Ch. 6: The Self Regulating Economy

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Ch. 6 The Self Regulating Economy
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Classical Economists and Says Law

• Says Law supply creates its own demand.
• Implied in Says Law there cannot be either a
  general overproduction or general underproduction
  of goods.
• Says 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.

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Classical Economist and Interest Rate Flexibility

• For Says 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.
• TECIG(EX-IM)
• SYdC (Income Tax Consumption Saving)
• S? (by 100) ? C? (by 100) ? I ? (by 100)

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Exhibit 1 The Classical View of the Credit
Market
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Exhibit 2 The Classical View of Says Law in a
Money Economy
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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.

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Self-Test

• Explain Says 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?

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Exhibit 3 Real GDP and Natural Real GDP Three
Possibilities

• Recessionary Gap Real GDP is less than the
  Natural Real GDP
• the unemployment rate is higher than the natural
  unemployment rate (surplus of labor)
• Inflationary Gap Real GDP is Greater than
  Natural Real GDP
• the unemployment rate is lower than the natural
  unemployment rate (shortage of labor)
• Long-Run Equilibrium Real GDP is Equal to
  Natural Real GDP
• unemployment rate is equal to the natural
  unemployment rate.

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Exhibit 3 Real GDP and Natural Real GDP Three
Possibilities
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Exhibit 4 The Physical and Institutional PPFs
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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.

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What happens if the Economy is in a Recessionary
Gap?

• Recessionary gap
• Unemployment Natural Unemployment
• Surplus in labor market
• Wages to fall
• SRAS shifts to the right
• Economy moves to long-run equilibrium.

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Exhibit 5 The Self-Regulating Economy
Removing a Recessionary Gap
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What happens if the Economy is in an Inflationary
Gap?

• Inflationary gap
• Unemployment
• Shortage in labor market
• Wages rise
• SRAS shifts to the left
• Economy moves to long-run equilibrium.

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Exhibit 6 The Self-Regulating Economy Removing
an Inflationary Gap
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Self-Regulating Economy A Recap

• Flexible wages (and other resource prices) play a
  critical role.
• Classical, New-Classical, and Monetarist believe
  the economy is self-regulating

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Policy Implications of Believing the Economy is
Self-Regulating

• Laissez-faire A 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.

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Exhibit 7 Changes in a Self-Regulating Economy
Short Run and Long Run
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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?