Chapter 8 and 9 Classical vs' Keynesian

1
Chapter 8 and 9 Classical vs. Keynesian
2
Basic Macroeconomic Relationships

• Chapter 8 and 9 looks at
• Says Law
• How Classical Works (or not)
• Interest Rate and Investment
• Income and Consumption (or savings)
• Changes in spending and changes in output
• Multiplier

3
SAYS LAW

• Economists agree Says law works in Barter economy
  and disagree about if it works in a money
  economy.
• Supply creates its own demand (example in book-
  baker bakes enough bread to trade for what he
  wants.
• That works.
• Classical economics believes it works in money
  economy and here is why.

4
Classical Theory

• Classical economics believed that prices, wages
  and interest rates are flexible.
• Says law says when economy produces a certain
  level of real GDP,
• it also generates the income needed to purchase
  that level of real GDP.)
• hence, always capable of achieving the natural
  level of GDP.
• Fallacy here no guarantee that the income
  received will be used to purchase g s.----some
  will be saved.
• But theory would be redeemed, if the savings
  goes into equal needed amounts of investment.

5
Interest Rate Flexibility

• For Says law to be valid, money saved must
  amount of invested.
• Why? Because of interest rate flexibility.
• More into savings, more available for
  investment would force rates down.
• In looking at TE CIGX-M
• Says believes if C decreases the same percentage
  increase will be seen in I

6
Classical belief on wages and prices

• Believed all markets competitive- (SD Key)
• If supply of labor, only temporary, wage rates
  drop and SD of labor will be in sinc.
• What holds for wages also applies to prices.
• Prices adjust quickly to surplus or shortages
• Equilibrium established again.

7
Three States of the Economy

• Real GDP is less than Natural Real GDP
  (recessionary gap)
• Real GDP is more than Natural Real GDP
  (inflationary gap)
• Real GDP is equal to Natural Real GDP.
• What is Natural Real GDP?
• Real GDP that is produced at the natural
  unemployment rate. (which we agree around 5)

8
Key Wage rates and prices will adjust quickly to
surplus or shortage

• In recession- unemployment rate higher than
  natural rate.
• Surplus exists in labor market
• Drives down wage rate
• 4) In inflationary gap, unemployment lower than
  natural rate
• 5) Shortage exists in labor market
• 6) Drives up the wage rate

9

• Lower wage rate firms hire more workers
• SRAS shifts to right until recessionary gap is
  gone.

10

• BOTH THEORIES CLASSICAL AND KEYNESIAN DO AGREE
• TWO THINGS WE CAN DO WITH DISPOSABLE INCOME-
• SPEND OR SAVE!
• We all know that consumption is 2/3 (or more) of
  GDP

11

• Classical theorists say, the funds from
  aggregate savings eventually borrowed and turned
  into investment expenditures which are a
  component of real GDP
• BUT. What if no or low savings?
• Theory breaks down here have to have equal
  amounts of investment for savings.
• (the idea here is that savings leads to
  investment) This is true but it probably wont
  do it by itself. Needs assistance through
  monetary or perhaps fiscal policy.

12
The Classical View of the CreditMarket

• In classical theory, the interest rate is
  flexible and adjusts so that saving equals
  investment.
• If saving increases and the saving curve shifts
  rightward the increase in saving eventually puts
  pressure on the interest rate and moves it
  downward.
• A new equilibrium is established where once again
  the amount households save equals the amount
  firms invest.

13
Savings, Investment and the Loanable Funds market
Savings and investment are linked through the
loanable funds market.
Click the graph below for a tutorial on this
subject.
14

• CLASSICAL BELIEVESMarkets will behave according
  to SD.
• In other words. SD will respond accordingly to
  Inflationary Gap, Recessionary Gap, and long run
  stability when all curves intersect.

15
Long-run Equilibrium
The condition where the Real GDP the economy is
producing is equal to the Natural Real GDP and
the unemployment rate is equal to the natural
unemployment rate.
16
Recessionary (Contractionary) Gap
The condition where the Real GDP the economy is
producing is less than the Natural Real GDP and
the unemployment rate is greater than the natural
unemployment rate.
17
Recessionary (Contractionary) Gap

• The economy is currently in short-run equilibrium
  at a Real GDP level of Q1.
• QN is Natural Real GDP or the potential output of
  the economy.
• Notice that Q1lt QN. When this condition (Q1lt QN)
  exists, the economy is said to be in a
  recessionary gap.

18
Inflationary (Expansionary) Gap
The condition where the Real GDP the economy is
producing is greater than the Natural Real GDP
and the unemployment rate is less than the
natural unemployment rate.
19
Inflationary (Expansionary) Gap

• The economy is currently in short-run equilibrium
  at a Real GDP level of Q1.
• QN is Natural Real GDP or the potential output of
  the economy.
• Notice that Q1gtQN. When this condition (Q1gtQN)
  exists, the economy is said to be in an
  inflationary gap.

20
Economy and Labor Market
21
Physical and Institutional PPFs

• The physical PPF illustrates different
  combinations of goods the economy can produce
  given the physical constraints of finite
  resources and (2) the current state of
  technology.
• The institutional PPF illustrates different
  combinations of goods the economy can produce
  given the physical constraints (1) finite
  resources, (2) the current state of technology,
  and (3) any institutional constraints.

Institutional constraints not always effective-
if economy operating beyond unemployment less
than natural
22
Self Regulating EconomyClosing the Recessionary
(Contractionary) Gap
Click the graph below for a tutorial on this
subject.
23
Self Regulating EconomyClosing the Inflationary
(Expansionary) Gap

• The economy is at P1 and Real GDP of 11
  trillion.
• Because Real GDP is greater than Natural Real GDP
  (10 trillion), the economy is in an inflationary
  gap and the unemployment rate is lower than the
  natural unemployment rate.

24
Self Regulating EconomyClosing the Inflationary
(Expansionary) Gap

• Wage rates rise, and the short-run aggregate
  supply curve shifts from SRAS1 to SRAS2.
• As the price level rises, the real balance,
  interest rate, and international trade effects
  decrease the quantity demanded of Real GDP.
• Ultimately, the economy moves into long-run
  equilibrium at point 2.

25
Policy Implication Laissez-faire

• Classical, new classical, and monetarist
  economists believe that the economy is
  self-regulating. For these economists, full
  employment is the norm The economy always moves
  back to Natural Real GDP.

Laissez-faire A public policy of not interfering
with market activities in the economy.
26
How would it automatically adjust? Classical

• Slump in output yields.
• Lower prices This increases consumer
  spending.
• Lower wages - eventually will occur with lower
  prices
• Lower interest rate Increases investment
  spending. Increases employment
• Excesses of supply of goods and workers would be
  eliminated and return to a balanced
  full-employment status.
• Production of output automatically provides the
  income needed to buy the output.
• This theory was prevalent until Depression of
  30s hit.

27
Then what happened?

• 25 unemployment
• Banks closed
• Production ceased
• Drought hit
• Stocks worthless
• No money for purchases
• No jobs
• Bleak!

AS 1
AD
AS
AD 1
P R I C E L E V E L
GDP
28
Bottom Line

• Classical viewpoint-
• not possible to overproduce goods because the
  production of those goods would always generate a
  demand that was sufficient to purchase the goods.
  
• (what would they say about
• car inventories, jelly shoes?)

29

• Keynesian Ideas
• The classical approach fell into disrepute during
  the economic decline of the 30s. Real GDP fell
  by more than 30 1930-33
• In 1939- per capital income was still 10 less
  than in 1929.
• U.S. began to embrace John Maynard Keyness
  theory of stimulating the economy through
  aggregate demand (Lord Keynes) had studied
  classical economics and wrote his famous General
  Theory of Employment, Interest and Money. (which
  was a complete rebuttal of the classical theory)

30
Chapter 9 Keynesian in a Nutshell
31
Keyness View of Says Lawin a Money Economy
According to Keynes, a decrease in consumption
and subsequent increase in saving may not be
matched by an equal increase in investment. Thus,
a decrease in total expenditures may occur.
To learn more about John Maynard Keynes, click
his photo above.
32
The Economy Gets Stuck in aRecessionary Gap

• If the economy is in a recessionary gap at point
  1, Keynes held that wage rates may not fall.
• The economy may be stuck in the recessionary gap.

33
Along comes John Maynard Keynes

• Keynesian Economics was the answer to Classical
  economic theories and the suggested way to
  jump-start the economy again pull out of the
  depression.
• Idea Government enters the economy.
• Stimulates the economy through Aggregate Demand.
• Fiscal policy would move the production engine by
  stimulating spending.
• increased employment, jobs would be filled,
  production would begin
• people would purchase with money they earned
  from jobs.

34
Classical vs. Keynes I
35
A Question of How Long It Takes forWage Rates
and Prices to Fall

• Suppose the economy is in a recessionary gap at
  point 1.
• Wage rates are 10 per hour, and the price level
  is P1.
• The issue may not be whether wage rates and the
  price level fall, but how long they take to reach
  long-run levels

The speed at which wage rate falls is a key To
whether Keynesian or Classical theory Is more
valid. Answers never for sure.
36
Consumption Function I

• The consumption function is the relationship
  between consumption (household sector spending)
  and disposable income.
• In the consumption function, consumption is
  directly related to disposable income and is
  positive even at zero disposable income
• C C0 (MPC) (Yd).

37

• The 45-Degree Line
• The 45-degree line represents all points where
  consumption and income are exactly equal.
• C YD

38
U.S. Consumption and Income
7000

6000
5000
CONSUMPTION (billions of dollars per year)
4000
3000
2000
1000
0
1000
2000
3000
4000
5000
6000
7000
DISPOSABLE INCOME (billions of dollars per year)
39
Autonomous Income

• Have you ever known people who spend money with
  out any income?
• 2. When disposable income is 0 and consumption
  still exists (food, clothing, shelter- basics)
  this is autonomous consumption
• 3. Whether one has to dig into ones savings, go
  on welfare, or else beg, borrow or steal, or call
  mom, one will spend that minimum amount

40
How does this work?

• Income is low- households tend to
  Dissave..(borrow from savings or borrow from
  other sources)
• Income increases- household aggregate income
  eventually equals and exceeds current consumption

41

• The Keynesian model assumes that there is a
  positive relationship between consumption and
  income.

• However, as income increases, consumption
  increases by a smaller amount.
• Thus, the slope of the consumption function
  (line C) is less than 1
• (less than the slope of the 45 line).

42

• Disposable Income
• Yd CS
• If we spend cannot save.
• If we spend more activity (production) takes
  place in the economy potential to increase GDP
• What happens if we do not save at all?

43
Connection between AE AD

AD
PL
AS
C O N S U M P T I O N
AD1
GDP
44

• When employment of the economys resources falls
  below the full employment level, (people seeking
  jobs unemployment rises)
• the equilibrium level of real GDP also falls
  below its natural level.
• (hence, if savings occurs might not achieve
  natural level of GDP)

45
What is the deciding factor on whether you spend
or not?

• Income
• Keynes felt we could learn a lot about
  consumption by focusing on the relationship
  between income and spending.
• He said income and consumer spending rise in
  tandem..
• If you know how much income consumers have to
  spend (Yd), you can predict what they will spend

46
By definition all disposable income is either
spent or saved

• Yd C S
• Why would we calculate or even consider savings
  as important?
• A low savings rate leads to a low productivity
  rate? Why
• Becausewithout savings to invest in new and
  better capital, we cant raise our productivity
  very quickly.

47
Keynes Consumption Function

• Keynes referred to this as fundamental law that
  men are disposed as a rule and on the average, to
  increase their consumption as their income
  increases, but not by as much as the increase in
  their income.
• 1)At low levels of aggregate income, the
  consumption expenditures of households will
  exceed their disposable income (when household
  income is low, households dissave- they either
  borrow or draw from past savings to purchase
  consumption goods

48
45 Degree Line
45 Degree Line
C YD
50
100
150
200
250
300
350
400
49
Keynes Said

• He believed that SPENDING induced business firms
  to supply g s.
• He said if spending FELL then business firms
  would respond by cutting back production.
• LESS SPENDING LEADS TO LESS OUTPUT.
• He said prices and wages were not flexible.
• He said- Equilibrium occurs when the level of
  total spending is equal to current output.
• When this happens producers have no reason to
  expand or contract output

50
LRAS
SRAS
AD 1
AD
Full Employment
According to Keynes equilibrium occurs where
LRAS, SRAS, and AD 1 intersect
51

• Keynes Cont.
• As with most theories, Keynes asks us to assume
  away a lot of the problem.
• We will assume there is a specific employment
  level of output. NARU is present when
  full-employment capacity is attained.
• Wages and prices are completely inflexible until
  full employment is reached
• Governments taxing, spending and monetary
  policies are constant.

52
Consumption function Continued

• As income increases, household aggregate income
  eventually equals and exceeds current
  consumption.
• Keynes believed that the amount consumers decide
  to spend is determined by their disposable
  income.
• Income and Consumption
• By definition, all disposable income is either
  consumed (spent ) or saved (not spent).
• Disposable income Consumption Saving
• YD C S

53
U.S. Consumption and Income
7000

6000
5000
CONSUMPTION (billions of dollars per year)
4000
3000
2000
1000
0
1000
2000
3000
4000
5000
6000
7000
DISPOSABLE INCOME (billions of dollars per year)
54

• Keynes said that the economy needs to be directed
  to full-employment through aggregate
  expenditures.
• (C I G X-M )

55
Consumption vs Savings
The average propensity to consume (APC) is total
consumption in a given period divided by total
disposable income.
56
Average Propensity to Save

• By definition, disposable income is either
  consumed (spent on consumption) or saved.
• APS 1 MPS

57

• Marginal Propensity to Save
• The marginal propensity to save (MPS) is the
  fraction of each additional (marginal) dollar of
  disposable income not spent on consumption.
• MPS 1 MPC

58
Keynes divided consumption into two categories

• 1. That which is influenced by current income
• 2. That which is not influenced by current
  income.
• 2. Autonomous consumption that segment of
  consumption spending independent of current
  income and is based on either expectations,
  wealth, taxes, credit or price levels.

59
Examples of ways DI might vary

• Expectations (rising prices or losing job)
• Wealth (amount of wealth a person owns- (assets
  into cash/)
• Credit availability of credit (0 financing. Low
  interest, or need to pay past debt may limit
  consumption) low rate savings diminished.
• Taxes a link to disposable income, lower taxes
  more consumption?
• Price levels Rising price levels reduce real
  value of money and may cause people to curtail
  spending.

60
Consumption Shifts

• Consumers have confidence in economy
• consumption shifts right (upward) (vice versa)
• When consumption shifts right. Aggregate demand
  curve does so also

61

• So why how can our spending or saving help the
  economy?
• What can government really do?

62
(No Transcript)
63

• A sluggish economy
• There are a number of ways to jump-start the
  economy
• Fiscally taxing spending.
• Should the classical or Keynesian approach be
  used. Or should an eclectic approach be used?

64
Formulas To Remember

• MPC, MPS, APC, APS show what the observed
  consumer behavior is statistically. What we
  really want to know is what DRIVES this change in
  consumer behavior.
• If government can make a statistical prediction
  on how our MPC will work, they can make necessary
  adjustments to the business cycle.
  (countercyclical moves that reverse the cycle-
  growth rather than recession.
• Sometimes peoples spending habits change even
  when incomes do not.

65
Lets Take a Look at The interest-rate-investment
relationship

• Investment means
• new plants, capital equipment, machinery,
  inventories, etc.
• The investment decision centers around
• Marginal Benefit-Marginal Cost Decision
• MB rate of return business hopes to get.
• MC interest rate that must be paid for borrowed
  funds.

66
What is Interest

• Interest rate financial cost of borrowing.
• Look at the cost of interest in relationship to
  expected net return.
• If the firm expects the investment to be
  profitable will perhaps engage in it.
• If not will back away.
• Firm should undertake all investment projects it
  thinks will be profitable Invest up to the point
  where r I (rate of return interest)

67
Quick reminder

• Need to calculate REAL rate of interest
• Not
• Nominal rate of interest.
• Level of investment depends on
• Expected rate of return
• Real Interest rates

68
Investment Demand Curve can shift also.R
increaseL decrease

• Acquisition, maintenance, and operating costs.
  (if electricity rates increase machinery that
  requires it will be reduced)
• Business Taxes
• Technological Change
• Stock of Capital Goods on Hand
• Expectations of the market

69
What attracts businesses to invest?
16 14 12 10 8 6 4 2 1
Real Interest Rate
ID 0
0 5 10 20 25 30 35
40 50
Investment
70
How stable is the I in Investment?

• Answer Not Very
• Investment will rise and fall with
• economic outlook
• Confidence level.
• Consumption function.
• Overall future outlook.
• Deficit.
• Future profits of company expected profits
  changes in exchange rates.
• Efficiency of production.
• government regulation

71

• All other things equal.. Direct relationship
  between changes in spending and changes in real
  GDP
• talking about levels of spending
• what do you do with excess money or cash?
• Why did Congress actually agree to a tax
  cut that was needed in the late 90s?
• Answer. Multiplier to help stimulate
  economy.

72

• Truisms?
• Falling Output and Prices
• Business firms are likely to react to undesired
  inventory buildups by cutting prices and reducing
  the rate of new output.
• A reduction in investment spending implies a
  reduction in household incomes.
• Firms usually cut wages and employment as they
  cut back production.

73

• Truisms Cont.
• Income-Dependent Consumption
• If disposable income falls, we expect consumer
  spending to drop as well.
• The consumption function tells how much spending
  will drop.
• The marginal propensity to consume (MPC) is the
  critical variable in this process.
• The marginal propensity to consume (MPC) is the
  fraction of each additional (marginal) dollar of
  disposable income spent on consumptionthe change
  in consumption divided by the change in
  disposable

74
The Multiplier

• The decline in spending will be much larger than
  the initial (autonomous) spending decrease.
• The multiplier is the multiple by which an
  initial change in aggregate spending will alter
  total expenditure after an infinite number of
  spending cycles.

75
What really is the multiplier?

• The multiplier is based on two concepts already
  covered
• GDP is the nations expenditure on all the final
  goods and services produced during the year at
  market prices.
• GDPCIG(X-M) Aggregate Demand

76

• Obviously if C goes up the entire GDP will go up
  also. When there is any change in spending- it
  will have a multiplied effect on GDP
• When money is spent by one person, it becomes
  someone elses income.
• When someone spends a dollar, perhaps someone who
  received that dollar would spend 80 cents and of
  that 80 cents received by the next person perhaps
  64 cents
• If we add up all the spending generated by that
  one dollar, it will add up to four or five or six
  times that dollar
• Hence, the name multiplier.

77

• The multiplier tells us the extent to which the
  rate of total spending will change in response to
  an initial change in the flow of expenditure.

Any change in spending (C, I, or G.) will set off
a chain reaction, Leading to a multiplied change
in GDP. If 1 million investment resulted in 4
million additional income, the multiplier would
be 4
78
Conclusion

• Keynesians believe that prices and wages are not
  so flexible they are sticky
• The stickiness of prices and wages in the
  downward direction prevents the economys
  resources from being fully employed and thereby
  prevents the economy from returning to the
  natural level of real GDP.
• Keynesian theory is a rejection of Says Law and
  the notion of self-regulation of an economy.

79
Classical Theory
LRAS
AS
P R E C E L E V E L
AD 2
AD 1
Real Domestic Output Classical Theory
AS determines full-employment level of real
output. AD determines price level.
Supply creates its own
demand.
80
Keynesian Theory
LRAS
P R I C E L E V E L
AD 2
AD 3 Price Goes up
AD 1
AS
Real GDP Output Keynesian Theory
AD unstable, prices and wages are inflexible AD
no effect on prices until LRAS
81
Aggregate Expenditures

• When planned Aggregate Expenditures equal the
  value of current output.. Keynes says
  equilibrium is reached. ( goods)
• When expenditures (CIGX) exceed output,
  inventories will decline.

82

• Firms then expand their output, and rebuild their
  inventories.(this is where you would see the
  inflationary gap on the consumption function
  line.)
• i.e. if government, investors and foreigners want
  to buy more than is produced while the
  consumption function shifted upwardsthis is the
  cause of an inflationary gap.

83
The Multiplier

• The Multiplier -- The multiple by which an
  initial change in spending will alter total
  expenditure after an infinite number of spending
  cycles

• An increase in spending by one party increases
  the income of others. Thus, an increase in
  spending can expand output by a much larger
  amount.
• The multiplier is the number by which the initial
  change in spending is multiplied to obtain the
  total amplified increase in income.
• The size of the multiplier increases with the
  marginal propensity to consume (MPC).

84
The Multiplier

• In evaluating the importance of the multiplier,
  one should remember

• taxes and spending on imports will dampen the
  size of the multiplier
• it takes time for the multiplier to work and,
• the amplified effect on real output will be valid
  only when the additional spending brings idle
  resources into production without price changes.

85

• Keynes rejected the classical notion of
  self-adjustment, (????) and he predicted things
  would get worse once a spending shortfall
  emerged.
• Example
• Business expectations of future sales worsens.
• Business investment is cut back.
• Unsold capital goods begins to pile up (includes
  office equip. machinery, airplanes, etc.)
• this is an undesired change
• Worsened sales expectations causes decline in
  investment spending that shifts the AD curve to
  the left leading to pileups of unwanted inventory.

86
Multiplier Formula

• Multiplier is
• ______1_____
• 1 MPC
• When money is spent by someone, it becomes
  someone elses income. When someone spends a
  dollar, perhaps someone who received that dollar
  would spend 80 cents..next person would spend 64
  centsIf you add up the spending created by that
  one dollar, it will add up to four or five times
  that dollar hence the multiplier

87

• The multiplier principle applies in reverse also.
  (decrease, yields reduction) (money in shoe box)
• Marginal Propensity to Consume is the key
• The multiplier builds on the principle that one
  individuals expenditure becomes the income of
  another.
• Income increases- we spend some on more stuff
  In turn consumption expenditures on stuff will
  generate additional income for others who will
  spend part of their income on stuff also.
• There is a direct correlation between expenditure
  multiplier and MPC.

88
The Multiplier Process
89
The Multiplier Principle
1,000,000
750,000
750,000
562,500
562,500
421,875
421,875
316,406
316,406
237,305
237,305
177,979
177,979
133,484
133,484
100,113
100,113
75,085
75,085
56,314
225,253
168,939

• The multiplier concept is fundamentally based
  upon the proportion of additional income that
  households choose to spend on consumption the
  marginal propensity to consume (here assumed to
  be 75 ? 3/4).

• Here, a 1,000,000 injection is spent, received
  as payment, saved and spent, received as payment,
  saved and spent etc. until . . .

effectively, 4 million is spent in the
economy.
90
Multiplier Effects
AS
m
d
a
P0
b
AD0
c
AD1
AD2
QF
2600
2800
91
(No Transcript)