Week One: An Overview of Modern Macroeconomics

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Week One: An Overview of Modern Macroeconomics

This week illustrates just how important macroeconomics can be in your personal and professional life. The lesson this week also provides a very informative historical overview of the development of modern macroeconomics. Beginning with Classical economics, we see how, over time, new theories like Keynesianism, Monetarism, Supply-side economics, and New Classical economics have emerged to try and cope with problems that the previous theories could not solve.

You should find such a history very useful in helping you to remember some of the more difficult theoretical material that you will encounter this course. Ultimately, it is only after we come to understand how macroeconomics has evolved--and how it keeps evolving over time--that we will come to realize just how important and relevant this subject is to everything we do.

Key Questions for Week One: An Overview of Modern Macroeconomics

1. At a personal level, what kind of questions can macroeconomics help you answer?

2. At a business and professional level, what kind of questions can macroeconomics help you answer?

3. Why is it important to study macroeconomics from an historical perspective?

4. How is microeconomics distinguished from macroeconomics?

5. How is inflation defined, and how is it typically measured? Why has inflation often been described as the cruelest tax? How is the unemployment rate measured?

6. Describe the three kinds of unemployment.

7. How is the rate of economic growth typically measured? Describe the two ways of measuring the gross domestic product.

8. What is the difference between actual and potential Gross Domestic Product?

9. What is the difference between nominal GDP and real GDP? Describe the phases of the business cycle.

10. What is fiscal policy? What is monetary policy?

11. Illustrate equilibrium in the aggregate supply-aggregate demand model.

12. What is the Classical view of unemployment?

13. John Maynard Keynes flatly rejected the Classical notion of a self-correcting economy. Why?

14. Use the aggregate supply-aggregate demand model to illustrate demand-pull inflation.

15. Use the aggregate supply-aggregate demand model to illustrate cost-push inflation.

16. What was the Keynesian dilemma that arose because of stagflation?

17. Milton Friedman's Monetarist School argued that the problems of both inflation and recession may be traced to one thing. What is it?

18. In the 1980 presidential election, Ronald Reagan ran on a Supply-side platform that promised to do what?

19. New Classical economics is based on what controversial theory? What is the central policy implication of this, theory?An overview of Modern Macroeconomics

Macroeconomics in our Personal LivesMacroeconomics helps you make important decisions:

Is it a good time to switch jobs?

Should you ask for a raise?

Go buy that new hour now or wait?

Get a fixed or a variable rate mortgage?

Macroeconomics helps you make critical business decisions!

How much to manufacture?

Inventory levels?

Invest in new plant and equipment?

Expand into foreign markets?

Downsize my firm?

The Real Power of MacroeconomicsArms us with a new way of thinking about the world we live and work in.

Helps us filter, sort and process information that will affect our business decisions.Jim wells DecisionJim owned a manufacturing business that made high precision components for computer games.

Jim had to decide how many components to produce for the upcoming holiday season.

Every year, he had doubled his production.

Because he never had trouble moving inventory, Jim decided to do the same thing again.

It meant taking out a big short term loan to finance the expansion.

Ignorance is Costly Not BlissJim never took a course in the principles of macroeconomics

His lack of knowledge would be very costly.

He missed some significant danger signs.

Jims company a turkey by thanksgivingBy thanksgiving, Jim was sitting on a huge inventory that he couldnt give away.

By December he was unable to pay a huge loan that wouldnt go away.

By June, Jims company was bankrupt.

Jim meets TeresaToday, Jim works as a consultant for one of his old Japanese competitors

At night, Jim studies macroeconomics.

He sits in the front row of his class right next to Teresa Watson.

Teresas American DreamTeresa is a single mother with a dream to own her own home.

She was a marketing director for a major corporation.

With a good salary, she saved up to put a down payment on a new home.

Teresas choice and Gamble!

A modest condo near work or a big, more expensive dream home out in the suburbs?

Buying her dream home meant taking a variable rate mortgage two points below a fixed rate mortgage.

Her variable mortgage payments would be much lower than a fixed rate mortgage but only if inflation and interest rates stayed low!

Some warning signsTeresa felt a little nervous about choosing the variable rate but the mortgage banker told her not to worry.

Rates had been stable so it shouldnt be a problem.

However, Teresa failed to see numerous warning signs of growing inflationary pressures.

Disaster strikesInterest rates climbed into double digits.

Teresa couldnt afford her variable rate mortgage payments

Rising interest rates plunged the economy into a recession.

The real estate market crashed!

Teresa was forced to sell her dream home for much less than she bought it for.

She lost every cent of her equity.

The power of macroeconomics in real lifeJim and Teresa could have avoided their hardships with a solid grasp of macroeconomic principles!

Jim could have halved his production rather than doubling it and stayed in business.

Teresa could have bought that less expensive condo with a fixed rate mortgage

Teresa could have even waited until the real estate market went soft and bought her dream house at a discount.

The Dismal ScienceDespite the enormous impact macroeconomics has on our personal and professional lives, most of us view it as a remote, complicated and indeed dismal science

Some Personal HistoryWhen I first studied macroeconomics, I got buried in a jumble of graphs and equations.

My epiphany: The best way to understand the power of macroeconomics is to teach it from an historical perspective.

Important for at least two reasons

History Reminds us macroeconomics is an evolving policy scienceMacroeconomic theories and solutions have changed to meet new economic problems.

Keynesian solutions worked to lift us out of the Great Depression in the 1930s and the doldrums of the 1960s

Keynesian solutions have not been working well in the sophisticated global economy of 2010s

How we will end this first lessonBriefly define macroeconomics

Identify key policy issues

Provide a short review of macroeconomic history well start with classical economics

New problems new complexitiesThe problems facing macroeconomists have become progressively more complex over time:

- Unemployment and inflation

- StagflationNew theories for new complexitiesNew macroeconomic theories have emerged in response to increasing complexity

Key turning points in the worlds economic history:

- Keynesianism in the 1930s- Monetarism in the 1970s

- Supply side economics in the 1980s

- New classical economics in the 1990sMacroeconomics DefinedMacro means big or large

Macroeconomics focuses on the big economic picture How the overall national economy performs

Microeconomics deals with the behavior of individual markets and the businesses, consumers, investors, and workers that make up the economy.

The Big Four Macro IssuesInflation

Unemployment

The rate of economic growth

Forecasting movements in the business cycle

Macro Problem #1: InflationAn upward movement of prices from one year to the next

Measured by the percentage change in price indices:Consumer Price Index (CPI)

Producer Price Index (PPI)

GDP deflator

Some Inflation Indices:Producer Price Index or PPI

Based on a number of important raw materials

Consumer Price Index or CPI

Calculated by pricing a basket of goods and services purchased by a typical household

Includes prices of items like food, clothing, shelter, fuel, transportation and college tuition

The Cruelest Tax

Inflation (price of goods) is greater than increase in our paychecks our purchasing power is declining even though wages are risingNot everyone loses from inflationUnanticipated inflation can actually benefit borrowers at the expense of lenders

How can borrowers gain from inflation?

An ExampleSuppose you borrow $1000 from a bank and promise to repay it in two years

If the price level doubles because of inflation, the $1000 which you repay will have only half of the purchasing power of the $1000 originally borrowed.

Borrowers can win from inflation! Lenders can lose!

Macro Problem #2: UnemploymentThe unemployment rate:

The number of unemployed persons divided by the number of people in the labor force.

Frictional UnemploymentThe least of the macroeconomists worriesA natural part of the job-seeing process

People quit their jobs just long enough to look for, and find, another

Cyclical UnemploymentA much more serious problem

Cyclical unemployment occurs when the economy dips into recession

Macroeconomists spend most of their time trying to solve cyclical unemployment

A third type of unemployment, structural unemployment, and poses major challenges too.

Structural UnemploymentIt occurs when a change in the technology makes someones job or job skills obsolete.

An auto worker replaced by a robot

A telephone operator replaced by a computerized voice synthesizer

Structural unemployment is VERY hard to cure!

Macro Problem #3: The rate of economic growthMeasured by growth in the Gross Domestic Product or GDP

GDP defined as the market value of all the final goods and services produced in a country in a given year.Economists have two ways of measuring GDP Flow-of-cost or income approach

Flow of product or expenditures approach

Flow of Product Approach AKA Flow of Expenditure Approach Vs. All income people earn in a year

Consumption by households

Wages for workers

+

Investment expenditure by businesses

Rents for property owners

+

Government purchases

Interest for lenders

+

Net exports = Exports Imports

Profits earned by firmsActual Vs. Potential GDPActual GDP: What we produce

Potential GDP: Maximum economy can produce without causing inflation

When actual GDP is less than potential GDP, we are in the recessionary range of the economy

When actual GDP is above potential GDP, we run the risk of inflation

Nominal Vs. Real GDPNominal GDP: Measured in market prices

Real GDP: Nominal GDP adjusted for inflation

GDP Deflator = Nominal GDP/Real GDP

GDP Deflator: Another valuable inflation index besides CPI and PPI

Output Growth

GDP: Best measure of the level and growth of output in the economy

Real GDP: Following its movements gives us the best pulse on our economy

Macro Problem #4: Business Cycles & Economic GrowthThe term business cycle refers to the recurrent ups and downs in real GDP over several years

Forecasting the business cycle is an important part of successfully managing an organization or investment portfolio.

Forecasting for Public PolicyWhat forces are behind movements in the business cycle?

Central Point: Both macroeconomists & our political leaders want to know what macroeconomic policies may be used to harness the expansionary ups and recessionary downs of the business cycle.

Forecasting for BusinessBusiness executives want to know if the economy is going to expand or go into recession.

Forecasting business cycle movements allows executives to plan things like production and inventory levels.

If a business bets on an economic expansion and increases production but then gets a recession, it could fail!

Major Macroeconomic Policy ToolsIn dealing with problems such as inflation and unemployment, the Federal government has a number of policy tools at its disposal

The two most important

Fiscal policy

Monetary policy

Fiscal Policy ToolsTo stimulate the economy:

Increased government spending

Tax cuts

To contract the economy to fight inflation:

Decreased government spending

Tax hikes

Fiscal Policy SummarizedIncreased government spending & Tax cuts

=======( Stimulate the economy to fight recession!

Cut government spending & Raise taxes

======( Contract economy to fight inflation!

Monetary PolicyIncrease the money supply ====( Stimulate the economy to fight recession!

Decrease the money supply ==( Contract economy to fight inflation

Monetary and fiscal policy often used together.

Macro Policy a Double-edged swordGood macroeconomic policies can create prosperity and growth

Bad macroeconomic policies can inflict great harm.

Example: Bad monetary policy helped trigger Great Depression of 1930s

Macroeconomics from an historical perspectiveOutline the historical evolution of macroeconomic thinking.

Show how new theories emerged to cope with new macroeconomic problems like Keynesianism and Monetarism.

See how macroeconomics continues to be an evolving science.

Learn how macroeconomics is relevant to much of what we do in our personal and professional lives.

AS AD Model (Graph) Aggregate Supply and Aggregate Demand Model Classical Economics

Dates back to the late 1700s

Rooted in the laissez faire writings of Adam Smith, David Ricardo, and Jean Baptiste Say.

A rise in wages, from an alteration in the value of money, produces a general effect on price, and for that reason it produces no real effect whatever on profits. David Ricardo

Classical Economics PrinciplesUnemployment a natural part of business cycle

Economy is self-correcting

No need for government intervention like fiscal or monetary policy!

The classical economists get run over by the great depressionBetween civil war and roaring 20s, a series of booms and busts Five Depressions

The economy always self-corrected like classical economist predicted.

Classical economists were no match, however, for the Great Depression.

The Great Depression ComethStock market crash in 1929

GDP falls by almost a third between 1929 and 1933

25% of work force unemployed

Business investment fell from $16 billion in 1929 to $ 1 billion by 1933!

The birth of Keynesian EconomicsPresident Herbert Hoover wrongly believed prosperity just around the corner

Classical economists waited fruitlessly for the inevitable recovery

Enter stage left:

Economist John Maynard Keynes

President Franklin Delano Roosevelt

The Keynesian ViewKeynes flatly rejected the classical notion of a self-correcting economy

He warned that patiently waiting for the eventual recovery was fruitless because in the long run, we are all deadClassical economics death spiralUnder certain circumstances, economy would not naturally rebound.

Instead, it would stagnate or fall into a death spiral!

The Keynesian Spending CureOnly way to get the economy moving again? Prime the economic pump with increased government expenditures!

Thus, fiscal policy was born! The Keynesian prescription became the underlying philosophy of Franklin Delano Roosevelts New Deal.

Roosevelts New Deal and World War II Lifts the economyThe new deals public works projects plus a World War II manufacturing boom lift the American economy up to unprecedented heights!

The Keynesian Cure ReduxKorean War expenditures stimulate the economy out of a 1950s recession

The famous Kennedy tax cut lifts the economy out of the doldrums in the 1960s.

The Promise of Fine TuningPresident Kennedys chief economic advisor popularized the term fine tuning

The concept: By mechanically applying Keynesian principles, the U.S. economy would be held very close to full employment with minimal inflation

The Kennedy Tax Cut1962: Heller recommends a large tax cut to stimulate the sluggish economy

This was revolutionary usually fiscal stimulus meant more government spending and not tax cuts

The Kennedy tax cut made the 1960s one of the most prosperous decades in America.

The foundation of StagflationThis fiscal stimulus laid the foundation for the emergence of stagflation

Stagflation is simultaneous high inflation and high unemployment

Stagflation would prove difficult to cure with traditional Keynesian tools

Guns or Butter You cant have bothPresident Johnson increased expenditures on the Vietnam WarHe refused to cut spending on his Great Society social welfare programs

LBJs refusal to cut butter while buying guns helped spawn a virulent demand pull inflation

Demand-Pull InflationToo much money chasing too few goods

When America tried to finance both the Vietnam War and the Great Society, severe demand pull inflation resulted.Demand-Pull Inflation GraphPresident Nixon imposes price and wage control in 1972

When controls lifted in 1973, inflation jumps!

Its partly a new kind of inflation cost push

Cost-Push InflationRapid increases in raw material prices or wage increases drive up production costs.

This can happen as a result of so-called supply shocks

1970s shocks included crop failures, a worldwide drought, and a quadrupling of the world price of crude oil.

A Budding Keynesian ParadoxPrior to the 1970s, economists didnt believe you could have simultaneous high inflation and high unemployment.

If inflation went up, unemployment had to go down and vice versa.

Keynesian economics turned out to be incapable of solving the new stagflation problem.

The Keynesian DilemmaIf expansionary policy were used to stimulate the economy to reduce unemployment, it would exacerbate inflation.

If contractionary policy were used to fight inflation, it would increase unemployment

Ergo, traditional Keynesian tools could solve only half of the stagflation problem at any one time and only by making the other half worse.

Friedmans Monetarist SchoolThe problems of both inflation and recession may be traced to one thing the rate of growth of the money supply

Inflation happens when the government prints too much money

Recessions happen when it prints too little money

The Monetarist PerspectiveStagflation is the inevitable result of activist fiscal and monetary policies

Activist Keynesians try to push the economy beyond its so-called natural rate of unemployment

The natural rate of unemployment is also called the lowest sustainable unemployment rate or LSUR

The LSUR or Natural RateThe lowest level of unemployment that can be attained without upward pressure on inflation.

Expansionary attempts to go beyond the LSUR may result in short run spurts of growth

After each growth spurt, prices and wages inevitably rise and drag the economy back to its LSUR at a higher rate of inflation!

Some Bitter MedicineAttempts to push the economy beyond its natural rate are futile. They lead to an upward inflationary spiral

Monetarists believe that the only way to wring the inflation and inflationary expectations out of the economy is to push the actual unemployment rate rise above the LSUR

That means inducing a recession!!!!

Inducing a RecessionThis is the interpretation of what the Federal Reserve did in 1979 under the Monetarist banner of setting monetary growth targets.

Under Chairman Paul Volcker, the Fed adopted a sharply contractionary monetary policy.

Interest rates soared to over 20%

Interest rate-sensitive sectors were particularly hard hit. Housing construction, automobile purchase and business investmentA Sweeter Economic CureThe Feds bitter medicine worked to wring inflation out of the economy.

But after three years of hard economic times, Americans wanted a sweeter cure.

Enter stage right: supply side economics

The Supply Side PromiseCut Taxes, Increase Government Tax Revenues, Accelerate the Rate of economic growth ==( without ===( Inducing Inflation

The Supply Side PhilosophyA supply side tax cut looks very similar to a Keynesian tax cut:

Example: The Kennedy tax cut of the 1960s

However, the supply siders viewed such tax cuts from a very different behavioral perspective.

Keynesianism

Tax Cut ==( increased demand for goods =( producers may increase prices ==( possible inflation

Supply side economicsTax Cut =( Workers keep more of what they earn =( Individuals work harder and increase their productivity ===( increased output and employment ==( shifts the supply curve out, Reducing inflation

Supply Siders Predicted Lower Budget Deficits!The loss in tax revenues from a supply side tax cut would be more than offset by the increase in tax revenues from increased economic growth.

End Result of the Regan Tax Cuts?The supply side prediction didnt come true

The economy boomed but so did Americas budget deficit.

Americas trade deficit also soared.

George Bushs New Classical ApproachThe budget and trade twin deficits deeply concerned Regans successor George Bush

After the budget deficit jumped over $200 billion in 1990, the economy slid into recession.

The Keynesian solution would have been more fiscal or monetary stimulus.

Bush refused more stimulus based on the advice of his New Classical advisors.

New Classical EconomicsBased on the theory of rational expectations

If you form your expectations rationally, you will take into account the future effects of activist fiscal and monetary policies(Robert Lucas: Won the Nobel Price in Economics for his work on rational expectation)

Central Idea of Rational ExpectationsActivist Keynesian policies might be able to fool people for a while.

People eventually learn from their experiences.

Then you cant fool people at all.

A Profound Policy ImplicationRational expectations render Keynesian policies ineffective so they should be abandoned.

Good Economics Makes Bad Politics?Refusing to engage in Keynesian stimulus was bad politics for President Bush

Bush advisors rejected a Keynesian quick fix even as the recession deepened.

Instead these advisors called for more stable and systematic policies based on long term goals

The deepening recession likely cost Bush the election!!!

Its The Economy Stupid!President Bush took his advisors advice and refused any Keynesian stimulus

The economy limped in the 1992 election.

Democrat Bill Clinton ran on a platform that highlighted the failure of Bushs economic policies.

Clinton beat Bush in 1992 just like Kennedy beat Nixon in 1960 because of a weak economy.

Clinton Restored ConfidencePresident Clinton actually did very little to stimulate the economy upon taking office

The mere fact, however, that Clinton promised a more activist approach helped restore business and consumer confidence.

An Easy Re-electionClintons 1993 deficit reduction legislation signaled Wall Street Clinton was serious about budget balance

These factors helped accelerate a recovery already began toward the end of the Bush presidency

The booming economy also set the stage for Clintons easy re-election in 1996

The 1990s marked the longest economic recovery in peacetime history.

The 2000s: A Decade Not so kind or ProsperousAfter President Bush took office in 2001:

A recession

The 9/11 terrorist attack

Two wars in Iraq and Afghanistan

China joins the WTOChina joins World Trade Organization in 2001Begins flooding American markets with illegally subsidized exports

Over 50,000 American factories disappear

More than 5 million manufacturing jobs lost

American GDP growth rate falls by 2/3rds.

The Great Recession of 2007A massive housing bubble bursts.

The U.S. enters its worst recession since the Great Depression of the 1930s.

Keynesian Economics on Steroids?White House and Congress orchestrate biggest fiscal stimulus in history

Federal Reserve engineers an equally massive monetary stimulus

Fed chairman Ben Bernake inaugurates tools like Quantitative Easing

A New Failure of Keynesianism?Fiscal and monetary stimulus packages have been less successful this century than last.

Economies around the globe seem to face structural problems increasingly resistant to Keynesian solutions.

Purpose of This CourseHelp you better understand the complex global economic forces affecting both your personal and professional life!!!

Week Two: The Aggregate Supply-Aggregate Demand Model and the Classical-Keynesian Debate

The debate between Classical economists and Keynesians is one of the most important in macroeconomics. This debate goes back to the 1930s and the Great Depression. However, it remains important even today. This is because many of the macroeconomic policies now favored by conservatives have their roots in Classical economics while those on the other side of the ideological spectrum are generally much more supportive of the Keynesian approach.

The purpose of this week is first to illustrate why Classical economics gave way to Keynesianism in the 1930s. This discussion sets the stage for the development of one of the most important tools used in macroeconomics, the aggregate supply-aggregate demand framework.

During this week, the most important point we'll make is that the Classical versus Keynesian controversy is primarily a dispute over how an economy adjusts back to full employment during a recession. On the one hand, the Classical economists believed that a ''price adjustment mechanism " would cure the economy. In the event of unemployment, prices, wages, and interest rates would all fall. This would increase consumption, production, and investment and quickly return the economy back to full employment.

In contrast, the Keynesian school argued that before the price adjustment mechanism had time to work, it would be overpowered by a more deadly "income adjustment mechanism": When an economy sinks into a recession, peoples' incomes fall. This causes them to both spend less and save less while businesses respond by investing and producing less. This drives the economy deeper into recession rather than back to full employment.

This debate is important because the Keynesian approach calls for large scale government intervention while the Classical approach believes that the best cure for a recession is to leave the free market alone.

Key Questions for Week Two: The Aggregate Supply-Aggregate DemandModel and the Classical-Keynesian Debate

1. The Classical versus Keynesian controversy is primarily a dispute over what?

2. State Say's Law.

3. What was Thomas Malthus' critique of Say's Law?

4. Use the circular flow diagram to illustrate Say's Law.

5. Describe the quantity theory of money.

6. Explain the two major assumptions of the quantity theory of money.

7. Describe the Keynesian income adjustment mechanism.

8. Illustrate equilibrium in the aggregate supply-aggregate demand model.

9. Explain the three reasons why the .aggregate demand curve slopes downward.

10. List at least five major reasons why the aggregate demand curve shifts.

11. Why does the aggregate supply curve slope upward?

12. List at least five reasons why the aggregate supply curve shifts.

13. Draw and explain the three ranges of the economy.

14. Draw and describe the Classical price adjustment mechanismPurpose of Lesson TwoIllustrate why Classical economics gave way to Keynesianism in the 1930s

Develop the Aggregate Supply-Aggregate Demand framework

A key tool in macroeconomic analysis.

An important debateThe debate between classical economists and Keynesians ranks as one of the most important in macroeconomics

The Classical-Keynesian DebateDebate goes back to the 1930s and the great depression but very important today!

Many of the macroeconomic policies now favored by conservatives have their roots in classical economics

Those on the other side of the ideological spectrum are generally more supportive of Keynesian approach.

The most important pointThe classical versus Keynesian controversy:

Primarily a dispute over how an economy adjusts during a recession and finds its way back to full employment

The classical viewA price adjustment mechanism would cure the economy

In the event of unemployment, prices, wages and interest would all fall.

This would increase consumption, production, and investment and quickly return the economy back to its full employment equilibrium.

The Keynesian ViewBefore price adjustment mechanism can work, it is overpowered by an income adjustment mechanism

When an economy sinks into a recession, peoples incomes fall.

They spend and sales while businesses invest produce lessThis income adjustment mechanism drives the economy further into recession rather than back to full employment.

Laissez-Fair EconomicsThe classical approach believes that the best cure for a recession is to leave the free market alone.

Laissez faire economists believe most government policies will probably make things worse- not better so the best policy is relatively little government

Activist EconomicsKeynesians prescribe large-scale government expenditures to prime the economic pump.

Keynesians are activists economists who believe that the government can create and implement policies that will positively affect the economy.

Classical EconomicsRoots are in the free market writings of Adam Smith, David Ricardo, and Jean Baptiste Say

Unemployment is a natural part of the business cycle and is self-correcting.

There is no need for government intervention into the free market!!!

Classical unemploymentUnemployment results when wages are too high.

In the event of a recession, unemployed workers would be will to work for less.

Wages would then fall back down to levels where it once again made it profitable for firms to hire the workers and the recession would end.

There is no cyclical unemploymentClassical economists agreed that frictional and structural unemployment could exist.

They did not agree that cyclical unemployment could be caused by a shortage of aggregate demand

John Maynard KeynesBorn in 1893, the son of British economist John Nevile Keynes

A stock speculator who made millions

An arts patron

A Cambridge University professor

A Key appointee to the British Treasury.

Keynes General TheoryKeynes flatly rejected the Classical notion of a self-correcting economy that would solve unemployment through adjustments in wages and prices

The general theory of employment, interest and money Book of Keynes

The Keynesian Bottom LineWaiting for eventual recovery was fruitless because in the long run, were all dead

Under certain circumstances, a recessionary economy would not rebound but fall into a deep spiral

The only way to get the economy moving again was to prime the economic pump with massive government expenditures!!!

Keynes An Economic HereticKeyness approach was economic heresy

Keynesian policies were initially rejected by virtually the entire economics profession

Keynes and his followers were branded as socialists or communist for advocating an activist role for the government.Keynesian Economics is BornKeynes stuck to his guns.

As the depression wore on, his teachings gained adherents and disciples.

The two pillars of classical economicsWhy did Keynesian economics triumph?

The two major pillars of classical economics crumbled under the weight of Keyness argument

Says Law: Supply creates its own demand

The Quantity Theory of Money: PQ = MVSays Law says.Formulated in the 1800s by French businessman Jean Baptiste Say and popularized by David Ricardo

Supply creates its own demand

What does this really mean?

How Says Law WorksWhen people work to produce goods and services, they earn income for doing so.

Says law states the total income must equal the value of the goods and services.

If the workers spend this income, it must be enough to pay for all the goods and services they produce.

Therefore, supply creates its own demand i.e., aggregate demand must equal aggregate supply!!!

Thomas Malthuss CritiqueSuppose income earners dont spend all their money and instead save some of it?

Thomas Malthus raised this possibility in his criticism of Says Law

If people dont spend all of their money, there would be a glut of goods and people would be out of work.

The Dismal ScienceThe Malthusian doctrine says population will grow faster than the production of food which will lead to mass starvation.

Malthus dark vision earned the economics profession its label as the dismal science (Thomas Malthus the original Dr.Doom)

Say and Ricardo Respond to MalthusIf people save some of their money, all of these savings will still be invested in the economy.

Therefore aggregate demand, which equals consumption plus investment, will always equal aggregate supply.

Says Law and the circular flow diagramAggregate Supply (AS) = Employee compensation, rents, interest, & profits

Households savings ==( Banking and Finance ==( Investment ==( Firms (production) ==( Consumption

Aggregate Demand (AD) = Consumption + InvestmentUnemployment Would Go AwaySay acknowledged unemployment could exist.

However, if wages, prices, and interest rates are allowed to adjust, unemployment goes away on its own.

The quantity theory of moneyClassical economists supported their Says Law analysis with the quantity theory of money

The quantity theory of money determines the price level while Says Law analysis determines real output.

The equation of exchangeM*V = P*Q

M = Money supply

V = Velocity of money or the amount of income generated each year by a dollar of money

P = General price level as measured by an index such as the consumer price index

Q = Quantity of real output soldP*Q = nominal inflation-adjusted output as measured by GDPM*V = P*QQuantity theory of money says price level varies in response to changes in quantity of money

Changes in the price level are caused by changes in the money supply

If M up 20%, P up by 20%

If M down by 5%, P down by 5%

Two assumptions & an implicationAssumption #1: Velocity is constant

Assumption #1: The veil of money real output not influenced by money supply

Implication: Increasing M will not increase Q

Given MV = PQ, why will increasing M only lead to an increase in P, i.e inflation?

MV = PQ

If V is constant on the left side, and

If Q on the right side is unaffected by M

The only thing that can change if M changes, is P!

Classical Economics Gives Way to Keynesian EconomicsThe failure of classical economics during the great depression resulted in a search for an alternative solution.

That solution was Keynesian economics.

Why classical economics failedThe problem with classical economics was not the price adjustment mechanism it relied on.

Keynes believed that before the price mechanism could work, it would be dwarfed by a much more powerful income adjustment mechanism

The income adjustment mechanismWhen an economy sinks into recession, peoples incomes fall.

A fall in income causes people to spend and save less

Businesses respond by investing and producing less.

This reduction in consumption, savings, investment, and output drives the economy deeper into recession rather than back to full employment

An Economy Stuck in a Classical RutEventually income falls far enough so that savings and investment return to equilibrium

However, the economy will be at a level well below full employment

In other words, the economy is stuck in a rut with a glut of goods

This is just as Thomas Malthus predicted in his original critique of the Classical Model.

A key difference in price assumptionsThe AS-AD framework has its roots in classical economics. It allows for price adjustments.

The Keynesian model assumes prices are fixedIn the remainder of this lecture

We develop the aggregate supply-aggregate demand model and then turn to the Keynesian model in the next lecture.

Both models are helpful in understanding how modern economies function.

Aggregate demand curveIt shows the various amounts of real output that domestic consumers, businesses and government along with foreign buyers collectively desire to purchase at each possible price

The downward slope of the aggregate demand curve means that as the general price level falls, consumers and businesses will increase their demand for goods and services.

First, there is a real balance or wealth effect.

As price level falls, purchasing power increases, and consumers demand more goods and services

This is because the real value of money is measured by how many goods and services each dollar will buy

A lower price level increases the real value or purchasing power of accumulated financial assets such as savings accounts and bonds that have fixed money values.For example, a household might not buy a new car or sailboat if the purchasing power of its assets is only $30,000

If there is deflation and the price level falls, the households real purchasing power may increase to, say, $50,000 so the new purchase is more likely to be made.

A second reason why the aggregate demand curve slopes downward is an interest rate effect

As the price level falls, so do interest rates.

Falling interest rates increase investment spending by businesses and certain kinds of consumer spending on items such as automobiles and housing.Third, there is a foreign purchases foreign-trade, or net export effectAs the domestic price level falls, the relative price of foreign goods increases

This reduces demand for the now more expensive foreign imports, increases export demand, and thereby increases aggregate quantity demanded.

Why the AD Curve Can ShiftWe now understand why the AD curve slopes downward

Lets also understand why the AD can shift !

Remember: the AD graph shows the various amounts of real output that would be purchased at each possible price level, holding other things constant.

By understanding what these other things are, we can understand why the AD curve shifts!Factors shifting the AD curveChange in consumption spending

a. Consumer wealth

b. Consumer expectations

c. Household indebtedness or credit conditions

d. Tax policy

2. Change in investment spending

a. Interest rates

b. Profit expectations on investment projects

c. Business taxes

d. Technology

e. Degree of excess capacity

3. Change in government spending

4. Change in net export spending

a. National income abroad

b. Exchange rates

These factors are referred to as the determinants of aggregate demand because they determine the location of the aggregate demand curve

Suppose that the Dow Jones stock market average plunges 2000 points in a week

Which item in the table will this affect and which way will AD curve shift?

How might news of a possible recession affect consumer and profit expectation and the AD curve? Shift the AD curve inward.

The AS-AD FrameworkThe upward sloping Aggregate Supply Curve

The curve slopes upward because higher price levels create an incentive for businesses to produce and sell additional output while lower price levels reduce output

Factors shifting the AS curve1. Domestic resource availability

a. Land

b. Labor

c. Capital

d. Entrepreneurial ability

2. Prices of imported resources

3. Market power

2. Change in technology and productivity

3. Change in legal-institutional environment

a. Business taxes and subsidies

b. Government regulations

Which way will the AS curve shift if the cost of imported oil rises

Productivity = total output / Total inputsAn increase in productivity means the economy can obtain more real output from its limited resources

So which way will the AS curve shift if productivity increases? AS curve shifts outwards

What will happen to the AS curve if the sales tax or the payroll tax or excise taxes are decreased?

A tax decrease will decrease production costs and thereby increase aggregate supply AS curve shifts outwards

What about an increase in government regulation such as tougher clean air or clean water requirements? AS curve shifts inwardsThree Ranges of the economyKeynesian Range

Increasing output will not lead to inflation

Economy either in severe recession or full-blown depression

Large amounts of unused machinery and equipment and unemployed workers available

Putting these resources back to work will have no effect on inflation

In the Keynesian range, prices are fixed

Fiscal policy can be used without causing inflation!

Classical RangeThe only impact of expansionary fiscal policy is inflation!!!

Intermediate RangeAny expansion of real output is accompanies by a rising price level

As economy moves to full employment, movements in all product and resource markets may not occur simultaneously

As economy expands in intermediate range, auto and steel workers may still be unemployed, but high-tech computer industry may begin to experience shortages in skilled workers.

Raw material shortages or bottlenecks in production may begin to appear in other industries.

The Classical Price Adjustment MechanismGraphs Step1, Step2, Step3

The Classical Price Adjustment Failed During the Great DepressionThe classical price adjustment mechanism did not lift the economy out of the great depression.

In the next lectureIntroduce the Keynesian multiplier model

Show how the Keynesian model can be used to illustrate a recovery from a recession or depression.

Please rememberEconomics is not something to be memorized but rather conceptualizedAs you study it, think about it too!!!