CHANDRAPAL T

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KEYNES ATTACK ONCLASSICAL ECONOMIC

THEORY

Presented by

CHANDRAPAL T

I MA ECONOMICS

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The Classical Economics


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Learning ObjectivesAssumptions of classical theory

.Says Law of market

.Output and employment determinationClassical theory and rate of interest

.General prices

.Great depression

.Keynesian revolution

.Keynes attack on classical theory

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IntroductionOrigins of monetary theory lie in Classical

Economics, starting with the works of

Adam Smith (17231790)Two cornerstones of classical economicsSays Lawdeals with interest rates,

employment and production

Quantity Theory of Moneyexamines the roleof money in the economy

Focused on long-term view of theeconomy

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IntroductionClassical economics was attacked by John

Maynard Keynes during the GreatDepression

Theory was resurrected and refined bymodern monetarists and new classicalmacroeconomics beginning in the 1970s

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Classical EconomicsSupply creates its own demand

The economy could never suffer from

underemploymentTotal spending (demand) would always be

sufficient to justify production at fullemployment (supply)

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Assumption of classical

theory.Perfect competition of market.Fullemploymen without inflation

.Supply creats its own demand. Money is medium of exchange.Lsisser faire economy.Perfect wage _price flexibility

.

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Says law of market.JB SAY

SUPPLY CREATS ITS OWN DEMAND

The mere circumstance of the creation of oneproduct immediately opens a vent for otherproducts

SAYS

.

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Output @Employmentdetermination

.Full employment level

.It determined by the aggregate productionfunction and the demand and supply schedule oflabour

.Aggregate production function ,given a fixed stockof capital and technology in the short period,postulate positive relationship between output and

employment..Higher level of output is leads to higher level of

employment and vice-versa Q=f{N K T}

Fixed stock of capital and technology{K T}

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determination curve

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QOQ=F{NKT}

N0W/P1

W/P0

W/P2

SL

C

DL={MPL}

N0


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Employment expand ,the level of outputalso increases but marginal physicalproduct of labour diminshes

w/p=mpl----- profit maximisationw/po -supply of labour at the equilibrium

real wage

w/p1-real wage rate is higher than thisequilibrium rate ,the labour supply will bein excess of the demand for labour.

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Classical Interest TheoryOverall level of interest rates is determined

by supply and demand for loanable funds(Figure 22.1)

However, classical economics focused onsavings and investment, the two factorsthat underlie the long-run supply and demand

for loanable funds

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FIGURE 22.1 Classical interest theory.

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Classical Interest TheorySavings (Figure 22.1)Function of interest ratesthe higher the rate of

interest, the more will be saved (positive ordirect relation)

Interest earned on savings is a reward fordelaying consumption in favor of futureconsumption

At higher interest rates people will be morewilling to forgo present consumption

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Classical Interest TheoryInvestment (Figure 22.1)Also a function of interest ratesthe lower the

rate of interest, the more entrepreneurs willborrow and invest (negative or indirect relation)

Investment in physical capital is undertakenbecause capital goods produce output in thefuture

The firm will undertake the investment if therate of return exceeds the cost of borrowing

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Classical Interest TheoryInvestment (Figure 22.1)The return on investments is subject to

diminishing returns, each successive projectearns a lower return on investment

Therefore, a lower rate of interest inducesentrepreneurs to undertake more and moreinvestments

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Classical Interest TheoryRole of money in determining interest

rateRate of interest is influenced in the long run by

the savings of the public (personal preferences)and investment of entrepreneurs (productivity ofcapital)Money plays no role in determining real

factors in the classical systemReal factors are determined by the supply of

capital, the labor force, and existing technologyInterest rates are determined by the thriftiness

of the public and the productivity of capital

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General price levelIn classical economics, money is strictly a veil

it affects the price level, but not the realfactors in the economy

Increase in money will lead only to increase inprices, but not output or employment

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NEUTRALITY OF MONEY


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Quantity Theory of

MoneyEquation of ExchangeM V = P YWhere: M = money supply

V = Income velocity (rate of turnover)

P = price level

Y = real income (GDP)

Fisher equation MV =PT

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-Quantity of Theory of

MoneyEquation of ExchangeOriginally this equation was expressed in terms

of T, the total level of transactions

Includes both real and financial assets

In this expression, V is called thetransactions velocity

The remainder of this discussion will be in termsof the income velocity

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Quant ty T eory o


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Quant ty T eory oMoney

The Cambridge ApproachRestates equation of exchange to focus on

fraction of total expenditure people hold asmoney

Manipulation of the equation of exchange resultsin the Cambridge cash-balance approach orthe demand-for-money equationM = kPY

Where: k = fraction of spending that people have commandover in the form of money balances

Since k = 1/V, both the equation of exchange and thecash-balance approach are identical

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Quantity Theory of

MoneyQuantity Theory of MoneyRe-interprets equation of exchange as a

behavioral relationshipan increase in quantityof money (M) causes what changes in othervariables

According to the quantity theory of money,a change in the money supply leads to a

proportionate change in the price level(cause-and-effect conclusion)

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Quantity Theory of

MoneyQuantity Theory of MoneyThe above is based on two propositions: Y is assumed fixed at full employment levels

V is assumed fixed by payment habits of thepopulation

The transmission mechanism of an increase inthe money supply is as follows: Money supply increases Individuals now hold larger cash balances Reduce cash balances by spending on goods/services Since output (Y) [real GDP] is fixed, the increased

demand drives up prices with no increase in real output

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Great depress on n


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Great depress on n1930

Classical postulates wrong

Inadequacy of the theoretical foundations ofthe laissez fair doctrine

Large scale of unemployment

GNP declines

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Keynesian Revolution1930-1960

Corrective measure and safe guard against thefailure of the market economy

General theory

Keynesian macro economic theories

1 employment 2 growth 3 stability

Government activity

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Keynes attack on classical

theory

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Reduction in money wages is an inexpedientway to reduce to real wages.

Deficiency in demand

Real balance effect

Unnecessarily excessive faith in interesteffect

Wrong economic policyNeglect of speculative demand for money

Dichotomy between real and monetarysectors

Failure of sa s law


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Copyright 2009 Pearson Addison-Wesley. All rightsreserved. 22-34


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AppendixGDP DEFINITIONS AND

RELATIONSHIPS


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APPE



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