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Chapter 11
CLASSICAL AND KEYNESIAN ECONOMICS
Chapter 11
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objectives
After this chapter you should be able to:
1.
2.
3.
4.
5.
6.
7.
Discuss Say’s law.
Analyze Classical equilibrium.
Explain and discuss the real balance, interest rate, and
foreign purchases effects.
Demonstrate the interaction between aggregate demand
and aggregate supply.
Summarize the Keynesian critique of the classical system.
Describe equilibrium and disequilibrium and distinguish
between them.
Summarize and discuss the Keynesian policy prescriptions.
11-2
Two Views of the Macro-Economy
 Are business cycles self-correcting?
 Do the forces of supply and demand lead a market economy
toward full employment growth with price stability on its own?
 Or do we need active government policies during
economic downturns?
 We will examine two alternative answers:
 Classical Economics
 Keynesian Economics
11-3
Part I: The Classical Economic System
 The centerpiece of classical economics is Say’s Law.
 Which states, “Supply creates its own demand.”
•



This means that somehow, what we produce—supply—all gets
sold (demanded).
When a seller sells a product (including his/her own labor),
she/he earns income.
This income is used to purchase other goods and services.
If all the income is spent, all the goods and services will be
sold.
11-4
Production in a Five-Person Economy
(Table shows each
person’s production.)
Sally keeps 1 tee shirt and sells the rest to buy tomatoes, bread,
butter, and shoes.
Question: What happens if Sally buys less bread and butter to save
for a new sewing machine?
11-5
What about savings?
 If some people save, then some things that are
produced will not be sold.

Money is leaking out of the system.
 Savings is important for future growth.
 Without savings, we could not have investment—the
production of plant, equipment, and inventory.
 How can the system stay in balance?
 Markets inject the savings back into the system.
 Savings doesn’t sit in a bank vault, it is lent out to businesses,
home buyers, and others.
 One person’s savings become someone else’s investment.
11-6
Consumer Goods and Investment Goods
 Start with just the private sector (no government or foreign
trade).
 All production (Supply) consists of:



Consumer goods (C).
Investment goods (I).
No G or Xn.
 If we think of GDP as total spending, then GDP = C + I.
 If we think of GDP as income received, then GDP = C + S.
11-7
Consumer Goods and Investment Goods
GDP = C + I
GDP = C + S
Things equal to the same thing are equal to each other:
C+I=C+S
Subtract the same thing (C) from both sides of the equation:
C+I=C+S
You are left with:
I=S
S leaks out, but is
Injected back in as I.
11-8
Supply and Demand Revisited
 Find equilibrium price: Approx. $7.20
 Find equilibrium quantity: 6
Classical economists applied this process to financial markets
to prove that I = S.
11-9
The Loanable Funds Market
 Savings supplies banks and
financial institutions with
loanable funds.
 Businesses borrow (demand)
funds for Investment.
 Interest rate is the price of
loanable funds; they are flexible.
 Equilibrium interest rate is 15%.
11-10
Questions for Thought and Discussion
 Why does the Savings Curve slope up like a Supply
Curve?

When would you be more likely to put money in your savings
account: when interest rates are high or low? (Hint: Think about
opportunity costs of keeping cash.)
 Why does the Investment Curve slope down like a
Demand Curve?

When would businesses prefer to borrow money: when interest rates
are high or low?
 If banks have too much money and not enough
borrowers, will they raise or lower interest rates?
11-11
In Classical Macroeconomics, Unemployment is
Temporary
 Labor markets are no different than any other
markets, under Say’s Law.

Unemployment is due to labor surplus
•

(Quantity supplied > Quantity demanded).
Lower price of labor (wage), until Labor Supply equals Labor
Demand.
 Conclusion: No involuntary unemployment.
 Need a job? Work cheaper!
 Anyone who isn’t working has decided not to work at the
equilibrium wage.
11-12
Hypothetical Labor Market
 At $9 per hour, there is a labor
surplus (unemployment).
 At $7 per hour:


Everyone who wants to work at
that rate can find a job.
Every employer willing to hire
workers at that rate can find as
many workers as s/he wants to
hire.
 There was a movement along the
Labor Supply Curve.

Some workers voluntarily decided
not to offer their labor.
11-13
Modeling Classical Equilibrium
 Macroeconomic Equilibrium
 When Aggregate Demand equals Aggregate Supply.
 Characteristics of Macroeconomic Equilibrium for
Classical Economists:


Full employment of labor (no involuntary unemployment)
Full employment of resources (maximum output)
 Classical Economists maintain that market
economies with flexible prices should tend toward
macroeconomic equilibrium.
11-14
The Aggregate Demand Curve
 Aggregate Demand is the
total value of real GDP that
all sectors of the economy (C
+ I + G + Xn) are willing to
purchase at various price
levels.
 When the price level
increases (inflation), people
purchase less output.
11-15
Three Reasons why the AD Curve
Slopes Down
 Real Balance Effect
 You feel poorer, so you spend less.
 Purchasing power declines with inflation.
 Interest Rate Effect
 Rising prices push up interest rates.
 Lenders need higher interest rates to compensate for eroding
purchasing power of money.
 Foreign Purchases Effect
 If prices rise in the U.S., exports decrease and imports
increase, so Xn decreases.
11-16
Aggregate Supply Curve
 Aggregate Supply is the amount of real GDP that
will be made available by sellers at various price
levels.
 Aggregate Supply looks different in the Long Run
and the Short Run:


In the Long Run, classical economists assume the economy
operates at full employment (maximum output), independent
of the price level.
In the Short Run, businesses will increase supply if the price
level increases.
11-17
Long-Run Aggregate Supply Curve (LRAS)
 A vertical line at full
employment level of
GDP
 Real GDP = $6
trillion at every point
on LRAS (regardless
of price level).
11-18
Long-Run Macroeconomic Equilibrium
LR equilibrium of
$6 trillion in real GDP
and price level of 100.
Supply Creates Its Own Demand!
11-19
Short-Run Aggregate Supply Curve
 Relatively flat at low levels of output, and gradually approaches vertical.
Beyond full employment GDP,
expanding production is more
expensive, so firms need large
price increase output.
At low levels of output, firms
can easily expand output when
prices rise.
11-20
Short-Run Macroeconomic Equilibrium
Output may be above or below
full employment in the SR, but
should settle at full employment
GDP in LR.
11-21
Classical View of Recessions
 Economy starts at AD1: E1 at Full
employment GDP and Price level
= 140.
 During recession, AD decreases
to AD2: E’ at lower output ($4
trillion).
 Surplus inventory of $2 trillion
so firms decrease prices until sell
off surplus at E2.
Conclusion: No government intervention necessary. Flexible prices
will pull economy out of recession. Economy is self-adjusting.
11-22
Part II: The Keynesian Critique of the Classical
System
 Until the Great Depression, classical economics was
the dominant school of economic thought.

“Laissez-Faire”: government should NOT intervene.
 The Great Depression undermined Say’s Law.
 Keynes developed alternative theory of
macroeconomics:


Advocated government intervention to bring an end to the
Great Depression.
Focused on boosting demand for output, not flexible prices.
11-23
Keynes’ Critique of Say’s Law:
S≠I
 Savings and Investment are not equal:
 Savings is not affected by interest rates. People save for future
purchases and based on income.
 Businesses invest when expect demand for product. In
recession, why expand even if interest rates are low?
 If S > I, not everything being produced would be
purchased.
 Supply does not create its own Demand.
11-24
Keynes’ Critique of Says Law:
Prices and Wages are not Flexible
 Prices are not downwardly flexible, even in a
recession.


Big firms in concentrated industries (oligopolies) can wait out
recession without lowering prices.
They would rather temporarily reduce output.
 Wages are not downwardly flexible, even in a
recession.


Labor unions with long-term contracts resist wage cuts.
Lowering wages not ideal way to increase inflation because it
reduces income.
 If prices and wages are not flexible, Supply does not
create its own Demand.
11-25
Keynesian View of Macroeconomic Equilibrium
 Economy was not always at, or tending toward, a full
employment equilibrium.
 Three equilibriums are possible:
 Below full employment
 At full employment
 Above full employment
11-26
Modified Keynesian Aggregate Supply Curve
 During recession, output can be
increased without raising prices
(flat part of curve).
 As approach full employment ($6
trillion), prices begin to increase
(upward sloping part of curve).
 At full employment level of GDP,
L-RAS is vertical. Output cannot
be expanded, but price level can
increase.
11-27
Keynesianism is Demand-Side Economics
 Keynes stood Say’s Law on its head:
 Can be summarized as, “Demand creates its own
Supply.”
 Business firms produce only the quantity of goods and services
they believe consumers (C), investors (I), governments (G),
and foreigners (Xn) will plan to buy.
 Aggregate Demand is the prime mover of the
economy.


If you can expand C, I, G, and/or Xn (demand for goods and
services), businesses will sell surplus and continue to expand.
Level of GDP depends upon planned expenditures.
11-28
Three Possible Equilibriums
AD3 Expanding
output beyond
full employment
is inflationary.
AD1 represents
aggregate
demand during
a recession or
depression. It
can increase
without
inflation.
AD2 crosses
the long-run
aggregate
supply curve
at full
employment
11-29
Summary of Two Theories
Classical View
 Assumes flexible price
Keynesian View
 Assumes flexible demand for
 Savings depends on interest
rates
 Investment depends on interest
rates
 Wages flexible
 Wait for Long Run




output
Savings depends on income
Investment depends on profit
expectations
Wages sticky
Fix in Short Run
Which assumptions seems more realistic to you?
11-30
Three Ranges of the Aggregate Supply Curve
 Contemporary macroeconomists
often synthesize the two theories,
suggesting that each theory could
hold true under different
economic conditions.
11-31
Part III: The Keynesian System
 Keynesian Aggregate Expenditure Model puts
consumer behavior at center of analysis.
As income rises, C rises, but not as quickly.
11-32
Equilibrium in Aggregate Expenditure Model
Note vertical axis is NOT price level.
Investment does
not depend on
income, so add as
fixed amount.
Equilibrium is
where AE line
crosses 45° line,
at $7 trillion.
11-33
Reaching Equilibrium
 When Aggregate Demand exceeds Aggregate Supply
the economy is in disequilibrium.


Planned inventories too low.
Signals firms to boost output.
 When Aggregate Supply exceeds Aggregate Demand
the economy is in disequilibrium.


Planned inventories are too high.
Workers are laid off, further depressing aggregate demand as
these workers cut back on their consumption.
 Inventories send signals to firms.
11-34
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.
11-35
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.
 This equilibrium does not have to be at full
employment level of GDP.
11-36
Keynesian Policy Prescriptions
 Keynes’s position was that recessions are not
necessarily temporary.




The government should then 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 prescribed lowering Aggregate Demand to
bring down inflation.

Rather than spending money, government should reduce
spending, raise taxes, decrease money supply.
11-37
Keynes and the New Deal
 Roosevelt's New Deal programs succeeded in
bringing about rapid economic growth 1933 to 1937.




However, Roosevelt decided to try to balance federal budget.
He raised taxes and cut government spending.
Federal Reserve sharply cut the rate of growth of the money
supply.
Output plunged and the unemployment rate soared.
 Military spending during WWII brought economy
out of Great Depression.
 Keynesian became the dominant macroeconomic
theory until the 1970s.
11-38
Questions for Thought and Discussion: Keynes
and Say in the 21st Century
 Until the 1970s, the U.S. was a closed economy.
 Workers spent additional income on U.S.-made goods and
services.
 How has globalization changed context for Keynesian
economics?
 How are the different assumptions and theories of
economists influencing current policy debates?

Can you find a news story that illustrates the two sides of the
discussion?
11-39