Unit 5 - Models of Output Determination n Two Primary Schools of Economic Thought are: 1. Classical Economics (Smith, Ricardo, Von Mises, Say, Hayek, Hazlitt,

Unit 5 - Models of Output Unit 5 - Models of Output DeterminationDetermination

Two Primary Schools Two Primary Schools

of Economic Thought are:of Economic Thought are:1.1. Classical Economics (Smith, Classical Economics (Smith,

Ricardo, Von Mises, Say, Hayek, Ricardo, Von Mises, Say, Hayek, Hazlitt, Friedman, economic Hazlitt, Friedman, economic conservatives).conservatives).

2.2. Keynesian Economics (Keynes, Keynesian Economics (Keynes, Galbraith, economic liberals).Galbraith, economic liberals).

Macroeconomics


The Classical Model:The Classical Model: is based on Adam Smith’s is based on Adam Smith’s

Wealth of NationsWealth of Nations (1776). (1776). is the foundation for neo-classical and is the foundation for neo-classical and

Austrian school economics, rational Austrian school economics, rational expectationism, and monetarism. expectationism, and monetarism.

was dominant before the 1920s. Gained was dominant before the 1920s. Gained in popularity again since the 1980s.in popularity again since the 1980s.

Macroeconomics


Classical Economists Believe that:Classical Economists Believe that: Market forces (flexible prices, wages, Market forces (flexible prices, wages,

and interest rates) correct economic and interest rates) correct economic problems.problems.

Limited government involvement in the Limited government involvement in the economy leads to maximum wealth economy leads to maximum wealth and the highest standard of living.and the highest standard of living.

Artificial government stimulation of the Artificial government stimulation of the economy leads to problems in the long economy leads to problems in the long run. run.

Macroeconomics


The Keynesian Model:The Keynesian Model: is based on the works of is based on the works of

John Maynard Keynes John Maynard Keynes (1883 – 1946).(1883 – 1946).

gained acceptance during the 1930s and gained acceptance during the 1930s and was supported by almost all western was supported by almost all western economists and politicians during the economists and politicians during the 1950s, 1960s, and 1970s.1950s, 1960s, and 1970s.

Macroeconomics

Keynes said: “In the long run we Keynes said: “In the long run we are all dead.” Do you agree?are all dead.” Do you agree?

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1.1. YesYes

2.2. NoNo

3.3. Not sureNot sure

4.4. I don’t care I don’t care (we’re all dead (we’re all dead soon)soon)


Macroeconomics

Keynes’s Analogy

The economy is like an elevator. If it goes up, it will continue to go up for a while. If it goes down, it will go down and may hit the bottom, unless someone stops it.


The Keynesian TheoryThe Keynesian Theory

During a recession, During a recession, Production decreases.Production decreases. Thus, layoffs increase.Thus, layoffs increase. Thus, incomes and demand for products fall.Thus, incomes and demand for products fall. Thus, production decreases even more.Thus, production decreases even more. Thus, layoffs increase further.Thus, layoffs increase further. And so forth.And so forth.

During an expansion the opposite happens.During an expansion the opposite happens.

Macroeconomics


The Keynesian SolutionThe Keynesian Solution

The government must intervene (stop The government must intervene (stop the elevator) through:the elevator) through:

1.1. Active fiscal policyActive fiscal policy

2.2. Active monetary policyActive monetary policy

Macroeconomics


Active Fiscal Policy

During recessions, Keynes supports: Increases in government spending. Decreases in taxes.

Of the two, Keynes prefers increases in government spending, because households and businesses may not spend their tax rebates.



Increases in government spending and decreases in taxes lead to (Keynes):

Higher incomes Increases in spending Increases in production More jobs Higher incomes And so forth



During expansions, Keynes supports Decreases in government spending Increases in taxes


Active monetary policyActive monetary policy

During recessions, Keynes supportsDuring recessions, Keynes supportsincreases in the nation’s money supply.increases in the nation’s money supply.

In the United States, the Federal Reserve In the United States, the Federal Reserve Board controls the nation’s money Board controls the nation’s money supply.supply.

Macroeconomics


Active monetary policyActive monetary policy

According to Keynes:According to Keynes:Money supply Money supply

interest rates interest rates

borrowing Spending borrowing Spending GDP GDP

Macroeconomics


The Keynesian MultiplierThe Keynesian Multiplier

When government increases spending,When government increases spending,

total spending in the economy total spending in the economy increases by a increases by a multiplemultiple of the increase of the increase in government spending.in government spending.

Macroeconomics


Multiplier ExampleMultiplier Example

Let’s say a government spends $1 billion Let’s say a government spends $1 billion ($1,000 million) on the construction of a ($1,000 million) on the construction of a stadium.stadium.This increases construction workers’ This increases construction workers’ incomes by $1 billion, compared to if the incomes by $1 billion, compared to if the government hadn’t spent the money. government hadn’t spent the money.

What happens to this $1 billion?What happens to this $1 billion?

Macroeconomics


Example (cont’d)Example (cont’d)

Let’s assume that the construction Let’s assume that the construction workers spend 80% ($800 million) of workers spend 80% ($800 million) of their additional income. We say that their additional income. We say that their Marginal Propensity to Consume their Marginal Propensity to Consume (MPC) is 80%.(MPC) is 80%.

Let’s say they spend it on clothes.Let’s say they spend it on clothes.

Macroeconomics



This generates $800 million in This generates $800 million in additional income for the clothes additional income for the clothes suppliers.suppliers.

What happens to the $800 million?What happens to the $800 million?

Macroeconomics



Let’s assume the clothes producers Let’s assume the clothes producers spend 80% of their additional income on spend 80% of their additional income on food.food.

This generates $640 million in additional This generates $640 million in additional income for food suppliers.income for food suppliers.

What will the food suppliers do with the What will the food suppliers do with the additional income? You get the picture.additional income? You get the picture.

Macroeconomics

$1,000$800$640$512



Thus, total spending in the Thus, total spending in the economy increases by (in millions):economy increases by (in millions):

$1,000 + $800 + $640 + $512 + … = $1,000 + $800 + $640 + $512 + … = $5,000$5,000

Macroeconomics


ExampleExample

$5,000 million is 5 times $1,000 million.$5,000 million is 5 times $1,000 million.

$1,000 is the initial government $1,000 is the initial government spending change.spending change.

Keynes called this factor 5 “the Keynes called this factor 5 “the multiplier”.multiplier”.

Macroeconomics


The Change in Total Spending in The Change in Total Spending in the Economythe Economy

According to Keynes:According to Keynes:

The additional total spending in the economy The additional total spending in the economy = multiplier x the change in initial spending.= multiplier x the change in initial spending.

Or:Or: total spending = m x total spending = m x initial initial spending.spending.

Macroeconomics


The Formula for the MultiplierThe Formula for the Multiplier

Multiplier = 1 / (1 – MPC)Multiplier = 1 / (1 – MPC)

Or,Or,

Multiplier = 1 / MPSMultiplier = 1 / MPS

Where MPS = Marginal Propensity Where MPS = Marginal Propensity to Saveto Save

Macroeconomics


Multiplier Example 1Multiplier Example 1

If the MPC = .8, thenIf the MPC = .8, then

m = 1 / (1 – .8) m = 1 / (1 – .8) = 1/(.2) = 1/(.2) = 5.= 5.

Macroeconomics

If the MPC is .9, then the If the MPC is .9, then the multiplier is:multiplier is:

1.1. 11

2.2. 2.2.

3.3. 33

4.4. 44

5.5. 55

6.6. 7.57.5

7.7. 1010

100 of 5



If the MPC = .9, thenIf the MPC = .9, then

m = 1 / (1 – .9) m = 1 / (1 – .9) = 1/(.1) = 1/(.1) = 10.= 10.

Macroeconomics

If the MPC is .75, then the If the MPC is .75, then the multiplier is:multiplier is:

1.1. 11

2.2. 22

3.3. 33

4.4. 44

5.5. 55

6.6. 7.57.5

7.7. 1010

100 of 5



WhenWhen the MPC = .75, then the MPC = .75, then

m = 1 / (1 – .75) m = 1 / (1 – .75) = 1/(.25) = 1/(.25) = 4.= 4.

Macroeconomics

If the MPS is .2, the multiplier is:If the MPS is .2, the multiplier is:1.1. 11

2.2. 22

3.3. 33

4.4. 44

5.5. 55

6.6. 7.57.5

7.7. 1010

100 of 5



If the MPC = .75, and the government increases If the MPC = .75, and the government increases spending by $2,000, by how much will total spending by $2,000, by how much will total spending change?spending change?

Remember,Remember, total spending = m x total spending = m x initial initial

spending.spending.

Thus, total spending = 4 x $2,000.Thus, total spending = 4 x $2,000.Thus, total spending = $8,000.Thus, total spending = $8,000.

Macroeconomics

If the MPC is .9, and government increases If the MPC is .9, and government increases spending by $20, what is the change in total spending by $20, what is the change in total

spending in the economy?spending in the economy?

1.1. $10$10

2.2. $18$18

3.3. $100$100

4.4. $200$200

5.5. $1,000$1,000

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Recessionary and Inflationary Recessionary and Inflationary Gaps: Gaps:

are the differences (negative and are the differences (negative and positive, respectively) between what positive, respectively) between what GDP is now and what GDP is at full GDP is now and what GDP is at full employment.employment.

Macroeconomics


Recessionary and Inflationary Gaps Recessionary and Inflationary Gaps ExampleExample

By how much should the government increase By how much should the government increase government spending if current GDP is $5,000, and government spending if current GDP is $5,000, and full employment GDP is $6,000, and the MPC full employment GDP is $6,000, and the MPC = .80?= .80?

Answer: $X times 5 = $1,000. $X = $200.Answer: $X times 5 = $1,000. $X = $200.

Macroeconomics

If current GDP is $10,000 and full employment GDP If current GDP is $10,000 and full employment GDP is $12,000, and the MPC is .8, by how much should is $12,000, and the MPC is .8, by how much should government increase spending to eliminate the government increase spending to eliminate the recessionary gap?recessionary gap?

10

1.1. $200$200

2.2. $300$300

3.3. $400$400

4.4. $500$500

5.5. $1,000$1,000

6.6. $2,000$2,000

0 of 5


Recessionary Gaps and Inflationary Recessionary Gaps and Inflationary Gaps ExampleGaps Example

Answer to the previous question: Answer to the previous question:

The equation to use is:The equation to use is:

Change in GDP = multiplier x change in Change in GDP = multiplier x change in government spending.government spending.

So: $2,000 = 5 x $400. So: $2,000 = 5 x $400.

Macroeconomics

Will a change in government spending Will a change in government spending cause a change in real GDP?cause a change in real GDP?

:10

1.1. Yes, both in the Yes, both in the short and long short and long runrun

2.2. Yes, but only in Yes, but only in the short run the short run

3.3. Yes, but only in Yes, but only in the long runthe long run

4.4. Not sureNot sure


Evaluation of the Keynesian Evaluation of the Keynesian TheoryTheory

Let’s evaluate the effects of Let’s evaluate the effects of government spending.government spending.

If the government increases spending, If the government increases spending, how does it pay for this?how does it pay for this?

Macroeconomics


Evaluation of the Keynesian TheoryEvaluation of the Keynesian Theory

The funds can come from 3 sources:The funds can come from 3 sources: newly printed money, ornewly printed money, or borrowed money, orborrowed money, or increase in taxesincrease in taxes

Macroeconomics



If the prints more money, it:If the prints more money, it: lowers interest rates in the short run. This lowers interest rates in the short run. This

increases borrowing and spending, and increases borrowing and spending, and stimulates the economy in the short run.stimulates the economy in the short run.

but it causes inflation and increases interest but it causes inflation and increases interest rates, and slows down the economy in the rates, and slows down the economy in the long run.long run.

Macroeconomics


Macroeconomics


If the government borrows the money, it: increases funds for the government. This increases spending in the government sector. but it decreases funds in the private sector. This decreases private sector spending. increases the national debt and increases future taxes. This slows down the economy in the long run.


Macroeconomics


If the government increases taxes, it: increases funds for the government. This increases spending in the government sector. but it decreases people’s incomes in the private sector. This decreases private sector spending. discourages people from working. This slows down the economy.


Evaluation of the Keynesian Theory Evaluation of the Keynesian Theory

Conclusion:Conclusion:

Keynesian policy may help the Keynesian policy may help the economy in the short run, but is economy in the short run, but is harmful to the economy in the long harmful to the economy in the long run.run.

Macroeconomics


The Role of SavingsThe Role of Savings

Keynesian theory: Keynesian theory: Savings are a leakage from our Savings are a leakage from our

economy.economy. Only increases in consumption lead to Only increases in consumption lead to

increases in production.increases in production.



Classical Theory:Classical Theory: Savings are important to Savings are important to

our economy.our economy. Increases in savings lead to increases in Increases in savings lead to increases in

funds for businesses.funds for businesses. Businesses use these funds for research Businesses use these funds for research

and technology and business and technology and business expansions.expansions.

Macroeconomics



Investments in research Investments in research

and technology lead and technology lead

to increases in productivity. to increases in productivity.

This enables businesses to pay higher This enables businesses to pay higher realreal wages. This leads to wages. This leads to realreal (not (not artificial) increases in demand.artificial) increases in demand.

Macroeconomics



Real demand increases Real demand increases

are made possible by are made possible by

greater capacities to produce, greater capacities to produce, and not by and not by artificial increases in artificial increases in government government spending or newly spending or newly printed money.printed money.

Macroeconomics


Macroeconomics

Aggregate Demand and Supply Aggregate Demand and Supply

Aggregate = “the sum of” Aggregate = “the sum of”

Aggregate demand = the Aggregate demand = the demand for demand for all products in the all products in the economy.economy.


Macroeconomics

Aggregate DemandAggregate Demand

The Aggregate The Aggregate demand curve demand curve is downward is downward slopingsloping


Macroeconomics


Macroeconomics


Macroeconomics

According to Keynesian theory, an increase in AD in the verticalpart of the AS curveincreases the price level.


Macroeconomics

A Shift in Aggregate Demand

According to Keynesian theory, an increase in AD in the upwardpart of the AS curveincreases GDP andthe price level.


Macroeconomics

The Phillips Curve

According to Keynesian theory,there exists an inverse relationshipbetween inflation and unemployment.


Macroeconomics

A Shift in Aggregate Supply

According to Classical theory, an increase in AS increases GDP, andlowers the pricelevel.

Documents

Unit 5 - Models of Output Determination n Two Primary Schools of Economic Thought are: 1. Classical Economics (Smith, Ricardo, Von Mises, Say, Hayek, Hazlitt,