Classical and Keynesian Economics: Contending Approaches to Macroeconomics

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Classical and Keynesian Economics: Contending Approaches to Macroeconomics

  1. 1. Classical and KeynesianEconomics: ContendingApproaches to Macroeconomics
  2. 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. 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. 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. 5. KEYNESIAN ECONOMICSWHO?John Maynard Keynes.CENTRAL PRINCIPLE:The economy often operates atless than full employment;market system does not selfadjust.
  6. 6. KEYNESIAN ECONOMICS1. MARKETS CLEAR ONLY SLOWLY, IF AT ALL. A) In a depression or recession, much unemployment is involuntary.
  7. 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. 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. 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. 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. 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. 12. Understanding themultiplier effect
  13. 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. 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. 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. 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. 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. 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. 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. 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. 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.

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