Classical and Keynesian Economics: Contending Approaches to Macroeconomics

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  • 1. Classical and KeynesianEconomics: ContendingApproaches to Macroeconomics
  • 2. Classical Economics WHO? Adam Smith, David Ricardo, Alfred Marshall CENTRAL PRINCIPLE: The economy is best organized as a self-regulating system of markets.
  • 3. Classical Economics1.WAGES AND PRICES ARE FULLY FLEXIBLE in order to clear markets rapidly.2.ECONOMY OPERATES AT FULL EMPLOYMENT most of the time. Classical Aggregate Supply Curve is vertical.
  • 4. Classical Economics3.MINIMAL GOVERNMENT INTERVENTION reflecting distrust of government and belief in its inefficiency.4. Unemployment in the economy is either voluntary or due to some external interference.
  • 5. KEYNESIAN ECONOMICSWHO?John Maynard Keynes.CENTRAL PRINCIPLE:The economy often operates atless than full employment;market system does not selfadjust.
  • 6. KEYNESIAN ECONOMICS1. MARKETS CLEAR ONLY SLOWLY, IF AT ALL. A) In a depression or recession, much unemployment is involuntary.
  • 7. KEYNESIAN ECONOMICS2.ECONOMY OFTEN OPERATES AT LESS THAN FULLEMPLOYMENT Since markets don’t clear.3. GOVERNMENT INTERVENTION MAY BEDESIRABLE TO STABILIZE THE BUSINESS CYCLE.Fiscal and Monetary Policies.
  • 8. Classical & Keynesian Economics Key Differences Between Classical & Keynes In the Classical World  Free market economies are always stable  Tending toward full employment & full production equilibrium  Freely fluctuating prices in the three major macro markets ensure this (goods, money and labor markets) In the Keynesian World  Free market economies are unstable  Equilibrium yes, but no reason for full employment/full production  Demand becomes a much bigger driving force  Supply will always adjust to Demand  In a way, according to Keynes “Demand creates its own Supply”
  • 9. Classical & Keynesian Economics Keynesian Policy Implications Under the Classical System, Government had no role in management of the economy – “Laissez-faire” or “do nothing” Under Keynes, Government must step in to correct the inherent instability of the economy  If the economy faces a recessionary gap (equilibrium at less than full employment) Government must increase demand by spending more; lowering taxes; lowering interest rates; increasing welfare  If the economy faces an inflationary gap (equilibrium at a level higher than full employment), Government must reduce demand by spending less; raise taxes; increase interest rates; reducing welfare
  • 10. Classical vs Keynesian Economics U.S. Federal Government Objectives for Economy Full Employment (1933 & by Law 1946) – Federal Government took responsibility to ensure the economy functions at full employment – No more than 5% unemployment Economic Growth (1950’s) – Federal Government took responsibility to ensure the economy grows at a consistent and healthy rate – Real GDP at approximately 4%/year Price Stability (1970’s) – Federal Government took responsibility to ensure the economy has stable prices – CPI increase at no more than 3%/year
  • 11. Classical & Keynesian Economics What You Have Learned There is no reason why the economy must come to equilibrium at full employment. The economy can experience recessionary gaps or inflationary gaps Aggregate Supply will always adjust to Aggregate Demand, not the other way around Therefore, Government has a role and responsibility as a maximizing entity (well-being of citizens) to manage the economy
  • 12. Understanding themultiplier effect
  • 13. DERIVING THE MULTIPLIER ALGEBRAICALLY IN A CLOSED ECONOMY Recall that our consumption function is: C = a(Y – T) where a is the marginal propensity to consume. In equilibrium: Y = a(Y-T) + I + G Now we solve this equation for Y in terms of I , G, C & T. Y = a (Y − T ) + I + G     C
  • 14. DERIVING THE MULTIPLIER ALGEBRAICALLYThis equation can be rearranged to yield: Y − aY = I + G – aT Y(1 - a) = I + G - aTWe can then solve for Y in terms of I , G & T by dividing through by(1 − a):  1  Y = ( I + G − aT )  1− a 
  • 15. DERIVING THE MULTIPLIER ALGEBRAICALLYNow look carefully at this expression and think aboutincreasing I by some amount, ΔI, with a held constant.If I increases by ΔI, income will increase by 1 ∆Y = ∆I × 1− aBecause a ≡ MPC, the expression becomes ∆Y 1 = ∆I 1 − MPC
  • 16. DERIVING THE MULTIPLIER ALGEBRAICALLYThe multiplier is 1 1 − MPCFinally, because MPS + MPC ≡ 1, MPS is equal to 1 − MPC,making the alternative expression for the multiplier 1/MPS•marginal propensity to consume (MPC) Thatfraction of a change in income that is consumed, orspent.•marginal propensity to save (MPS) That fraction ofa change in income that is saved.
  • 17. The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G . In this model, the govt purchases multiplier equals ∆Y 1 = ∆G 1 − MPCExample: If MPC = 0.8, then An increase in G An increase in G causes income to causes income to ∆Y 1 increase 5 times increase 5 times = = 5 ∆G 1 − 0.8 as much! as much!
  • 18. Why the multiplier is greater than 1 Initially, the increase in G causes an equal increase in Y: ∆Y = ∆G. But ↑Y ⇒ ↑C ⇒ further ↑Y ⇒ further ↑C ⇒ further ↑Y So the final impact on income is much bigger than the initial ∆ G .
  • 19. SAMPLE QUESTIONKeynesian equilbrium: Solution procedureStart with the equation in general form:Y = a ( Y - T) + I p + G + NXSubstitute in the given numbers:Y = 0.8 ( Y - 1000) + 1500 + 1200 + 500Collect all the constant terms:Y = 3200 + 0.8Y - 800Y = 2400 + 0.8YSubtract 0.8 Y from both sides of the equation:0.2 Y = 2400Finally, multiply both sides by 1 / 0.2 = 5Y = 5 (2400) = 12,000
  • 20. SAMPLE QUESTIONThe MultiplierRerun the previous exercise, raising planned investment by 500.Y = 0.8 ( Y - 1000) + 2000 + 1200 + 500Collect all the constant terms:Y = 3700 + 0.8Y - 800Y = 2900 + 0.8YSubtract 0.8 Y from both sides of the equation:0.2 Y = 2900Finally, multiply both sides by 1 / 0.2 = 5Y = 5 (2900) = 14, 500GDP is UP BY 2,500, NOT up by only 500.Investment spending has a MULTIPLIER EFFECT of 5
  • 21. Balanced Budget Multiplier with Lump-Sum Taxes (Cont.)The balanced budget multiplier: ∂Y ∂Y + =1/(1-c) - c/(1- c) = 1 ∂G ∂TA change of 100 in both G and T also raised income by 100.Balanced change in G and T is not macro economically neutral. Balanced budget multiplier holds that if government revenues and expenditure increase or decrease simultaneously and equally, then national income will also change in the same amount - which means that the balanced budget multiplier equals to 1.