Chapter 11

Classical and Keynesian Economics

McGraw-Hill/Irwin
2009 The McGraw-Hill Companies, All Rights Reserved

Learning Objectives
In this chapter we shall take up:
1.
2.
3.
4.
5.
6.
7.

Says law.
Classical equilibrium.
Real balance, interest rate, and foreign purchases effects.
Aggregate supply and aggregate demand.
The Keynesian critique of the classical system.
Disequilibrium and equilibrium.
Keynesian policy prescriptions.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-2

Two Views of the Macroeconomy

Are business cycles self-correcting?

Do the forces of supply and demand lead a market

economy toward full employment growth with price
stability on its own?

Or do we need active government policies during

economic downturns?
We will examine two alternative answers:

Classical Economics
Keynesian Economics

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-3

Part I: The Classical Economic System

The centerpiece of classical economics is Says Law.
Says Law states, Supply creates its own demand.
This means that somehow, what we producesupplyall gets
sold (demanded).

Why?
When a seller sells a product (including his/her own labor),
she/he earns income.
This income is used to purchase other goods and services.
So, selling one product creates demand for another, until all
the income is used up.
If all the income is spent, all the goods and services will be
sold.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-4

Production in a Five-Person Economy

(Table shows each

persons production.)

Joe sells 8 bushels of tomatoes (keeping 2 to eat), and uses

the money to buy a tee shirt, 4 loaves of bread, 2 pounds of
butter, and a pair of wooden shoes.
Sally keeps 1 tee shirt and sells the rest to buy tomatoes,
bread, butter, and shoes.
And so on
Question: What happens if Sally buys less bread and butter to
save for a new sewing machine?

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-5

What about Saving?

The macroeconomy begins to have problems when
people save part of their incomes.
If some people save, then some things that are produced will
not be sold.
Money is leaking out of the system.

But, saving is important for future growth.

Without saving, we could not have investmentthe
production of plant, equipment, and inventory.

How can the system stay in balance?

Markets inject the savings back into the system.
Savings dont sit in a bank vault, they are lent out to
businesses, home buyers, and others.
One persons savings become someone elses investment.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-6

Consumer Goods and Investment Goods

Start with just the private sector (no government or
foreign trade).
All production (Supply) consists of:
Consumer goods (C).
Investment goods (I).
No G or Xn.

If we think of GDP as total spending, then

GDP = C + I.
If we think of GDP as income received, then
GDP = C + S.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-7

Consumer Goods and Investment Goods

(continued)
GDP = C + I
GDP = C + S
Things equal to the same thing are equal to each
other:

C + I = C + S
Subtract the same thing (C) from both sides of the
equation:

You are left with:

C + I = C
+ S
I=S

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

S leaks out, but is

Injected back in as I.
11-8

Supply and Demand Revisited

Find equilibrium price: Approx. $7.20

Find equilibrium quantity: 6
Classical economists applied this process to prove I = S.
2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-9

The Loanable Funds Market

Saving supplies banks
and financial institutions
with loanable funds.
Businesses borrow
(demand) funds for
Investment.
Interest rate is the price of
loanable funds; they are
flexible.
Equilibrium interest rate is
15%.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-10

Questions for Thought and Discussion

Why does the Saving Curve slope up like a Supply
Curve?
When would you be more likely to put money in your savings
account: when interest rates are high or low? (Hint: Think
about opportunity costs of keeping cash.)

Why does the Investment Curve slope down like a

Demand Curve?
When would businesses prefer to borrow money: when
interest rates are high or low?

If banks have too much money and not enough

borrowers, will they raise or lower interest rates?
2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-11

In Classical Macroeconomics, Unemployment is

Temporary
Labor markets are no different than any other markets,
under Says Law.
Unemployment is due to labor surplus
(Quantity supplied > Quantity demanded).
Lower price of labor (wage), until Labor Supply equals Labor
Demand.

Conclusion: No involuntary unemployment.

Need a job? Work cheaper!
Anyone who isnt working has decided not to work at the
equilibrium wage.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-12

Hypothetical Labor Market

At $9 per hour, there is a
labor surplus
(unemployment).
At $7 per hour:
Everyone who wants to
work at that rate can find a
job.
Every employer willing to
hire workers at that rate can
find as many workers as
s/he wants to hire.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-13

Modeling Classical Equilibrium

Microeconomic (Market) Equilibrium:
When quantity demanded for a product equals quantity
supplied.

Macroeconomic Equilibrium
When Aggregate Demand equals Aggregate Supply.

Characteristics of Macroeconomic Equilibrium for

Classical Economists:
Full employment of labor (no involuntary unemployment)
Full employment of resources (maxim output)

Classical Economists maintain that market

economies with flexible prices should tend toward
macroeconomic equilibrium.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-14

The Aggregate Demand Curve

Aggregate demand is the total value of real GDP that
all sectors of the economy (C + I + G + Xn) are willing
to purchase at various price levels

When the price level

increases, (inflation)
people purchase
less output.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-15

Three Reasons why the AD Curve

Slopes Down
Real Balance Effect
You feel poorer, so you spend less.
Purchasing power declines with inflation.

Interest Rate Effect

Rising prices push up interest rates.
Lenders need higher interest rates to compensate for eroding
purchasing power of money.

Foreign Purchases Effect

If prices rise in the US, exports decrease and imports
increase, so Xn decreases.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-16

Aggregate Supply Curve

Aggregate Supply is the amount of real GDP that will
be made available by sellers at various price levels.
Aggregate Supply looks different in the Long Run and
the Short Run:
In the Long Run, classical economists assume the economy
operates at full employment (maximum output), independent
of the price level.
In the Short Run, businesses will increase supply if the price
level increases.

Lets see what each one looks like

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-17

Long-Run Aggregate Supply Curve (LRAS)

LRAS is vertical line at full employment level of GDP
(regardless of price level).

Real GDP = $6 trillion

at every point on LRAS.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-18

Long-Run Macroeconomic Equilibrium

LR equilibrium of
$6 trillion in real GDP
and price level of 100.

Supply Creates Its Own Demand!

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-19

Short-Run Aggregate Supply Curve

SRAS is relatively flat at low levels of output, and
gradually approaches vertical.
Beyond full employment GDP,
expanding production is more
expensive, so firms need large
price increase output.
At low levels of output, firms
can easily expand output when
prices rise.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-20

Short-Run Macroeconomic Equilibrium

Output may be above or below

full employment in the SR, but
should settle at full employment
GDP in LR.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-21

Classical View of Recessions

1. Economy starts at AD1: E1 at
Full employment GDP and
Price level = 140.
2. During recession, AD
decreases to AD2: E at lower
output ($4 trillion).
3. Surplus inventory of $2
trillion so firms decrease
prices until sell off surplus at
E2.

Conclusion: No government intervention necessary. Flexible prices

will pull economy out of recession. Economy is self-adjusting!
2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-22

Part II: The Keynesian Critique of the Classical

System
Until the Great Depression, classical economics was
the dominant school of economic thought.
Laissez-Faire: government should intervene in economic
affairs as little as possible.

The Great Depression undermined faith in Says Law.

John Maynard Keynes developed alternative theory of
macroeconomics:
Advocated government intervention to bring an end to the
Great Depression.
Focused on boosting demand for output, not flexible prices.

These two views continue to shape policy debates.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-23

Keynes Critique of Says Law:

SI
Savings and investment not equalized by interest
rates:
Savings not affected by interest rates. People save for future
purchases and based on income.
Businesses invest when expect demand for product. In
recession, why expand even if interest rates are low?

If S > I, not everything being produced would be

purchased.
Supply does not create its own Demand.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-24

Keynes Critique of Says Law:

Prices and Wages are not Flexible
Prices are not downwardly flexible, even in a
recession.
Big firms in concentrated industries (oligopolies) can wait out
recession without lowering prices.
They would rather temporarily reduce output.

Wages are not downwardly flexible, even in a

recession.
Labor unions with long-term contracts resist wage cuts.
Lowering wages not ideal way to increase inflation because
it reduces income.

If prices and wages are not flexible, Supply does not

create its own Demand.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-25

Keynesian View of Macroeconomic

Equilibrium
Economy was not always at, or tending toward, a full
employment equilibrium.
Three equilibriums are possible:
Below full employment
At full employment
Above full employment

Famous quote: In the Long Run, we are all dead.

Dont wait for the economy to fix itself, even if it could.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-26

Modified Keynesian Aggregate Supply Curve

1. During recession, output can
be increased without raising
prices (flat part of curve).
2. As approach full
employment ($6 trillion),
prices begin to increase
(upward sloping part of
curve).
3. At full employment level of
GDP, L-RAS is vertical.
Output cannot be expanded,
but price level can increase.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-27

Keynesianism is Demand-Side Economics

Keynes stood Says Law on its head:
Can be summarized as, Demand creates its own Supply.
Business firms produce only the quantity of goods and
services they believe consumers (C), investors (I),
governments (G), and foreigners (X) will plan to buy.

Aggregate Demand is the prime mover of the

economy.
If you can expand C, I, G, and/or X (demand for goods and
services), businesses will sell surplus and continue to expand.
Level of GDP depends upon planned expenditures.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-28

Three Possible Equilibriums

Expanding
output beyond
full
employment is
inflationary.
AD1
represents
aggregate
demand
during a
recession or
depression. It
can increase
without
inflation.
2009 by The McGraw-Hill Companies, Inc. All rights reserved.

AD2 crosses
the long-run
aggregate
supply
curve at full
employment

11-29

Summary of Two Theories

Classical View
Assumes flexible price
Savings depends on
interest rates
Investment depends on
interest rates
Wages flexible
Wait for Long Run

Keynesian View
Assumes flexible
demand for output
Savings depends on
income
Investment depends on
profit expectations
Wages sticky
Fix in Short Run

Which assumption seems more realistic to you?

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-30

Three Ranges of the Aggregate Supply Curve

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-31

Part III: The Keynesian System

Keynesian Aggregate Expenditure Model puts
consumer behavior at center of analysis.

As income rises, C rises,

but not
as quickly.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-32

Equilibrium in Aggregate Expenditure Model

Note vertical axis is NOT price level.

Investment
does
not depend
on income,
so add as
fixed amount.

Equilibrium is
where AE line
crosses 45 line,
at $7 trillion.
2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-33

Reaching Equilibrium
When Aggregate Demand exceeds Aggregate Supply
the economy is in disequilibrium.
Planned inventories too low, so they are depleted.
Signals firms to boost output is increased to meet excess
demand.

When Aggregate Supply exceeds Aggregate Demand

the economy is in disequilibrium.
Planned inventories are too high, so output is decreased.
Workers are laid off, further depressing aggregate demand as
these workers cut back on their consumption.
Eventually, inventories are sufficiently depleted and equilibrium
is restored.

Inventories send signals to firms.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-34

Summary: How Equilibrium Is Attained

Aggregate demand (C + I) must equal the level of
production (aggregate supply) for the economy to be
in equilibrium.
When the two are not equal, aggregate supply must
adjust to bring the economy back into equilibrium.
This equilibrium does not have to be at full
employment level of GDP.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-35

The Classical Position Summarized

Recessions are temporary because the economy is
self-correcting.
Declining investment will be pushed up again by falling
interest rates.
If consumption falls, it will be raised by falling prices and
wages.

Because recessions are self-correcting, the role of

government is to stand back and do nothing.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-36

Keynesian Policy Prescriptions

Keyness position was that recessions are not
necessarily temporary.
Therefore, it is necessary for the government to intervene by
spending money.
How much money? As much money as it takes.
When the government spends more money, thats not the
same thing as printing more money.
Generally it borrows more money and then spends it.

Keynes would have prescribed lowering Aggregate

Demand to bring down inflation.
Rather than spending money, government should reduce
spending, raise taxes, decrease money supply.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-37

Keynesianism and the New Deal

Roosevelt's New Deal programs succeeded in
bringing about rapid economic growth 1933 to 1937.
However, Roosevelt decided to try to balance federal budget.
He raised taxes and cut government spending.
Federal Reserve sharply cut the rate of growth of the money
supply.
Output plunged and the unemployment rate soared.

Military spending during WWII brought economy out

of Great Depression.
Keynesian became dominant macroeconomic theory.

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-38

Questions for Thought and Discussion:

Keynes and Say in the 21st Century
Until the 1970s, the US was a closed economy.
Workers spent additional income on US-made goods and
services.

How has globalization changed context for Keynesian

economics?

2009 by The McGraw-Hill Companies, Inc. All rights reserved.

11-39