Chapter 11Classical & 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

Language & Methodology – New Terms Recessionary Gap Inflationary Gap

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

Chapter 11Classical & 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 11Classical & 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 11Classical & 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 11Classical & 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)

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 11-40

Real GDP

Keynesianrange

Aggregatesupply

The Ranges of the Aggregate Supply Curve

11-38

The Keynesian Critique of the Classical System

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

180

160

140

120

100

80

60

40

20

0

L-RAS

AD1 AD2

AD3

Real GDP (in trillions of dollars)0 1 2 3 4 5 6 7 8 9 10

Three Aggregate Curves

AD1 represents aggregate demand during a recession or depression

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

AD3 represents excessive demand

Chapter 11Classical & 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 In the Keynesian World

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”

Chapter 11Classical & 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 11Classical & 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 (1950’s) – Federal Government took responsibility to ensure the economy grows at a consistent and healthy rate – Real GDP at approximately 4%/year

Price Stability (1970’s) – 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 11Classical & 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 11Classical & 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