Download Powerpoint Chapter 11 - Classical and Keynesian Economics

Chapter 11
Classical and Keynesian Economics
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-1
Chapter Objectives
• Say’s law
• Classical equilibrium
• Real balance, interest rate, and foreign
exchange effects
• Aggregate demand
• Aggregate supply in the long run and
short run
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-2
Chapter Objectives
• The Keynesian critique of the classical
system
• Equilibrium at varying price levels
• Disequilibrium and equilibrium
• Keynesian policy prescriptions
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11-3
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
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11-4
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
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11-5
Consumer Goods and Investment
Goods
• Think of production as consisting of two
products: consumer goods and investment goods (for now, we’re ignoring
government goods)
• The money spent on consumer goods is
designated by the letter C
• The money spent on investment goods is
designated by the letter I
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11-6
Consumer Goods and
Investment Goods
If we think of GDP as total spending, then
GDP would be C + I
If we think of GDP as income received, then
GDP would be C + S
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11-7
Consumer Goods and
Investment Goods
(Continued)
If we think of GDP as total spending, then
GDP would be C + I
If we think of GDP as income received, then
GDP would be C + S
GDP = C + I
GDP = C + S
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11-8
Consumer Goods and
Investment Goods
(Continued)
GDP = C + I
GDP = C + S
And since things equal to the same thing are equal to
each other, we have
C+I=C+S
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11-9
Consumer Goods and
Investment Goods
(Continued)
GDP = C + I
GDP = C + S
Things equal to the same thing are equal to each other
C+I=C+S
Next, we can subtract the same thing from both sides
of the equation. In this case we subtract C
I=S
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-10
Say’s Law Revisited
Households
Households
The economy produces a supply of
consumer goods and investment
goods (Aggregate Supply = AS)
7.0 AS
Firms
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11-11
Say’s Law Revisited
S=0.5 They save the rest
Households
Households
AS=7.0
The people who produce
these goods (Households)
spend part of their incomes
on consumer goods
C=6.5
Firms
I=0.5
Their savings are
borrowed by investors
who spend this money on
investment goods
11-12
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Say’s Law Revisited
S=0.5
Households
Households
AS=7.0
GDP = C + I
GDP = 6.5 + 0.5
GDP = 7.0
C=6.5
I=S
Firms
I=0.5
GDP = 7.0 = Aggregate Demand (AD)
We can see that Say’s law holds up, at least in accordance with classical analysis.
Supply does create its own demand. Everything produced is sold. (AS = GDP=AD)
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-13
Supply and Demand Revisited
The curves cross at a
price of $7.30 and a
quantity of 6
10
S
9
8
7
D
6
2
4
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6
8
Quantity
10
12
14
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Supply and Demand Revisited
The Loanable Funds Market
The demand and
supply curves cross at
an interest rate of 15
percent
Supply of
savings
20
15
10
5
Demand f or
investment
f unds
0
Quantity of loanable f unds
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11-15
Supply and Demand Revisited
If the quantity supplied is
greater than the quantity
demanded at a certain price
(in this case $8), the price
will fall to the equilibrium
level ($6), at which quantity
demanded is equal to
quantity supplied.
Market for Hypothetical Product
14
S
12
10
8
6
4
2
D
0
Quantity
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11-16
Supply and Demand Revisited
Hypothetical Labor Market
If the wage rate is set too high
($9 an hour),the quantity of
labor supplied exceeds the
quantity of labor demanded.
The wage rate falls to the
equilibrium level of $7; at
that wage rate, the quantity of
labor demanded equals the
quantity supplied
20
Supply of
labor
18
16
14
12
10
8
6
4
2
Demand
f or labor
0
Quantity of labor
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11-17
The Classical Equilibrium: Aggregate
Demand Equals Aggregate Supply
• On the micro level, when quantity demanded
equals quantity supplied, we’re at equilibrium
• On the macro level, when aggregate demand
equals aggregate supply, we’re at equilibrium
• The classical economist believed our economy
was either at, or tending toward , full
employment
• So at classical equilibrium – the GDP at which
aggregate demand was equal to aggregate
supply – we were at full employment
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11-18
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
180
160
140
120
100
80
60
Aggregate
demand
40
20
0
0
1
2
8
7
6
5
4
3
Real GDP (in trillions of dollars)
9
10
Aggregate demand is the total value of real GDP that all sectors of
the economy are willing to purchase at various price levels
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11-19
The Aggregate Demand Curve
• There are three reasons why the quantity
of goods and services purchased declines
as the price level increases
– An increase in the price level reduces the
wealth of people holding money, making
them feel poorer and reducing their
purchases
• This is called the real balance effect
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11-20
The Aggregate Demand Curve
• The higher price level pushes up the
interest rate, which leads to a reduction
in the purchase of interest-sensitive
goods, such as cars and houses
– This is called the interest rate effect
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11-21
The Aggregate Demand Curve
• Net exports decline as foreigners buy less
from us and we buy more from them at
the higher price level
– This is called the foreign purchases effect
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11-22
The Real Balance Effect
• The real balance effect is the influence of
a change in your purchasing power on
the quantity of real GDP that you are
willing to buy
– A decrease in the price level increases the
quantity of real money
• The larger the quantity of real money, the larger
the quantity of goods and services demanded
– An increase in the price level decreases the
quantity of real money
• The smaller the quantity of real money, the
smaller the quantity of goods and services
demanded
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-23
The Interest Rate Effect
• A rising price level pushes up interest
rates, which in turn lower the
consumption of certain goods and
services and also lower investment in new
plant and equipment
– A rising price level pushes up interest rates
and lowers both consumption and
investment
– A declining price level pushes down interest
rates and encourages both consumption and
investment
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11-24
The Foreign Purchases Effect
• When the price level in the United States rises
relative to the price levels in other countries
– American goods become more expensive relative to
foreign goods
• American imports rise (foreign goods are cheaper)
• American exports decline (American goods are more
expensive)
• Thus, American net exports (exports minus
imports) component of GDP declines
• When the price level declines, the net exports
component (and GDP) rises
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-25
The Long-Run Aggregate
Supply Curve
Long-Run Aggregate Supply curve (in trillions of dollars)
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
180
160
L-RAS
140
120
100
80
60
40
20
0
0
1
2
3
4
5
6
7
Real GDP (trillions of dollars)
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8
9
10
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Aggregate Demand and LongRun Aggregate Supply
Aggregate Demand and Long-Run Aggregate
Supply (in trillions of dollars)
180
L-RAS
160
The long-run equilibrium of
real GDP is $6 trillion at a
price level of 100
140
120
100
80
60
Aggregate
demand
40
20
0
0
1
2
7
6
5
4
3
Real GDP (trillions of dollars)
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8
9
10
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The Short-Run Aggregate
Supply Curve
Short-Run Aggregate Supply Curve (in trillions
of dollars)
180
160
Why does the short-run
aggregate supply curve
sweep upward to the right?
Because business firms will
supply increasing amounts
of output as prices rise
S-RA S
140
120
100
80
60
40
20
0
0
1
2
3
4
5
6
7
8
9
10
Real GDP (in trillions of dollars)
Full-employment GDP
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11-28
Aggregate Demand, Long-Run
and Short-Run Aggregate Supply
Aggregate Demand, Long-Run and Short-Run
Aggregate Supply (in trillions of dollars)
180
L-RA S
160
The long-run aggregate
supply curve, the short-run
aggregate supply curve, and
the aggregate demand come
together at full-employment
S-RA S
140
120
100
A ggregate
demand
80
60
40
20
0
0
1
2
3
4
5
6
7
8
Real GDP (in trillions of dollars)
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
9
10
11-29
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
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11-30
The Keynesian Critique of the
Classical System
• Keynes asked the question. “What if
savings and investment were not equal?”
– If savings were greater than investment,
there would be unemployment
– Not everything being produced would be
purchased
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11-31
The Keynesian Critique of the
Classical System
– Keynes disputed the view that the interest
rate would equilibrate savings & investment
– Keynes maintained that
• Saving and investment are done by different people for
different reasons
• Most saving is done by individuals for big ticket items
• Investing is done by those who run a business and are
trying to make a profit
• They will invest only when there is a reasonably good profit
outlook
• Even when interest rates are low, business firms won’t
invest unless it is profitable for them to do so
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11-32
The Keynesian Critique of the
Classical System
– Keynes questioned whether wages and prices
were downwardly flexible, even during a
severe recession
– Studies have indicated that prices are seldom
lowered and that wage cuts (even as the only
alternative to massive layoffs) are seldom
accepted
– Keynes pointed out that even if wages were
lowered, this would lower worker’s incomes,
consequently lowering their spending on
consumer goods
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11-33
The Keynesian Critique of the
Classical System
– Keynes concluded that the economy was not
always at, or tending toward a full
employment equilibrium
– Keynes believed three possible equilibriums
existed
• Below full employment
• At full employment
• Above full employment
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11-34
The Keynesian Critique of the
Classical System
Modified Keynesian Aggregate Supply Curve
180
As an economy works its
way out of a depression,
output can be raised
without raising prices, so
the aggregate supply curve
is flat.
160
140
L-RAS
120
100
80
60
40
20
0
0
1
2
3
4
5
6
7
8
Real GDP (in trillions of dollars)
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9
10
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The Keynesian Critique of the
Classical System
Modified Keynesian Aggregate Supply Curve
180
However, as resources
becomes more fully
employed and bottlenecks
develop, costs and prices
begin to rise. When this
happens the aggregate
supply curve begins to
curve upward.
160
140
L-RAS
120
100
80
60
40
20
0
0
1
2
3
4
5
6
7
8
Real GDP (in trillions of dollars)
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9
10
11-36
The Keynesian Critique of the
Classical System
Modified Keynesian Aggregate Supply Curve
180
160
When we reach full
employment (at a real GDP
of $6 trillion), output cannot
be raised any further
140
L-RAS
120
100
80
60
40
20
0
0
1
2
3
4
5
6
7
8
Real GDP (in trillions of dollars)
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9
10
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The Keynesian Critique of the
Classical System
Three Aggregate Curves
AD1 represents aggregate
180
demand during a recession or
depression
160
L-RAS
140
120
AD2 crosses the long-run
aggregate supply curve at full
employment
100
80
AD3
60
40
AD1
20
AD3 represents excessive demand
AD2
0
0
1
2
3
4
5
6
7
8
Real GDP (in trillions of dollars)
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9
10
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The Keynesian System
• Keynes stood Say’s law on its head
• Keynesian theory can be summarized
with the statement, “ Demand creates its
on supply”
– Keynes maintained that aggregate demand is
the prime mover of the economy
• Aggregate demand determines the level of output
and employment
• Business firms produce only the quantity of
goods and services they believe consumers,
investors, governments, and foreigners will plan
to buy
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11-39
The Ranges of the Aggregate Supply Curve
A ggregate
supply
Keynesian
range
Real GDP
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11-40
The Keynesian Aggregate Expenditure Model
The Consumption and Saving Functions
When consumption
(C) is greater than
disposable income
(DI), savings is
negative
9
8
Saving
C
7
6
5
Dissaving
4
When disposable
(DI) income is
greater than
consumption (C),
savings is positive
3
2
1
0
0
1
2
3
4
5
6
7
8
9
10
Disposable income (in trillions of dollars)
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11-41
The Keynesian Aggregate Expenditure Model
The Investment Sector
Real GDP (in trillions of dollars)
When C + I represents
aggregate demand, how
much is equilibrium GDP
9
8
C+I
C
7
6
5
Answer: Approximately $7.0
trillion
4
3
2
1
45û
0
0
1
2
3
4
5
6
7
8
Real GDP (in trillions of dollars)
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9
10
11-42
Aggregate Demand Exceeds
Aggregate Supply
• When aggregate demand exceeds aggregate
supply the economy is in disequilibrium
– Output is increased in response
– Eventually, the economy approaches full capacity
followed by price increases
• It appears that there are two ways to raise
aggregate supply
– By increasing output
– By increasing prices
• By doing this, aggregate supply is raised
relative to aggregate demand and equilibrium
is restored
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-43
Aggregate Supply Exceeds
Aggregate Demand
• When aggregate supply exceeds aggregate
demand the economy is in disequilibrium
– Inventories rise and output is decreased
– Workers are laid off, further depressing aggregate
demand as these workers cut back on their
consumption
– Eventually, inventories are sufficiently depleted
• In the meantime, aggregate supply has fallen
back into equilibrium with aggregate demand
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11-44
Summary: How Equilibrium Is
Attained
• When the economy is in disequilibrium, it
automatically moves back into
equilibrium
• It is always aggregate supply that adjust
– When aggregate demand is greater than
aggregate supply, aggregate supply rises
– When aggregate supply is greater than
aggregate demand, aggregate supply declines
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11-45
Summary: How Equilibrium Is
Attained
• Aggregate demand (C + I) must equal the
level of production (aggregate supply) for
the economy to be in equilibrium
• When the two are not equal, aggregate
supply must adjust to bring the economy
back into equilibrium
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-46
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
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11-48