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Ch. 8: The Self Regulating Economy James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University ©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning 1 Classical Economists and Say’s Law Say’s Law: supply creates its own demand. Implied in Say’s Law: there cannot be either a general overproduction or general underproduction of goods. Say’s Law still holds in a money economy, where individuals sometimes spend less than their full incomes. This argument was partly based on the assumption of interest rate flexibility. 2 Classical Economist and Interest Rate Flexibility For Say’s Law to hold in a money economy, funds saved must give rise to an equal amount of funds invested. Interest rates will adjust to equate saving and investment. Any fall in consumption (and consequent rise in saving) will be matched by an equal rise in investment. 3 Exhibit 1: The Classical View of the Credit Market 4 Exhibit 2: The Classical View of Say’s Law in a Money Economy 5 Classical Economists on Prices and Wages Classical economists believed most, if not all, markets are competitive. Prices and wages will adjust quickly to any surpluses or shortages and equilibrium will be quickly reestablished. 6 Self-Test Explain Say’s law in terms of a barter economy. According to classical economists, if saving rises and consumption spending falls, will total spending in the economy decrease? Explain. What is the classical position on prices and wages? 7 Exhibit 3: Real GDP and Natural Real GDP: Three Possibilities Recessionary Gap: Real GDP is less than the Natural Real GDP Inflationary Gap: Real GDP is Greater than Natural Real GDP Long-Run Equilibrium: Real GDP is Equal to Natural Real GDP 8 Exhibit 3: Real GDP and Natural Real GDP: Three Possibilities 9 The Labor Market and The Three States of the Economy Recessionary Gap: the unemployment rate is higher than the natural unemployment rate (surplus of labor) Inflationary Gap: the unemployment rate is lower than the natural unemployment rate (shortage of labor) Long-Run Equilibrium: the unemployment rate is equal to the natural unemployment rate. 10 Exhibit 4: The Physical and Institutional PPFs 11 Self-Test What is a recessionary gap? an inflationary gap? What is the state of the labor market when the economy is in a recessionary gap? in an inflationary gap? If the economy is in an inflationary gap, locate its position in terms of the two PPFs discussed in this section. 12 What happens if the Economy is in a Recessionary Gap? 1. 2. 3. 4. 5. 6. Recessionary gap Unemployment > Natural Unemployment Surplus in labor market Wages to fall SRAS shifts to the right Economy moves to long-run equilibrium. 13 Exhibit 5: The Self-Regulating Economy: Removing a Recessionary Gap 14 What happens if the Economy is in an Inflationary Gap? 1. 2. 3. 4. 5. 6. Inflationary gap Unemployment < Natural Unemployment Shortage in labor market Wages rise SRAS shifts to the left Economy moves to long-run equilibrium. 15 Exhibit 6: The Self-Regulating Economy: Removing an Inflationary Gap 16 Self-Regulating Economy: A Recap Flexible wages (and other resource prices) play a critical role. Classical, NewClassical, and Monetarist believe the economy is selfregulating 17 Policy Implications of Believing the Economy is Self-Regulating Laissez-faire: Aa public policy of not interfering with market activities in the economy. Some economists believe the government does not have an economic management role to play. 18 Exhibit 7: Changes in a SelfRegulating Economy: Short Run and Long Run 19 Self-Test If the economy is self-regulating, what happens if it is in a recessionary gap? If the economy is self-regulating, what happens if it is in an inflationary gap? If the economy is self-regulating, how do changes in aggregate demand affect the economy in the long run? 20 Coming Up (Ch. 9): Economic Instability A Critique of the Self-Regulating Economy 21