Chapter 11 - Classical and Keynesian economics. This chapter include 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.
Chapter 11 Classical and Keynesian Economics Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 111 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 McGrawHill Companies, Inc. All rights reserved 112 Chapter Objectives • The Keynesian critique of the classical system • Equilibrium at varying price levels • Disequilibrium and equilibrium • Keynesian policy prescriptions Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 113 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 114 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 115 Consumer Goods and Investment Goods • Think of production as consisting of two products: consumer goods and invest ment 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 116 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 117 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 118 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 119 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 McGrawHill Companies, Inc. All rights reserved 1110 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 1134 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 Real GDP (in trillions of dollars) Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 10 1135 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 Real GDP (in trillions of dollars) Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 10 1136 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 Real GDP (in trillions of dollars) Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 10 1137 The Keynesian Critique of the Classical System Three Aggregate Curves 180 AD1 represents aggregate demand during a recession or depression L-RAS 160 140 120 AD2 crosses the longrun 100 aggregate supply curve at full employment 80 AD3 60 40 AD3 represents excessive demand AD1 20 0 AD2 Real GDP (in trillions of dollars) Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 10 1138 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 1139 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved The Ranges of the Aggregate Supply Curve Aggregate supply Keynesian range Real GDP Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 1140 The Keynesian Aggregate Expenditure Model The Consumption and Saving Functions When consumption (C) is greater than disposable income (DI), savings is negative Saving C Dissaving When disposable (DI) income is greater than consumption (C), savings is positive Disposable income (in trillions of dollars) Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 10 1141 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 C+I C Answer: Approximately $7.0 trillion 45û Real GDP (in trillions of dollars) Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 10 1142 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 McGrawHill Companies, Inc. All rights reserved 1143 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 1144 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 1145 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 McGrawHill Companies, Inc. All rights reserved 1146 Keynesian Policy Prescriptions • The Classical position summarized – Recessions are temporary because the economy is selfcorrecting • 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 selfcorrecting, the role of government is to stand back and do nothing Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 1147 Keynesian Policy Prescriptions • Keynes’s position was that recessions are not necessarily temporary – The selfcorrecting 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 Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 1148 ... of output as prices rise S-RAS 140 120 100 80 60 40 20 0 10 Real GDP (in trillions of dollars) Full-employment GDP Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 11 28 Aggregate Demand, LongRun ... together at fullemployment L-RAS 160 S-RAS 140 120 100 Aggregate demand 80 60 40 20 Real GDP (in trillions of dollars) Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 10 11 29 The Keynesian Critique of the ... goods (Aggregate Supply = AS) 7.0 AS Firms Copyright 2002 by The McGrawHill Companies, Inc. All rights reserved 11 11 Say’s Law Revisited S=0.5 They save the rest Households Households AS=7.0 The people who produce