Download Lecture 3 Theories of output determination

Principles of Macroeconomics
Lecture 3a
THEORIES OF OUTPUT DETERMINATION
Theories of Output Determination

Two Primary Schools
of Economic Thought are:
1.
2.
Classical Economics (Smith,
Ricardo, Von Mises, Say, Hayek, Hazlitt, Friedman,
economic conservatives).
Keynesian Economics (Keynes, Galbraith, economic
liberals).
Macroeconomics
Theories of Output Determination
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The Classical Model:
is based on Adam Smith’s
Wealth of Nations (1776).
is the foundation for neo-classical and Austrian school
economics, rational expectationism, and monetarism.
was dominant before the 1920s. Gained in
popularity again since the 1980s.
Macroeconomics
Theories of Output Determination
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Classical Economists Believe that:
Market forces (flexible prices, wages, and interest
rates) correct economic problems.
Limited government involvement in the economy
leads to maximum wealth and the highest
standard of living.
Artificial government stimulation of the economy
leads to problems in the long run.
Macroeconomics
Theories of Output Determination
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The Keynesian Model:
is based on the works of
John Maynard Keynes
(1883 – 1946).
gained acceptance during the 1930s and was
supported by almost all western economists and
politicians during the 1950s, 1960s, and 1970s.
Macroeconomics
Keynes said: “In the long run we are all
dead.” Do you agree?
1.
2.
3.
4.
0 of 5
Yes
No
Not sure
I don’t care (we’re all
dead soon)
:10
Theories of Output Determination

Keynes’s Analogy
The economy is like an
elevator. If it goes up, it will
continue to go up for a while.
If it goes down, it will go
down and may hit the bottom,
unless someone stops it.
Macroeconomics
Theories of Output Determination

The Keynesian Theory
During a recession,
 Production decreases.
 Thus, layoffs increase.
 Thus, incomes and demand for products fall.
 Thus, production decreases even more.
 Thus, layoffs increase further.
 And so forth.
During an expansion the opposite happens.
Macroeconomics
Theories of Output Determination

1.
2.
The Keynesian Solution
The government must intervene (stop the
elevator) through:
Active fiscal policy
Active monetary policy
Theories of Output Determination

Active Fiscal Policy

During recessions, Keynes supports:
Increases in government spending.
Decreases in taxes.

Of the two, Keynes prefers increases in
government spending, because
households and businesses may not
spend their tax rebates.
Theories of Output Determination
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Active Fiscal Policy
Increases in government spending and
decreases in taxes lead to (Keynes):
Higher incomes
Increases in spending
Increases in production
More jobs
Higher incomes
And so forth
Theories of Output Determination

Active Fiscal Policy

During expansions, Keynes supports
Decreases in government spending
Increases in taxes

Theories of Output Determination

Active monetary policy
During recessions, Keynes supports
increases in the nation’s money supply.
In the United States, the Federal Reserve Board
controls the nation’s money supply.
Theories of Output Determination

Active monetary policy
According to Keynes:
Money supply
interest rates
borrowing
GDP
Spending
Macroeconomics
Theories of Output Determination

The Keynesian Multiplier
When government increases spending,
total spending in the economy increases by a
multiple of the increase in government spending.
Theories of Output Determination

Multiplier Example
Let’s say a government spends $1 billion ($1,000
million) on the construction of a stadium.
This increases construction workers’ incomes by $1
billion, compared to if the government hadn’t spent
the money.
What happens to this $1 billion?
Theories of Output Determination

Example (cont’d)
Let’s assume that the construction workers spend
80% ($800 million) of their additional income. We
say that their Marginal Propensity to Consume
(MPC) is 80%.
Let’s say they spend it on clothes.
Macroeconomics
Theories of Output Determination

Example (cont’d)
This generates $800 million in additional income
for the clothes suppliers.
What happens to the $800 million?
Macroeconomics
Theories of Output Determination

Example (cont’d)
$512
$640
$800
$1,000
Let’s assume the clothes producers spend 80% of
their additional income on food.
This generates $640 million in additional income
for food suppliers.
What will the food suppliers do with the additional
income? You get the picture.
Macroeconomics
Theories of Output Determination

Example (cont’d)
Thus, total spending in the economy increases
by (in millions):
$1,000 + $800 + $640 + $512 + … = $5,000
Macroeconomics
Theories of Output Determination
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Example
$5,000 million is 5 times $1,000 million.
$1,000 is the initial government spending change.
Keynes called this factor 5 “the multiplier”.
Macroeconomics
Theories of Output Determination

The Change in Total Spending in the Economy
According to Keynes:
The additional total spending in the economy = multiplier x
the change in initial spending.
Or:
total spending = m x
initial spending.
Macroeconomics
Theories of Output Determination

The Formula for the Multiplier
Multiplier = 1 / (1 – MPC)
Or,
Multiplier = 1 / MPS
Where MPS = Marginal Propensity to Save
Macroeconomics
Theories of Output Determination

Multiplier Example 1
If the MPC = .8, then
m = 1 / (1 – .8) = 1/(.2)
= 5.
Macroeconomics
If the MPC is .9, then the multiplier is:
1.
2.
3.
4.
5.
6.
7.
0 of 5
1
2.
3
4
5
7.5
10
10
Theories of Output Determination
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Multiplier Example 2
If the MPC = .9, then
m = 1 / (1 – .9) = 1/(.1)
= 10.
Macroeconomics
If the MPC is .75, then the multiplier is:
1.
2.
3.
4.
5.
6.
7.
0 of 5
1
2
3
4
5
7.5
10
10
Theories of Output Determination
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Multiplier Example 3
When the MPC = .75, then
m = 1 / (1 – .75)
= 1/(.25)
= 4.
Macroeconomics
If the MPS is .2, the multiplier is:
1.
2.
3.
4.
5.
6.
7.
0 of 5
1
2
3
4
5
7.5
10
10
Theories of Output Determination
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Multiplier Example 4
If the MPC = .75, and the government increases spending
by $2,000, by how much will total spending change?
Remember,
total spending = m x
Thus,
Thus,
initial spending.
total spending = 4 x $2,000.
total spending = $8,000.
Macroeconomics
If the MPC is .9, and government increases spending
by $20, what is the change in total spending in the
economy?
1.
2.
3.
4.
5.
0 of 5
$10
$18
$100
$200
$1,000
10
Theories of Output Determination

Recessionary and Inflationary Gaps:
are the differences (negative and positive,
respectively) between what GDP is now and what
GDP is at full employment.
Theories of Output Determination

Recessionary and Inflationary Gaps Example
By how much should the government increase government
spending if current GDP is $5,000, and full employment
GDP is $6,000, and the MPC = .80?
Answer: $X times 5 = $1,000. $X = $200.
If current GDP is $10,000 and full employment GDP is
$12,000, and the MPC is .8, by how much should
government increase spending to eliminate the recessionary
gap?
1.
2.
3.
4.
5.
6.
$200
$300
$400
$500
$1,000
$2,000
10
Theories of Output Determination

Recessionary Gaps and Inflationary Gaps
Example
Answer to the previous question:
The equation to use is:
Change in GDP = multiplier x change in government
spending.
So:
$2,000 = 5 x $400.
Will a change in government spending cause a
change in real GDP?
1.
2.
3.
4.
Yes, both in the short and long run
Yes, but only in the short run
Yes, but only in the long run
Not sure
Theories of Output Determination
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Evaluation of the Keynesian Theory
Let’s evaluate the effects of government
spending.
If the government increases spending, how does
it pay for this?
Macroeconomics
Theories of Output Determination
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Evaluation of the Keynesian Theory
The funds can come from 3 sources:
newly printed money, or
borrowed money, or
increase in taxes
Macroeconomics
Theories of Output Determination

Evaluation of the Keynesian Theory
If the prints more money, it:
 lowers interest rates in the short run. This increases
borrowing and spending, and stimulates the economy in
the short run.
 but it causes inflation and increases interest rates, and
slows down the economy in the long run.
Macroeconomics
Theories of Output Determination

Evaluation of the Keynesian Theory
If the government borrows the money, it:
 increases funds for the government. This
increases spending in the government sector.
 but it decreases funds in the private sector. This
decreases private sector spending.
 increases the national debt and increases future
taxes. This slows down the economy in the long
run.
Macroeconomics
Theories of Output Determination

Evaluation of the Keynesian Theory
If the government increases taxes, it:
 increases funds for the government. This increases
spending in the government sector.
 but it decreases people’s incomes in the private sector.
This decreases private sector spending.
 discourages people from working. This slows down the
economy.
Macroeconomics
Theories of Output Determination

Evaluation of the Keynesian Theory
Conclusion:
Keynesian policy may help the economy in the
short run, but is harmful to the economy in the
long run.
Macroeconomics
Theories of Output Determination

The Role of Savings
Keynesian theory:
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
Savings are a leakage from our economy.
Only increases in consumption lead to increases in
production.
Theories of Output Determination

The Role of Savings
Classical Theory:
 Savings are important to
our economy.
 Increases in savings lead to increases in funds for
businesses.
 Businesses use these funds for research and
technology and business expansions.
Macroeconomics
Theories of Output Determination

The Role of Savings
Investments in research
and technology lead
to increases in productivity.
This enables businesses to pay higher real wages.
This leads to real (not artificial) increases in demand.
Macroeconomics
Theories of Output Determination

The Role of Savings
Real demand increases
are made possible by
greater capacities to produce, and not by
artificial increases in government spending or newly
printed money.
Macroeconomics