in US History. You will find the term, “overproduction” attributed to one of the reasons of the Depression.  Classicists’ argue that there is no such thing as overproduction.  If there is a surplus of goods, prices must fall to accommodate the additional supply that has not sold.  The reduced price will stimulate the appropriate level of demand. Classical economics assumes market forces will correct itself. But….not everyone out there agrees with it.

7. Classical Economics Criticized Classical economics assumes that there is a natural, economic tendency for all markets and economies to move towards equilibrium. This equilibrium is not just the intersection of demand and supply but also the equilibrium levels of employment as well. Critics claim that Classical thought oversimplifies the behavior of individuals. Critics argue that there is no such tendency in the market to move towards this equilibrium. The large-scale critique of Classical thought happened during the Great Depression.

8. Keynesian Economics Man creates his own supply (demand-side economics) Keynes advocated a situation where government policy is implemented in an attempt to move the economy towards full employment. Classical economists are extremely laissez-faire in their approach to government. Case Study: Great Depression  Classical solution: Cut wages  Keynes said that people will resist wage cuts. This is because of various factors, most important of which is because people see wages in nominal terms, not real terms.  Keynes argued for counter-cyclical fiscal policies. Policies that act counter to the business cycle.

9. Keynesian Criticisms Critics of Keynesian theory point most squarely to the “crowding out effect.”  This is the notion that as government involves itself in the economy and attempts fiscal policies, it ends up removing some of the possible economic activity that would have otherwise been engaged in by private entities.  This is largely because government does not produce. Therefore, any money it gains is taken or borrowed from the economy. Thereby stifling the funds available for private enterprise.

10. Who is Right? Well. They both are.  The majority of economists today hold that Keynesian ideas are primarily correct in the consideration of an economy in the short-term.  Classical thought is seen to represent how the economy works in the long-term. To get even more confusing, we still haven’t discussed the monetarist school of thought yet.  Still! We can illustrate both of these economists’ principles on the AD/AS model.

11. The Aggregate Supply Model