Download Aggregate Demand Aggregate demand

Classical and Keynesian Economics
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-1
Aggregate Supply
• Aggregate supply is the total supply of goods
and services that firms in a national economy
plan on selling during a specific time period.
• It is the total amount of goods and services
that firms are willing to sell at a given price
level in an economy
Aggregate Demand
• Aggregate demand (AD) is the total demand
for final goods and services in the economy at
a given time and price level. It specifies the
amounts of goods and services that will be
purchased at all possible price levels
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
– The Classical economics theory is based on the
premise that free markets can regulate
themselves if left alone, free of any human
intervention.
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-5
The Aggregate Demand Curve
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
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Aggregate
demand
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0
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Real GDP (in trillions of dollars)
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Aggregate demand is the total value of real GDP that all sectors of the economy are willing to
purchase at various price levels
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-19
The Long-Run Aggregate Supply
Curve
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
Long-Run Aggregate Supply curve (in trillions of dollars)
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L-RAS
140
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100
80
60
40
20
0
0
1
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Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Real GDP (trillions of dollars)
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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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-30
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-47
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
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-48
• Contrary to Say's law, which is based on
supply, Keynesian economics stresses on the
importance of effective demand. Effective
demand is derived from the actual household
disposable incomes and not from the
disposable income that could be gained at full
employment, as the classical theories state