The Power Of Macroeconomics

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The Power Of Macroeconomics
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Aggregate Supply, Aggregate Demand, and the
Classical-Keynesian Debate
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The Purpose Of This Lesson

• Is to illustrate why Classical economics gave way
  to Keynesianism in the 1930s.
• This discussion sets the stage for the
  development of one of the most important tools
  used in macroeconomics, the aggregate
  supply-aggregate demand framework.

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Lesson 2 Colander McConnell Samuelson
Schiller Brue Nordhaus 3rd Edition 14th
Edition 16th Edition 8th Edition
Complete Textbook (includes both Micro-and
Macroeconomics) Macroeconomics Text Only
10 11 23, 29 8
10 11 7, 13 8
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An Important Debate
Peter Navarro 3

• The debate between Classical economists and
  Keynesians ranks as one of the most important in
  macroeconomics.

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The Classical/Keynesian Debate
Peter Navarro 4

• It is a debate that goes back to the 1930s and
  the Great Depression.
• Many of the macroeconomic policies now favored by
  conservatives have their roots in Classical
  economics while those on the other side of the
  ideological spectrum are generally much more
  supportive of the Keynesian approach.

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The Most Important Point
Peter Navarro 5

• The Classical versus Keynesian controversy is
  primarily a dispute over how an economy adjusts
  during a recession and finds its way back to full
  employment.

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The Classical View
Peter Navarro 6 change to diagram

• A price adjustment mechanism would cure the
  economy.
• In the event of unemployment, prices, wages, and
  interest rates would all fall.
• This would increase consumption, production, and
  investment and quickly return the economy back to
  its full employment equilibrium.

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The Keynesian View
Peter Navarro 7 change to a diagram

• Before the price adjustment mechanism can work,
  it would be overpowered by an income adjustment
  mechanism.
• When an economy sinks into a recession, peoples
  incomes fall.
• This causes them to spend and save less while
  businesses invest and produce less.
• This drives the economy further into recession
  rather than back to full employment.

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Laissez-Fair Economics
Peter Navarro 8

• One school of economics -- the Classical approach
  -- believes that the best cure for a recession is
  to leave the free market alone.
• This approach is also known as laissez-faire,
  and laissez faire economists are those who
  believe that most government policies will
  probably make things worse--not better--so the
  best policy is relatively little government.

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Activist Economics

• On the other hand, the Keynesians prescribe
  large-scale government expenditures to prime the
  economic pump.
• Keynesians typically are activist economists
  who believe that the government can create and
  implement policies that will positively affect
  the economy.

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Classical Economics
Peter Navarro 9 insert diagram

• Has its roots in the free market writings of Adam
  Smith, David Ricardo, and Jean Baptiste Say.
• Unemployment is a natural part of the business
  cycle and is self-correcting.
• There is no need for government intervention.

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Classical Unemployment
Peter Navarro 10

• Unemployment results when wages are too high.
• In the event of a recession, unemployed workers
  would be willing to work for less.
• Wages would then fall back down to levels where
  it once again made it profitable for firms to
  hire the workers and the recession would end.

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There Is No Cyclical Unemployment

• Classical economists agreed that frictional and
  structural unemployment could exist, but they did
  not agree that cyclical unemployment could be
  caused by a shortage of aggregate demand.

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The Classical EconomistsMeet the Great Depression
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The Great Depression
Peter Navarro 12

• With the stock market crash of 1929, the economy
  fell first into a severe recession and then a
  deep depression.
• Gross domestic product fell by almost a third.
• By 1933, 25 of the work force was unemployed.
• Business investment dropped from about 16 billion
  dollars in 1929 to only one billion dollars by
  1933.

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Peter Navarro 13

• A Deepening Crisis

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John Maynard Keynes
Peter Navarro 14

• Born in 1883, the son of British economist John
  Neville Keynes.
• Keynes was a stock speculator, an arts patron, a
  professor, and worked for the British Treasury.

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Peter Navarro 15

• In 1936, with the global economy flat on its
  back, Keynes published The General Theory of
  Employment, Interest, and Money.
• In that book, Keynes flatly rejected the
  Classical notion of a self-correcting economy
  that would solve unemployment through adjustments
  in wages and prices.

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The Keynesian Bottom Line
Peter Navarro 16

• Patiently waiting for the eventual recovery was
  fruitless because in the long run, were all
  dead.
• Under certain circumstances, a recessionary
  economy would not rebound but fall into a deep
  spiral.
• The only way to get the economy moving again was
  to prime the economic pump with massive
  government expenditures.

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Economic Heresy
Peter Navarro 17

• At the time, Keynes approach was economic heresy
  and initially rejected by virtually the entire
  economics profession.
• Far worse, Keynes and his followers were branded
  as socialists or even communists for advocating
  such an activist role for the central government.

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Keynesian Economics is Born
Peter Navarro 18

• To his credit, Keynes stuck to his guns and as
  the Depression wore on, his teachings gained both
  adherents and disciples.

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The Two Pillars of Classical Economics
Peter Navarro 19

• To understand why Keynesian economics eventually
  triumphed, it is important to understand how the
  two major pillars of Classical Economics crumbled
  under the weight of Keynes argument.
• These two pillars are Says Law and the Quantity
  Theory of Money.

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Peter Navarro 20 CDend 701

• Formulated in the 1800s by French businessman
  Jean Baptiste Say and popularized by David
  Ricardo.
• Supply creates its own demand.
• But what does this really mean?

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How Says Law Works
Peter Navarro 21

• When people work to produce goods and services,
  they earn income for doing so.
• Says Law states that the total income generated
  by this work must equal the value of the goods
  and services.
• Thus, if the workers spend this income, it must
  be enough to pay for all the goods and services
  they produce.
• Therefore, supply creates its own demand.

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Thomas Malthus Critique
Peter Navarro 22

• Suppose income earners dont spend all their
  money and instead save some of it?
• Thats exactly the problem Thomas Malthus
  raised.
• Malthus said that if people didnt spend all of
  their money, there would be a general glut of
  goods and people would be out of work.

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The Dismal Science
Peter Navarro 23

• Malthus is famous for the Malthusian doctrine
  that population will grow faster than the
  production of food and that this will lead to
  mass starvation.
• In fact, it was Malthus dark vision that
  originally earned the economics profession its
  label as the dismal science.

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Says Response
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• It doesnt matter if people save some of their
  money because all of these savings will, in turn,
  be invested in the economy.
• Therefore aggregate demand, which equals
  consumption plus investment, will always equal
  aggregate supply.

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Peter Navarro 25
Says Law and the Circular Flow Diagram
Aggregate Supply(AS) Employee compensation,
rents, interest, and profit
Aggregate Demand (AD) Consumption Investment
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Unemployment Would Go Away

• Says law didnt say unemployment couldnt exist.
• If wages, prices, and interest rates were allowed
  to adjust, unemployment would go away on its own.

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The Quantity Theory of Money

• Classical economists supported their Says Law
  analysis with the quantity theory of money.
• The quantity theory of money determines the price
  level while Says Law analysis determines real
  output.

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The Equation Of Exchange
Peter Navarro 27

• M V P Q
• M equals the money supply.
• V is the velocity of money or the amount of
  income generated each year by a dollar of money.
• P is the general price level as measured by an
  index such as the consumer price index.
• Q is the quantity of real output sold.

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M V P Q
Peter Navarro 29

• The quantity theory of money says that the price
  level varies in response to changes in the
  quantity of money.
• Changes in the price level are caused simply by
  changes in the money supply.
• If the money supply goes up by 20 percent, prices
  go up by 20 percent.

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Two Important Assumptions
Peter Navarro 30

• 1. Velocity is constant.
• 2. Veil of Money Real output is not influenced
  by the money supply.
• It doesnt matter how much money the government
  prints, it will not increase the amount of goods
  and services that the economy can actually
  produce.
• Looking at MVPQ, why will increasing the money
  supply will only lead to inflation?

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MVPQ
Peter Navarro 32

• If V is constant on the left side and Q on the
  right side is unaffected by M, the only thing
  that can change if M changes, is P.

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The Great Depression

• The reality of the Great Depression in the 1930s
  resulted in a search by the worlds political
  leaders for an alternative economic solution.
• That solution turned out to be Keynesian
  economics.

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To John Maynard Keynes

• The problem with Classical economics was not the
  price adjustment mechanism it relied on.
• Keynes believed that before such a mechanism had
  time to work, it would be dwarfed by a much more
  powerful and deadly income adjustment mechanism.

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To Keynes

• When an economy sinks into recession, peoples
  incomes fall.
• This fall in income causes them to both spend
  less and save less while businesses respond by
  investing and producing less.
• This reduction in consumption, savings,
  investment, and output, in turn, drives the
  economy deeper into recession rather than back to
  full employment.

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Stuck In A Rut

• While eventually income will fall far enough so
  that savings and investment return to
  equilibrium, the economy will be at a level well
  below full employment with no way to get out.
• Stuck in a rut with a glut of goods, just as
  Thomas Malthus predicted in his original critique
  of the Classical model.

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Two Important Models

• The Aggregate Supply-Aggregate Demand framework
  has its roots in Classical economics and allows
  for price adjustments.
• The Keynesian model assumes that prices are fixed.

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In The Remainder Of This Lecture

• We will develop the aggregate supply-aggregate
  demand model and then turn to the Keynesian model
  in the next lecture.
• As we shall see, both models are very helpful in
  understanding how modern economies function.

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End of Part 1
Lecturer Peter Navarro Multimedia Designer Ron
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