Chapter 14 - WordPress.com...14-15 Flaws in the Classical Model: our economy has not proved to be stable, and we have regular business cycles • Great Depression proved once and for

Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Chapter 14 Macroeconomic Theory: Classical and Keynesian Models

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 14-2

The Debate Over Long Run Adjustment: the Classical & Keynesian Models

•  Classical Model: Economy is always self-adjusting; there is no need for government intervention.

•  Keynesian Model: Economy is not self-correcting; proper fiscal and monetary policies can improve the functioning of the market system.


1st Pillar of the Classical Model: Quantity Theory of Money

•  Equation of Exchange: M * V = P * Q M = M1=Money Supply V = Velocity = # of times per year, on average, $1 is

spent or paid as income P = Price Index = GDP Deflator Q = Real GDP P * Q = Nominal GDP


1st Pillar of the Classical Model: Quantity Theory of Money

•  Classical Economists believed that, since Velocity (V) is stable, the Money Supply (M) determines Nominal GDP. –  Expanding the money supply when the economy is at its

normal capacity is ineffective: •  The economy is in long run equilibrium so increasing M1 only

leads to inflation. •  And since the economy adjusts quickly, there is no need to increase

M1 in recessions due to the other pillars of classical economic theory.


Second Pillar of classical economics: Say’s Law, Supply Creates Demand

•  Based on the circular flow model •  Production always generates enough income to

purchase all goods produced. •  Markets never overproduce.

FIGURE 14.BP.5 Simple Circular Flow


3rd Pillar of classical economics: Savings is always equal to Investment

•  If people save more b/c of worries about the economy, the supply of savings increases, decreasing interest rates, and increasing Investment.

•  So the more some people save the more other folks invest.

•  Therefore, a lower level of spending (and higher levels of savings) does not necessarily cause a recession


FIGURE 14.BP.1 Saving and Investment in the Classical Model


FIGURE 14.1 The Classical Credit Market


4th Pillar of classical economics: All markets, including labor markets, adjust quickly and efficiently

•  In recessions, wages and input prices will fall quickly.

•  This decreases the costs of production for firms, which increases their profitability.

•  Firms then supply more, creating more jobs and income and moving the economy back to Potential Real GDP.


FIGURE 14.BP.2 Labor Market Adjustment in the Classical Model


Classical Model in an overheated economy

•  Wages and input prices increase dramatically due to the economy operating beyond its normal capacity –  Firms cannot find the skilled workers they need, and they

must pay higher wages to attract new workers; inputs get more expensive due to high demand.

–  This increase in the costs of production then causes firms to supply less until the economy reaches equilibrium back at its normal capacity at a higher price level.


Classical model when consumption decreases

•  In a (temporary) downturn, increases in savings (from a decrease in consumption) lead to increases in investment, so there will only be a temporary downturn. – The �C is offset by the ↑I and AD returns to its

normal capacity


Classical Model: in a full-fledged recession

•  If the economy stays in the downturn for any length of time, wages and input prices tend to fall due to high levels of unemployment and slack demand. – This decrease in the costs of production causes

firms to increase production, increasing GDP until the economy reaches equilibrium at its normal capacity and at a lower price level.


Classical Model Redux

•  In the long run, the economy always returns to its normal capacity –  In small downturns, increases in savings are

offset by increases in investment. –  In recessions, wages & input prices fall,

reducing costs and causing production to increase back to its normal level.

–  In an overheated economy, wages & input prices increase, raising costs and reducing production back to its normal capacity.


Flaws in the Classical Model: our economy has not proved to be stable, and we have regular business cycles

•  Great Depression proved once and for all that the economy is not self-adjusting

–  Decline in the money supply DID decrease Real GDP, so money was not neutral.

–  Supply exceeded demand due to declines in investment even though savings had increased, so Say’s Law did not hold and investment did not equal savings.

–  Balanced Budget adopted in the early 1930s was a disaster as it contributed to the problems of the Depression.

–  Wages took several years to decline, and after that the lower costs did not stimulate new production.


FIGURE 14.2 Business Cycles


The Classical Model could not explain the depression, but Keynes could

•  Say’s Law does not hold unless Injections = Leakages •  In equilibrium, injections = leakages:

–  I + G + X = S + T + M •  But in the Depression, S > I, leakages were greater than

injections –  More money was leaving the economy than was being put in –  This led to lower spending, which led producers to reduce supply,

which reduced incomes, which lowered GDP even further –  Firms would not invest despite low interest rates; lower wages

reduced spending so firms would not produce more despite lower costs


KEYNES on RECESSIONS

1.  Increases in savings do not lead to increases in investment just because interest rates fall. Firms don’t invest when expected sales are low.

2.  Wages and input prices are sticky (they do not fall quickly, if at all)

3.  Even if wages do fall, firms will not increase supply because there is no demand for their goods.

Copyright © 2011Pearson Addison-Wesley. All rights reserved. 14-19

KEYNES on RECESSIONS

•  Economy can linger in a recession for many years. •  When the economy does finally pull out of recession,

–  It will be led by Demand (especially consumer spending), not Supply.

•  Since the government can affect Demand –  through fiscal policy (G or T) or monetary policy (changes

in interest rates affect C, I), –  the government can shorten the length and severity of

recessions.


Keynes on an Overheated Economy

•  We should avoiding an overheated economic state by –  Reducing government spending, increasing taxes, or increasing interest

rates. •  Keeping the economy from growing too quickly can prevent

booms from accelerating unsustainably and turning into busts. –  Wages and input prices do increase in an overheated economy, and this

does cause a decrease in supply. –  But the economy won’t stop at its normal capacity:

•  Layoffs and stock market declines undermine consumer and business confidence, decreasing demand.

•  So overheated economies are usually followed by recessions. –  Careful macroeconomic policy can almost always improve on the

outcomes of an unregulated market.


Concept Check

•  What do proponents of the classical model think will happen to the economy if there is a decrease in consumption and an increase in savings?

•  How would Keynes respond?


Concept Check

•  What do classical economist think will happen to the economy in a recession?


•  What do classical economists think will happen to an overheated economy?



FIGURE 14.3 The Circular Flow with Leakages (L) and Injections (IN)


Households Businesses

Product Markets

Dollar Flow Real Flow

Resource Markets

Banks Sa

ving

s (S

) Investment (I)

Consumptio

n (C)

Inco

me (

Y) Govt. Net Taxes (T)

Gov

t. S

pend

ing

(G)

Disposable

Income (DI)

Rest of the World

Exports (X)

Imports (IM)



Product Markets


Resource Markets

Banks Sa

ving

s (S

) Investment (I)

Consumptio

n (C)

Inco

me (

Y)

Households either consume (C) or save (S) their disposable income. Banks take Savings and loan it out for Investment purchases (I).



Product Markets


Resource Markets

Banks Sa

ving

s (S

) Investment (I)

Consumptio

n (C)

Inco

me (

Y)

Rest of the World

Exports (X)

Imports (IM)

Export (X) purchases increase spending on US goods, Imports (IM) decrease spending.



Product Markets


Resource Markets

Banks Sa

ving

s (S

) Investment (I)

Consumptio

n (C)

Inco

me (


Gov

t. S

pend

ing

(G)

Disposable

Income (DI)

Rest of the World

Exports (X)

Imports (IM)

The government takes money out of the flow in net taxes (T), & returns it to the flow via govt. spending on goods & services (G).



Product Markets


Resource Markets

Banks Sa

ving

s (S

) Investment (I)

Consumptio

n (C)

Inco

me (


Gov

t. S

pend

ing

(G)

Disposable

Income (DI)

Rest of the World

Exports (X)

Imports (IM)

Total Spending = Aggregate Demand (AD)

AD = C + I + G + X - IM



Product Markets


Resource Markets

Banks Sa

ving

s (S

) Investment (I)

Consumptio

n (C)

Inco

me (


Gov

t. S

pend

ing

(G)

Disposable

Income (DI)

Rest of the World

Exports (X)

Imports (IM)

Total Income = Y = DI + T and DI = C + S, so

Y = C + S + T


GDP = Total Income (Y) = Total Expenditure (AD)

•  AD = C + I + G + X – IM •  Y = C + S + T •  C + I + G + X – IM = C + S + T •  I + G + X – IM = S + T •  I + G + X = S + T + IM •  Injections = Leakages



Product Markets


Resource Markets

Banks Sa

ving

s (S

) Investment (I)

Consumptio

n (C)

Inco

me (


Gov

t. S

pend

ing

(G)

Disposable

Income (DI)

Rest of the World

Exports (X)

Imports (IM)

I + G + X = S + T + IM Injections = Leakages


The Multiplier

•  Shows how a $1 change in spending causes AD & GDP to change by more than $1

•  Example: –  With a marginal propensity to consume of .8 (mpc=0.8),

•  $100 of spending (C=$100) becomes $100 of income for someone. •  The people receiving the $100 will then spend $80 (C=$80) of this

$100, saving $20. –  But the $80 in spending is income for someone else, who then spends

80% of $80 (C=$64, S=$16). »  The $64 in spending is income for yet another person, who then

spends 80% of $64 (C=$51.20), which is then income for someone else.


•  The total change in consumption from the initial change in consumer spending is: $100+$80+$64+$51.20+..... = $100 (1+.8+.82+.83+....) = $100 (1/(1-.8)) = $100 * 5

= $500 –  In this example, the multiplier is 5. – This means that each $1 change in spending

ultimately generates $5 in total spending. – Note: this analysis excludes the presence of 2

leakages -- taxes and imports.

The total change in consumption using the multiplier


FIGURE 14.BP.9 The Keynesian Multiplier Effect


FIGURE 14.BP.10 The Keynesian Multiplier


Actual formula for the multiplier: multiplier = 1/(1-mrr)

•  Where mrr is the marginal respending rate (the amount of each dollar that actually gets respent on US goods and services).

•  mrr = mpc(1-t)-mpm, –  Where mpc is the marginal propensity to consume, t is the tax

rate, and mpm is the marginal propensity to import –  Some of each $1 of spending will be respent, depending on

the amount consumers save, the amount the government takes in taxes, and the amount that flows overseas to pay for imports.


Typical numbers for the MRR

•  MPC = 0.9 •  T = 0.2 •  MPM = 0.12 •  mrr = mpc(1-t)-mpm = (.9)(.8)-(.12) = 0.6 •  Multiplier = 1/(1-mrr) = 1/(1-.6) = 1/(0.4) = 2.5


FIGURE 14.4 The Consumption Function

•  Consumption increases as disposable income increases


FIGURE 14.5 The 45° Line

•  Tells us when expenditure (C) equals income


FIGURE 14.6 The Consumption Function and the 45° Line

•  Expenditure equals income at $3.0 trillion


FIGURE 14.7 Your Consumption Function

•  What would your consumption function look like over time? How would your income and spending patterns change?


TABLE 14.1 Data for Hypothetical Consumption Function


FIGURE 14.8 Marginal Propensity to Consume


TABLE 14.2 Derivation of Saving Function from Consumption Data


Consumption, Savings and Disposable Personal Income

–  Disposable Personal Income = Total Income (RGDP) - Net Taxes (T)

–  Disposable Personal Income (DPI) is either consumed (C) or saved (S):

DPI = C + S

–  Marginal Propensity to Consume: mpc=ΔC/ΔDPI –  Marginal Propensity to Save: mps=ΔS/ΔDPI –  mpc+mps=1 –  (disposable income is either consumed or saved)


FIGURE 14.9 The Saving Function

•  If the slope of C is 0.75, then the slope of S is 0.25


TABLE 14.3 Data for Hypothetical Saving Example


FIGURE 14.10 The Investment Function

•  Investment shifts the expenditure curve up by the amount of investment


Data for Hypothetical Investment Function

•  What is the mpc in this example? What is the mps? What is the multiplier?


FIGURE 14.11 Equilibrium Level of Income

Equilibrium occurs where AE is equal to Real GDP, which is where the AE curve intersects the 45 degree line. Savings is equal to investment at the equilibrium level of Real GDP.


FIGURE 14.12 An Increase in Investment Spending

•  An increase of investment of $0.2 trillion causes an increase in Real GDP of $0.4 trillion

•  The mpc is 0.5, so the multiplier in this case is 2.


FIGURE 14.BP.3 Saving, Consumption, and Income


FIGURE 14.BP.4 Savings, Investment, and Income in the Keynesian Model


FIGURE 14.BP.6 Saving Leakage from the Circular Flow


FIGURE 14.BP.7 Investment Injection into the Circular Flow


FIGURE 14.BP.8 Initial Investment Received as Income


TABLE 14.5 Keynesian Respending Effect


FIGURE 14.13 The Government Spending Function


FIGURE 14.14 The Keynesian Model with C, I, and G Spending


FIGURE 14.15 Effects of Increased Government Spending on the Equilibrium Level of Income


FIGURE 14.BP.11 The Keynesian Model—Four Sectors


FIGURE 14.16 A Problem on the Keynesian Model


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Chapter 14 - WordPress.com...14-15 Flaws in the Classical Model: our economy has not proved to be stable, and we have regular business cycles • Great Depression proved once and for