Chapter 9 supplementClassical/Keynesian

Which is better?

9- supplementClassical vs. Keynesian

One more thing???? Which is best?

Bottom line difference!• Classical Believes: Markets will behave

according to S&D. Leave alone and they self-correct. Prices and wages are flexible. Supply creates demand

• Keynesian Believes: Prices and wages sticky. Need government injection to increase consumption. Only works on AD. AS is stationary

A Self-Regulating Economy

• Classical economics: the economy “self-adjusts” to any deviations from its long-term growth.

• Wages and prices are flexible. The producer can:

• Lower prices to sell off excess goods.• Decrease output and lay off workers. Laid-off workers

compete for jobs by asking for lower wages. At lower wages, firms will hire more workers.

8-4

The Classical Model (cont'd)

• Classical economists—Adam Smith, J.B. Say, David Ricardo, John Stuart Mill, Thomas Malthus, A.C. Pigou, and others—wrote from the 1770s to the 1930s.

• They assumed wages and prices were flexible, and that competitive markets existed throughout the economy.

Key: Wage rates and prices will adjust quickly to surplus or shortage-classical view

1) In recession- unemployment rate higher than natural rate.

2) Surplus exists in labor market3) Drives down wage rate

++++++++++++++4) In inflationary gap, unemployment lower than natural

rate5) Shortage exists in labor market 6) Drives up the wage rate

SAY’S LAW- Supply creates its own demand

Economists agree Says law works in Barter economy and disagree about if it works in a money economy.

Baker bakes enough bread to trade for what he wants.That works. As long as one has a double coincidence of wants.

Classical economics believes it works in money economy and here is why.

***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 won’t do it by itself. Needs assistance through monetary or perhaps fiscal policy.

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.

Policy Implication Laissez-faire

• Classical 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-faireA public policy of not interfering

with market activities in the economy.

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 the recent inventories of our auto industry?)

• Keynesian Ideas

The classical approach fell into disrepute during the economic decline of the 30’s. 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 Keynes’s 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)

Then what happened?

25% unemploymentBanks closedProduction ceasedDrought hitStocks worthlessNo money for purchasesNo jobsBleak!

ASADAD 1

AS 1

GDP

PRICE

LEVEL

GREAT DEPRESSION

Keynes’s View of Say’s 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.

John Maynard Keynes and the Great Depression

• Classical Economics: In a recession,– Wages will fall (more will

be hired)– Prices will fall (more will

be bought)– The economy self-

regulates, and– Moves back to full-

employment GDP

• Keynes’ criticism: In a recession, – Wages would not fall.– Prices would not fall.– Self-regulation could not occur.– The economy could get “stuck” with high unemployment.

Keynes’ Prescription

• For an economy “stuck” at a high unemployment equilibrium,– Self-regulation was not working.– A “jumpstart” was needed:– An injection of new spending to get the economy

moving again.• The only spender who could do this was

Government.

Keynesian Economics

• Works only on the AD curve• Assumes AS is stationary• Critics of Keynes:– …But this will cause deficits!– …But the government can’t spend that much!

Example: Are the U.S. and European SRAS Curves Horizontal?

• New Keynesians contend that the SRAS is essentially flat.

• Based on research, they contend SRAS is horizontal because firms adjust their prices about once a year.

• If the SRAS schedule were really horizontal, how could the price level ever increase?

Keynesian Theory

AS

LRAS

PRICE

LEVEL

Real GDP OutputKeynesian Theory

AD unstable, prices and wages are inflexible AD no effect on prices until LRAS

AD 1 AD 2 AD 3 *PriceGoes up

Figure 11-9 Real GDP Determination with Fixed versus Flexible Prices

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.

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.

Consequences of Changes in Aggregate Demand

• Aggregate Demand Shock – Any event that causes the aggregate demand

curve to shift inward or outward

• Aggregate Supply Shock– Any event that causes the aggregate supply curve

to shift inward or outward

So--- which is best? ????

Classical prefers to move the AS.Keynesian prefers to move the ADBoth have good points, and neither is perfect.