Chapter 11 Classical & Keynesian Economics What You Will Learn From This Lesson

Theory & Principles

The Depression and Classical Economics The Fatal Flaw in Classical Thinking The Keynesian System Recessionary Gap Inflationary Gap

Language & Methodology New Terms

Historical Evolution from Laissez-faire to significant government economic management role

Chapter 11 Classical & Keynesian Economics The Keynesian Critique of Classical Economics

If Supply creates its own Demand, why are we having a world wide depression? The Roaring Twenties

Electrification of America led to mass production of consumer goods Over the decade, however, these new markets became saturated with products Demand declined, Inventories increased, Supply > Demand

Point -- There can be a disconnect between the buying side of the market and the selling side of the market

Chapter 11 Classical & Keynesian Economics The Keynesian Critique of Classical Economics

Keynes posed this problem to Classical World What if Savings and Investment were not equal?

Then Spending would not equal production, and The economy could experience natural periods of unemployment or inflation, and The economy is inherently unstable rather than stable

Spending decisions and Saving decisions are made by different groups than Production and Investment decisions Prices, especially in the factor markets are not downwardly flexible

Chapter 11 Classical & Keynesian Economics The Keynesian System

If there could be a disconnect between spending and production in an economy, then economies are inherently unstable There is no reason why an economy has to come to equilibrium at full employment, and Even if an economy does come to a full employment equilibrium, there is no reason why it must remain there These statements are not compatible with the Classical System

Chapter 11 Classical & Keynesian Economics The Keynesian System

If economies are inherently unstable, then three outcomes are possible: The economy can come to equilibrium at a level of production lower than full employment (Recessionary Gap) The economy can come to equilibrium at a level of production at full employment, or The economy can come to equilibrium at a level of employment above equilibrium (Inflationary Gap)

The Ranges of the Aggregate Supply Curve

A g g te g re a s p ly up

K y e ia ens n ra g ne

RaG P el D

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Keynesian Critique of the Classical System

Three Aggregate Curves

AD1 represents aggregate

demand during a recession or depression

180 160 140 120 L-RAS

AD2 crosses the long-run

aggregate supply curve at full employment

100 80 60 40 AD3

AD3 represents excessive demand

20 0 0 1 2

AD1

AD2 9 10

3 4 5 6 7 8 Real GDP (in trillions of dollars)

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Chapter 11 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 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

In the Keynesian World

Chapter 11 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

Chapter 11 Classical & 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 (1950s) Federal Government took responsibility to ensure the economy grows at a consistent and healthy rate Real GDP at approximately 4%/year Price Stability (1970s) Federal Government took responsibility to ensure the economy has stable prices CPI increase at no more than 3%/year So, from no role prior to the great depression to comprehensive responsibilities post depression

Chapter 11 Classical & Keynesian Economics Review of What You Have Learned

The Depression proved there must be a flaw in the Classical Economic Theory John Maynard Keynes suggested the flaw was very fundamental The depression proved there could be a disconnect between Aggregate Demand and Aggregate Supply It is not assured that production will create its own demand. Demand is more of a driver of economic equilibrium

Chapter 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 The U.S. Government has accepted that responsibility

For Next Time

The Keynesian Aggregate Spending Model, pages 264266, Chapter 11 The Keynesian Consumption Function, pages 95-107, Chapter 5