Download Classical vs Keynesian

Classical vs Keynesian
Which one do you prefer?
CLASSICAL BELIEVES:
Markets will behave according to S&D.
In other words. S&D will respond accordingly
to “Inflationary Gap,
Recessionary Gap,
and long run stability when all curves
intersect.
SAY’S LAW
Economists agree Says law works in Barter
economy and disagree about if it works in a
money economy.
Supply creates its own demand… baker
bakes enough bread to trade for what he
wants.
That works.
Classical economics believes it works in
money economy and here is why.
The Classical Model (cont'd)
• Classical economists—Adam Smith, J.B. Say,
David Ricardo, John Stuart Mill, Thomas
Malthus, A.C. Pigou, and others—wrote from
the 1770s to the 1930s.
• They assumed wages and prices were flexible,
and that competitive markets existed
throughout the economy.
The Classical Model (cont'd)
• Assumptions of the classical model
– Pure competition exists.
– Wages and prices are flexible.
– People are motivated by self-interest.
– People cannot be fooled by money illusion.
The Classical Model
• Consequences of The Assumptions
– If the role of government in the economy is
minimal,
– If pure competition prevails, and all prices and
wages are flexible,
– If people are self-interested, and do not
experience money illusion,
– Then problems in the macroeconomy will be
temporary and the market will correct itself.
Classical Theory
Classical economists believed that prices, wages and
interest rates are flexible.
Say’s law says when economy produces a certain level
of real GDP, it also generates the income needed
to purchase that level of real GDP.) hence, always
capable of achieving the natural level of GDP.
Fallacy here: no guarantee that the income received
will be used to purchase g & s.----some will be
saved.
But theory would be redeemed, if the savings goes into
equal needed amounts of investment.
Classical belief on wages and prices
Believed all markets competitive- (S&D * Key) –
adjust to surplus and shortage….
If oversupply of labor, wage rates drop and
S&D of labor will be in sinc.
What holds for wages also applies to
prices.
Prices adjust quickly to surplus or
shortages
Equilibrium established again.
Three States of the Economy
1.
Real GDP is less than Natural Real GDP (recessionary
gap)
2. Real GDP is more than Natural Real GDP (inflationary
gap)
3. Real GDP is equal to Natural Real GDP.
What is Natural Real GDP?
Real GDP that is produced at the natural unemployment
rate. (which we agree around 5%)
Key: Wage rates and prices will adjust quickly to
surplus or shortage
1) In recession- unemployment rate higher than natural
rate.
2) Surplus exists in labor market
3) Drives down wage rate
++++++++++++++
4) In inflationary gap, unemployment lower than natural
rate
5) Shortage exists in labor market
6) Drives up the wage rate
BOTH THEORIES CLASSICAL AND KEYNESIAN DO
AGREE……
TWO THINGS WE CAN DO WITH DISPOSABLE
INCOMESPEND OR SAVE!
We all know that consumption is 2/3 (or more)
of GDP
***Classical theorists say, the funds from aggregate
savings eventually borrowed and turned into
investment expenditures which are a component of
real GDP
BUT…. What if no or low savings?
Theory breaks down here – have to have equal
amounts of investment for savings.
(the idea here is that savings leads to investment) This
is true… but it probably won’t do it by itself. Needs
assistance through monetary or perhaps fiscal
policy.
The Classical View of the Credit
Market
In classical theory, the interest
rate is flexible and adjusts so
that saving equals investment.
If saving increases and the
saving curve shifts rightward
the increase in saving
eventually puts pressure on the
interest rate and moves it
downward.
A new equilibrium is
established where once again
the amount households save
equals the amount firms invest.
Long-run Equilibrium
The condition where the
Real GDP the economy is
producing is equal to the
Natural Real GDP and
the unemployment rate
is equal to the natural
unemployment rate.
Recessionary (Contractionary) Gap
The condition where the
Real GDP the economy is
producing is less than the
Natural Real GDP and
the unemployment rate is
greater than the natural
unemployment rate.
Recessionary (Contractionary) Gap
The economy is currently in
short-run equilibrium at a
Real GDP level of Q1.
QN is Natural Real GDP or
the potential output of the
economy.
Notice that Q1< QN. When
this condition (Q1< QN) exists,
the economy is said to be in a
recessionary gap.
Inflationary (Expansionary) Gap
The condition where the
Real GDP the economy is
producing is greater than
the Natural Real GDP
and the unemployment
rate is less than the
natural unemployment
rate.
Inflationary (Expansionary) Gap
The economy is currently
in short-run equilibrium at a
Real GDP level of Q1.
QN is Natural Real GDP or
the potential output of the
economy.
Notice that Q1>QN. When
this condition (Q1>QN) exists,
the economy is said to be in
an inflationary gap.
Economy and Labor Market
Self Regulating Economy
Closing the Inflationary (Expansionary) Gap
 The economy is at P1 and
Real GDP of $11 trillion.
 Because Real GDP is greater
than Natural Real GDP ($10
trillion), the economy is in
an inflationary gap and the
unemployment rate is lower
than the natural
unemployment rate.
Self Regulating Economy
Closing the Inflationary (Expansionary) Gap
 The economy is at P1 and
Real GDP of $11 trillion.
 Because Real GDP is greater
than Natural Real GDP ($10
trillion), the economy is in
an inflationary gap and the
unemployment rate is lower
than the natural
unemployment rate.
Self Regulating Economy
Closing the Inflationary (Expansionary) Gap
 Wage rates rise, and the shortrun aggregate supply curve
shifts from SRAS1 to SRAS2.
 As the price level rises, the real
balance, interest rate, and
international trade effects
decrease the quantity
demanded of Real GDP.
 Ultimately, the economy
moves into long-run
equilibrium at point 2.
Policy Implication
Laissez-faire
•
Classical, new classical, and monetarist economists
believe that the economy is self-regulating. For these
economists, full employment is the norm: The economy
always moves back to Natural Real GDP.
Laissez-faire
A public policy of not interfering
with market activities in the economy.
How would it automatically adjust? Classical
 Slump in output yields….
 Lower prices
This increases consumer
spending.
 Lower wages - eventually will occur… with lower prices
 Lower interest rate
Increases investment
spending Increases employment
Excesses of supply of goods and workers would be eliminated and
return to a balanced full-employment status.
*Production of output automatically provides the income needed to
buy the output.
This theory was prevalent until Depression of 30’s hit.
Then what happened?
25% unemployment
Banks closed
Production ceased
Drought hit
Stocks worthless
No money for purchases
No jobs
Bleak!
AS 1
AD 1
AD
P
R
I
C
E
L
E
V
E
L
GDP
AS
Bottom Line
Classical viewpointnot possible to overproduce goods because the
production of those goods would always
generate a demand that was sufficient to
purchase the goods.
(what would they say about the
recent inventories of our auto industry?)
• Keynesian Ideas
The classical approach fell into disrepute during the
economic decline of the 30’s. Real GDP fell by more
than 30% 1930-33
In 1939- per capital income was still 10% less than in
1929.
*U.S. began to embrace John Maynard Keynes’s
theory of stimulating the economy through
aggregate demand (Lord Keynes) had studied
classical economics and wrote his famous General
Theory of Employment, Interest and Money. (which
was a complete rebuttal of the classical theory)
Keynesian in a Nutshell
John Maynard Keynes
Nutshell explained
• The General Theory of
Employment, Interest and
Money (1936)
• Direct response to
Depression.
• His response to Say – merely
producing goods would not
spark demand for them
• Government had an
obligation to step in when
economy was in trauma.
Keynes’s View of Say’s Law
in a Money Economy
According to Keynes, a
decrease in consumption
and subsequent increase in
saving may not be matched
by an equal increase in
investment. Thus, a decrease
in total expenditures may
occur.
To learn more about
John Maynard Keynes,
click his photo above.
Keynes’ Prescription
• For an economy “stuck” at a high
unemployment equilibrium,
– Self-regulation was not working.
– A “jumpstart” was needed:
– An injection of new spending to get the economy
moving again.
• The only spender who could do this was
Government.
Keynesian Economics
• Works only on the AD curve
• Assumes AS is stationary
• Critics of Keynes:
– …But this will cause deficits!
– …But the government can’t spend that much!
The Economy Gets “Stuck” in a
Recessionary Gap
If the economy is
in a recessionary
gap at point 1,
Keynes held that
wage rates may
not fall.
The economy
may be stuck in
the recessionary
gap.
Keynesian Economics and the Keynesian Short-Run Aggregate
Supply Curve (cont'd)
• Real GDP and the price level, 1934–1940
– Keynes argued that in a depressed economy, increased
aggregate spending can increase output without raising prices.
– Data showing the U.S. recovery from the Great Depression seem
to bear this out.
– In such circumstances, real GDP is demand driven.
Keynesian Economics was the answer to Classical
economic theories and the suggested way to “jumpstart” the economy again… pull out of the
depression.
Idea: Government enters the economy.
Stimulates the economy through Aggregate Demand.
Fiscal policy would move the production engine by
stimulating “spending.”
increased employment, jobs would be filled,
production would begin
people would purchase with money they earned from
jobs.
Classical vs. Keynes I
A Question of How Long It Takes for
Wage Rates and Prices to Fall
 Suppose the economy is in
a recessionary gap at point
1.
 Wage rates are $10 per
hour, and the price level is
P1.
 The issue may not be
whether wage rates and
the price level fall, but how
long they take to reach
long-run levels
•
The speed at which wage rate falls is a key
To whether Keynesian or Classical theory
Is more valid. Answers never for sure.
Keynes rejected the classical notion of selfadjustment, (????) and he predicted things would
get worse once a spending shortfall emerged.
Example:
• Business expectations of future sales worsens.
• Business investment is cut back.
• Unsold capital goods begins to pile up (includes office equip.
machinery, airplanes, etc.)
• *this is an “undesired” change…
• Worsened sales expectations causes decline in investment
spending that shifts the AD curve to the left leading to pileups
of unwanted inventory.
Example: Are the U.S. and European SRAS Curves
Horizontal?
• New Keynesians contend that the SRAS is essentially
flat.
• Based on research, they contend SRAS is horizontal
because firms adjust their prices about once a year.
• If the SRAS schedule were really horizontal, how could
the price level ever increase?
Keynesian Theory
P
R
I
C
E
AD 1
AD 2
AD 3 *Price
Goes up
L
E
V
E
L
AS
Real GDP Output
Keynesian Theory
AD unstable, prices and wages are inflexible AD no effect on prices until LRAS
Figure 11-9 Real GDP Determination with Fixed
versus Flexible Prices
Shifts in SRAS Only
Table 11-2 Determinants of Aggregate
Supply
Consequences of Changes in
Aggregate Demand
• Aggregate Demand Shock
– Any event that causes the aggregate demand
curve to shift inward or outward
• Aggregate Supply Shock
– Any event that causes the aggregate supply curve
to shift inward or outward