chapter 11b -- keynes vs classical, updated sept 12 2015 (1)
TRANSCRIPT
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Classical and
KeynesianEconomicsChapter 11
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc !ll rights reser"e#
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Learning Objectives
After this chapter you should be able to :1. Discuss Say’s law.2. Analyze Classical equilibrium.
. !"plain and discuss the real balance# interest rate# and forei$n
purchases effects.%. Demonstrate the interaction between a$$re$ate demand and
a$$re$ate supply.&. Summarize the 'eynesian critique of the classical system.(. Describe equilibrium and disequilibrium and distin$uish
between them.). Summarize and discuss the 'eynesian policy prescriptions.
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Two iews o! the "acroeconomy
Are business cycles self*correctin$+, Do the forces of supply and demand lead a mar-eteconomy toward full employment $rowth with pricestability on its own+
r do we need acti/e $o/ernment policies durin$economic downturns+
0e will e"amine two alternati/e answers:, Classical Economics, Keynesian Economics
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$art %& The Classical Economic 'ystem
he centerpiece of classical economics is 'ay(s Law ., Say’s aw states# 3 Supply creates its own demand.” , his means that somehow# what we produce4supply4all $ets
sold 5demanded6.
0hy+, 0hen a seller sells a product 5includin$ his7her own labor6#
she7he earns income., his income is used to purchase other $oods and ser/ices., So# sellin$ one product creates demand for another# until all
the income is 3used up.8, 9f all the income is spent# all the $oods and ser/ices will besold.
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*hat abo+t 'aving,
he macroeconomy be$ins to ha/e problems whenpeople sa/e part of their incomes., 9f some people sa/e# then some thin$s that are produced will
not be sold., oney is lea-in$ out of the system.
;ut# sa/in$ is important for future $rowth., 0ithout saving # we could not ha/e investment 4the
production of plant# equipment# and in/entory.
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Start with =ust the pri/ate sector 5no $o/ernment orforei$n trade6.
All production 5Supply6 consists of:, Consumer $oods 5C6.
, 9n/estment $oods 596., >o ? or @ n.
9f we thin- of ?D as total spending # then
?D B C 9.9f we thin- of ?D as income received # then
?D B C S.
Cons+mer .oods and %nvestment .oods
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Cons+mer .oods and %nvestment .oods0contin+ed
GDP = C + I
GDP = C + S
Things equal to the same thing are equal to each other:
C + I = C + S
Subtract the same thing (C) from both sides of the equation:
9 B S
C + I = C+ S
ou are left with:S lea-s out# but is9n=ected bac- in as 9.
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Supply and Demand Ee/isited
Find equilibrium price: Appro". G).2HFind equilibrium quantity: (
Classical economists applied this process to financial mar-etsto pro/e that 9 B S.
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The Loanable 4+nds "ar5et
Sa/in$ supplies ban-sand financial institutionswith loanable funds.;usinesses borrow5demand6 funds for
9n/estment.9nterest rate is the price ofloanable fundsI they arefle"ible.!quilibrium interest rate is1&J.
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6+estions !or Tho+ght and 7isc+ssion
0hy does the Sa/in$ Cur/e slope up li-e a SupplyCur/e+
, 0hen would you be more li-ely to put money in your sa/in$saccount: when interest rates are hi$h or low+ 5
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%n Classical "acroeconomics89nemployment is Temporary
abor mar-ets are no different than any other mar-ets#under Say’s aw.
, Knemployment is due to labor surplus5Luantity supplied M Luantity demanded6.
, ower price of labor 5wa$e6# until abor Supply equals aborDemand.
Conclusion: >o in/oluntary unemployment. , >eed a =ob+ 0or- cheaperN, Anyone who isn’t wor-in$ has decided not to wor- at the
equilibrium wa$e.
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:ypothetical Labor "ar5et
At GO per hour# there is a laborsurplus 5unemployment6.
At G) per hour:, !/eryone who wants to wor-
at that rate can find a =ob., !/ery employer willin$ to hire
wor-ers at that rate can findas many wor-ers as s7hewants to hire.
here was a mo/ement alon$the abor Supply Cur/e.
, Some wor-ers /oluntarilydecided not to offer theirlabor.
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"odeling Classical E;+ilibri+m
icroeconomic 5 ar-et6 !quilibrium:, 0hen quantity demanded for a product equals quantity
supplied. acroeconomic !quilibrium
, 0hen A$$re$ate Demand equals A$$re$ate Supply.
Characteristics of acroeconomic !quilibrium forClassical !conomists:
, Full employment of labor 5no in/oluntary unemployment6, Full employment of resources 5ma"im output6
Classical !conomists maintain that mar-eteconomies with fle"ible prices should tend towardmacroeconomic equilibrium.
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The =ggregate 7emand C+rve
=ggregate 7emand is the total /alue of real ?D thatall sectors of the economy 5C 9 ? @ n 6 are willin$to purchase at /arious price le/els.
0hen the pricele/el increases#5inflation6# peoplepurchase less
output.
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>eal ?alance E!!ect, ou feel poorer# so you spend less., urchasin$ power declines with inflation.
%nterest >ate E!!ect, Eisin$ prices push up interest rates., enders need hi$her interest rates to compensate for erodin$
purchasin$ power of money.
4oreign $+rchases E!!ect, 9f prices rise in the KS# e"ports decrease and imports
increase# so @ n decreases.
Three >easons why the =7 C+rve'lopes 7own
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=ggregate '+pply C+rve
=ggregate '+pply is the amount of real ?D thatwill be made a/ailable by sellers at /arious pricele/els.
A$$re$ate Supply loo-s different in the Long >+nand the 'hort >+n :
, %n the Long >+n # classical economists assume theeconomy operates at full employment 5ma"imum output6#independent of the price le/el.
, %n the 'hort >+n # businesses will increase supply if theprice le/el increases.
et’s see what each one loo-s li-eP
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Long->+n =ggregate '+pply C+rve 0L>='EAS is /ertical line at full employment le/el of ?D
5re$ardless of price le/el6.
Eeal ?D B G( trillionat e/ery point on EAS.
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Long->+n "acroeconomic E;+ilibri+m
E equilibrium ofG( trillion in real ?Dand price le/el of 1HH.
Supply Creates 9ts wn DemandN
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'hort->+n =ggregate '+pply C+rveSEAS is relati/ely flat at low le/els of output# and$radually approaches /ertical.
At low le/els of output# firms
can easily e"pand output whenprices rise.
;eyond full employment ?D #e"pandin$ production is moree"pensi/e# so firms need lar$e
price boosts to increase output.
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'hort->+n "acroeconomic E;+ilibri+m
utput may be abo/e orbelow full employment inthe SE# but should settle atfull employment ?D in E.
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Classical iew o! >ecessions
1. !conomy starts at AD 1: ! 1 atFull employment ?D and
rice le/el B 1%H.2. Durin$ recession# AD
decreases to AD 2: !’ at loweroutput 5G% trillion6.
. Surplus in/entory of G2 trillionso firms decrease prices untilsell off surplus at ! 2.
Conclusion: 9t’s a *step process mo/in$ from !1 to !’ to !2.>o $o/ernment inter/ention necessary. Fle"ible prices will pull
economy out of recession. he economy is self*ad=ustin$N
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$art %%& The Keynesian Criti;+e o! theClassical 'ystem
Kntil the ?reat Depression# classical economics wasthe dominant school of economic thou$ht.
, 3 aissez*Faire8: $o/ernment should inter/ene in economicaffairs as little as possible.
he ?reat Depression undermined faith in Say’s aw.Qohn aynard 'eynes de/eloped alternati/e theory ofmacroeconomics:
, Ad/ocated $o/ernment inter/ention to brin$ an end to the
?reat Depression., Focused on boostin$ demand for output# not fle"ible prices.
hese two /iews continue to shape policy debates.
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Keynes( Criti;+e o! 'ay(s Law& ' @ %
Sa/in$s and in/estment are not equalized by interestrates:
, Sa/in$ is not affected by interest rates. eople sa/e for futurepurchases and based on income.
, ;usiness in/ests when it e"pects demand for their product. 50hye"pand in recessions e/en if interest rates are low+ Can’t sell.6
9f S M 9# not e/erythin$ bein$ produced would bepurchased.
Supply does not create its own Demand.
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Keynes( Criti;+e o! 'ays Law&$rices and *ages are not !leAible downward
rices are not downwardly fle"ible# e/en in arecession. 5 rices are stic-y downward.6
, ;i$ firms in concentrated industries 5oli$opolies6 can wait outrecession without lowerin$ their prices.
, hey would rather temporarily reduce output.
0a$es are not downwardly fle"ible# e/en in arecession.
, abor unions with lon$*term contracts resist wa$e cuts.
9f prices and wa$es are not fle"ible downward# Supplydoes not create its own Demand.
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Keynesian iew o! "acroeconomicE;+ilibri+m
!conomy was not always at# or tendin$ toward# a fullemployment equilibrium.
hree equilibriums are possible:, Below full employment, At full employment, Above full employment
Famous quote: 39n the on$ Eun# we are all dead.8, Don’t wait for the economy to fi" itself# e/en if it could.
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"odi!ied Keynesian =ggregate '+pplyC+rve
1. Durin$ recession# output canbe increased without raisin$prices 5flat part of cur/e6.
2. As approach full employment5G( trillion6# prices be$in toincrease 5upward slopin$ partof cur/e6.
. At full employment le/el of?D # *EAS is /ertical.
utput cannot be e"panded#but price le/el can increase.
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Keynesianism is 7emand-'ide Economics
'eynes stood Say’s aw on its head: , Can be summarized as# B7emand creates its own '+pply D, ;usiness firms produce only the quantity of $oods and
ser/ices they belie/e consumers 5C6# in/estors 596#$o/ernments 5?6# and forei$ners 5@6 will plan to buy.
A$$re$ate Demand is the prime mo/er of theeconomy.
, 9f you can e"pand C# 9# ?# and7or @ 5demand for $oods and
ser/ices6# businesses will sell surplus and continue to e"pand., e/el of ?D depends upon planned eApendit+res .
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Three $ossible E;+ilibri+ms
AD1 representsa$$re$atedemanddurin$ arecession ordepression. 9tcan increasewithoutinflation.
AD2 crossesthe lon$*runa$$re$atesupplycur/e at fullemployment
!"pandin$output beyondfullemployment is
inflationary.
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'+mmary o! Two Theories
Classical iew Assumes fle"ible price
Sa/in$s depends on
interest rates9n/estment depends oninterest rates0a$es fle"ible0ait for on$ Eun
Keynesian iew Assumes fle"ible demandfor outputSa/in$s depends on
income9n/estment depends onprofit e"pectations0a$es stic-yFi" in Short Eun
0hich assumptions seems more realistic to you+
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Three >anges o! the =ggregate '+pplyC+rve
Contemporarymacroeconomists oftensynthesize the two theories#
su$$estin$ that each theorycould hold true under differenteconomic conditions.
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$art %%%& The Keynesian 'ystem'eynesian A$$re$ate !"penditure odel putsconsumer beha/ior at center of analysis.
As income rises# C rises#but not as quic-ly.
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E;+ilibri+m in =ggregate EApendit+re "odel
9n/estmentdoes
not dependon income#so add asfi"ed amount.
>ote /ertical a"is is > price le/el.
!quilibrium iswhere A! linecrosses %&R line#at G) trillion.
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>eaching E;+ilibri+m
0hen A$$re$ate Demand e"ceeds A$$re$ate Supplythe economy is in disequilibrium., lanned in/entories too low# so they are depleted., Si$nals firms to boost output is increased to meet e"cess
demand.
0hen A$$re$ate Supply e"ceeds A$$re$ate Demandthe economy is in disequilibrium.
, lanned in/entories are too hi$h# so output is decreased., 0or-ers are laid off# further depressin$ a$$re$ate demand as
these wor-ers cut bac- on their consumption., !/entually# in/entories are sufficiently depleted and
equilibrium is restored.
9n/entories send si$nals to firms.
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'+mmary& :ow E;+ilibri+m %s =ttained
A$$re$ate demand 5C 96 must equal the le/el ofproduction 5a$$re$ate supply6 for the economy to bein equilibrium.
0hen the two are not equal# a$$re$ate supply mustad=ust to brin$ the economy bac- into equilibrium.
his equilibrium does not ha/e to be at fullemployment le/el of ?D .
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The Classical $osition '+mmari ed
Eecessions are temporary because the economy isself*correctin$., Declinin$ in/estment will be pushed up a$ain by fallin$
interest rates., 9f consumption falls# it will be raised by fallin$ prices and
wa$es.
;ecause recessions are self*correctin$# the role of$o/ernment is to stand bac- and do nothin$.
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Keynesian $olicy $rescriptions
'eynes’s position was that recessions are notnecessarily temporary.
, herefore# it is necessary for the $o/ernment to inter/ene byspendin$ money.
,
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Keynesianism and the Few 7ealEoose/elt s >ew Deal pro$rams succeeded in brin$in$
about rapid economic $rowth 1O to 1O ).,