Download keynesian economics

KEYNESIAN ECONOMICS
DEMAND-SIDE ECONOMICS
A REVIEW OF CLASSICAL ECONOMICS
The economy is always at full employment.
• Aggregate supply is vertical
• Supply creates its own demand
Classical economists believe since INTEREST RATES,WAGES AND
PRICES ARE FLEXIBLE, the economy will reach full employment by itself.
Since the MARKET IS SELF-REGULATING, there is no need for the
government to intervene and thus it can take a LAISSEZ FAIRE approach.
(Most economists believe this is true for the LR but not the SR)
The Great Depression of the 1930s
• GDP fell by 40 percent in U.S. and the
unemployment rate rose to nearly 25
percent.
• John Maynard Keynes asked,“If
supply creates its own demand, why
are we having a worldwide
depression?”
JOHN MAYNARD KEYNES
GENERAL THEORY OF EMPLOYMENT, INTEREST, AND MONEY, 1936
• Provided an alternative to classical theory, to explain periods
of recession.
• Not all income is always spent, contrary to Say’s law.
• Producers may respond to unsold inventories by reducing
output rather than cutting prices.
• A recession or depression could follow this decline in
employment and incomes.
“In the long run we
are all dead.”
THE KEYNESIAN CRITIQUE OF THE CLASSICAL THEORY
• Wages are sticky in the downward direction
• wage contracts are typically adjusted no more than once a year
• Union pressure to maintain/increase wages
• a reluctance to threaten company morale
• Even if wages were lowered, this would lower worker’s incomes, consequently
lowering their spending on consumer goods.
• If wages cannot adjust to match price levels, deviations from full employment
output might persist until the government intervenes.
THE KEYNESIAN CRITIQUE OF THE CLASSICAL THEORY
• Prices are also sticky
• Firms must pay to change prices (ex: menu costs: re-pricing items in
inventory, advertising new prices to consumers, etc.).
• The economy is not always competitive enough to allow prices to fall
(anticompetitive and monopolistic practices).
• Producers will lower output rather than prices.
THE KEYNESIAN CRITIQUE OF THE CLASSICAL THEORY
• On savings and investment…
• Investing is mostly done by businesses who are trying to make a profit so
they will invest only when there is a reasonably good profit outlook.
• Even when interest rates are low, businesses won’t invest unless it is
profitable for them to do so.
• If savings were greater than investment, there would be unemployment and not
everything being produced would be purchased.
KEYNESIAN ECONOMICS
• Keynes maintained that aggregate demand is the prime mover of the economy
• Aggregate demand determines the level of output and employment
• “ Demand creates its own supply”
• The self-correcting mechanisms of falling interest rates and falling prices and
wages might be insufficient to push investment and consumption back up
again so it is necessary for the government to intervene by spending money.
Keynesian economists believe that
SAVINGS AND INVESTMENT ARE
NOT ALWAYS EQUAL AND PRICES
AND WAGES ARE STICKY
(downward direction). Market forces
can cause depressions so government
should play an active role in stabilizing
the economy.
THE KEYNESIAN
CRITIQUE OF THE
AGGREGATE SUPPLY
Classical Theory
1. AS is vertical so a change in AD will not change output, only cause
changes in the price level.
AS
Price
level
AD2
AD
Yf
AD3
Real domestic output, GDP
Keynesian Theory
1. At lower output levels, AS is flat. Many resources are underutilized
and thus can easily be put into use to increase the real GDP without
the price level rising much, if at all.
2. An increase in AD during a recession doesn’t cause inflation.
Price
level
AS
AD
Yf
AD2
Real domestic output, GDP
Keynesian Theory:Three Ranges of Aggregate Supply
•
•
•
•
When the economy grows at a quicker rate, resources will become
increasingly scarce.
AS slopes at a steeper and steeper rate the higher output gets.
When AD increases, both output and price level will increase.
The economy normally operates in the intermediate range of the
SRAS curve.
AS
Price
level
AD2
AD
Y
Intermediate
Range
Three Ranges of Aggregate Supply
•
•
Output has reached a maximum there are no more unused
resources AS is vertical.
Rightward AD shifts only lead to higher price levels
AS
Price
level
Classical
Range
Keynesian
Range
Intermediate
Range
Y
AD2
AD