Chapter 11 Classical and Keynesian Economics 11-1 Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

Chapter 11

Classical and Keynesian Economics

11-1Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Objectives

• Say’s law

• Classical equilibrium

• Real balance, interest rate, and foreign purchases effects

• Aggregate demand

• Aggregate supply in the long run and short run


Objectives

• The Keynesian critique of the classical system

• Equilibrium at varying price levels

• Disequilibrium and equilibrium

• Keynesian policy prescriptions


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


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



• Think of production as consisting of two products: consumer goods and investment 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

Consumer Goods and Investment Goods


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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

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

11-9


(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


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(Continued)

GDP = C + I

GDP = C + S

Things equal to the same thing are equal to each other

C + I = C + S


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(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


Supply and Demand Revisited

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HouseholdsHouseholds

Firms

7.0The economy produces a supply of consumer goods and investment goods (Aggregate Supply = AS)

AS



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Firms

7.0AS=

The people who produce these goods (Households) spend part of their incomes on consumer goods

C=6.5

They save the restS=0.5

Their savings are borrowed by investors who spend this money on investment goods

I=0.5



11-14


Firms

7.0AS= C=6.5

S=0.5

I=0.5

GDP = C + IGDP = 6.5 + 0.5GDP = 7.0

GDP = 7.0 = Aggregate Demand (AD)

I = S

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)




Quantity

10

9

8

7

6D

S

2 4 6 8 10 12 14

The curves cross at a price of $7.20 and a quantity of 6



Quantity of loanable funds

20

15

10

5

0

Supply ofsavings

Demand forinvestment

funds

The Loanable Funds Market

The demand and supply curves cross at an interest rate of 15 percent



14

12

10

8

6

4

2

0

S

D

Quantity

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.



Quantity of labor

20

18

16

14

12

10

8

6

4

2

0

Supplyoflabor

Demandfor labor

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

The Classical Equilibrium: Aggregate Demand Equals Aggregate Supply

• On the micro level, when quantity demanded equals quantity supplied, we’re at equilibrium

• Similarly, on a 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


The Aggregate Demand Curve

Aggregate demand is the total value of real GDP that all sectors of the economy are willing to purchase at various price levels


Real GDP (in trillions of dollars)

180

160

140

120

100

80

60

40

20

0

Aggregatedemand

0 1 2 3 4 5 6 7 8 9 10

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

• 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 poorer and reducing their purchases

• This is called the real balance effect

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• 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

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• 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

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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 and able 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


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


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, the American net exports (exports minus imports) component of GDP declines

• When the price level declines, the net exports component (and GDP) rises


The Long-Run Aggregate Supply Curve


180

160

140

120

100

80

60

40

20

0

L-RAS

Real GDP (trillions of dollars)0 1 2 3 4 5 6 7 8 9 10

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

Aggregate Demand and Long-Run Aggregate Supply


180

160

140

120

100

80

60

40

20

0

Aggregatedemand

L-RAS

Real GDP (trillions of dollars)0 1 2 3 4 5 6 7 8 9 10

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

The Short-Run Aggregate Supply Curve


180

160

140

120

100

80

60

40

20

0

S-RAS

Full-employment GDP


0 1 2 3 4 5 6 7 8 9 10

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

Aggregate Demand, Long-Run and Short-Run Aggregate Supply


180

160

140

120

100

80

60

40

20

0

Aggregatedemand

L-RAS

S-RAS

Real GDP (in trillions of dollars)0 1 2 3 4 5 6 7 8 9 10

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

Part II: 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


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



– Keynes disputed the view that the interest rate would equilibrate savings and investment. Keynes maintained

• 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 to do so



– 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



– 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


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180

160

140

120

100

80

60

40

20

0

L-RAS


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.

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180

160

140

120

100

80

60

40

20

0

L-RAS



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.

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180

160

140

120

100

80

60

40

20

0

L-RAS



When we reach full employment (at a real GDP of $6 trillion), output cannot be raised any further

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180

160

140

120

100

80

60

40

20

0

L-RAS

AD1 AD2

AD3


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

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


Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 11-41

Real GDP

Keynesianrange

Aggregatesupply

The Ranges of the Aggregate Supply Curve

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The Consumption and Saving Functions


Disposable income (in trillions of dollars)

Saving

Dissaving

00

1

1

2

2

3

3

4

4

5

5

6

6

7

7

8

8

9

9

10

C

When consumption (C) is greater than disposable income (DI), savings is negative

When disposable (DI) income is greater than consumption (C), savings is positive

The Keynesian Aggregate Expenditure Model

The Keynesian Aggregate Expenditure Model

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The Investment Sector


C + I

45û


0

1

2

3

4

5

6

7

8

9

C


When C + I represents aggregate demand, how much is equilibrium GDP

Answer: Approximately $7.0 trillion

Aggregate Demand Exceeds Aggregate Supply

• When aggregate demand exceeds aggregate supply the economy is in disequilibrium– Output is increased– 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


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


Summary: How Equilibrium Is Attained

• When the economy is in disequilibrium, it automatically moves back into equilibrium

• It is always aggregate supply that adjusts– When aggregate demand is greater than

aggregate supply, aggregate supply rises– When aggregate supply is greater than

aggregate demand, aggregate supply declines


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



When consumption is greater than disposable income , saving is negative, when disposable income is greater than consumption, saving is positive


When C+I represents demand, equilibrium GDP is $7 trillion

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


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


Why Didn’t New Deal Spending Get Us out of the Economic Crisis

of the 1930s?• It did succeed in bringing about rapid

economic growth between1933 and 1937• However, Roosevelt suddenly decided to try to

balance the federal budget– He raised taxes and cut government spending

• The Federal Reserve sharply cut the rate of growth of the money supply

• Output plunged and the unemployment rate soared


Current Issue: Keynes and Say in the 21st Century

• Until the 1970s the American economy was essentially a closed system– We made it and then we bought it– Our system was best describe by Say’s Law: Supply

creates its own demand

• Today, we no longer operate a closed system – We consume much more than we produce– Neither Keynes nor Say is giving us what we need– We are running huge and growing trade deficits which

are not good for our long term economic health


Documents

Chapter 11 Classical and Keynesian Economics 11-1 Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved