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Classical and Keynesian

Economics: Contending
Approaches to Macroeconomics
Classical Economics
WHO?
Adam Smith, David Ricardo, Alfred
Marshall
CENTRAL PRINCIPLE:
The economy is best organized as
a self-regulating system of
markets.

Classical Economics
1.WAGES AND PRICES ARE FULLY
FLEXIBLE in order to clear markets
rapidly.
2.ECONOMY OPERATES AT FULL
EMPLOYMENT most of the time.
Classical Aggregate Supply Curve is
vertical.
Classical Economics
3.MINIMAL GOVERNMENT
INTERVENTION reflecting distrust of
government and belief in its
inefficiency.
4. Unemployment in the economy is
either voluntary or due to some
external interference.
KEYNESIAN ECONOMICS
WHO?
John Maynard Keynes.
CENTRAL PRINCIPLE:
The economy often operates at
less than full employment; market
system does not self adjust.

KEYNESIAN ECONOMICS
1. MARKETS CLEAR ONLY SLOWLY, IF AT
ALL.
A) In a depression or recession,
much unemployment is
involuntary.
2.ECONOMY OFTEN OPERATES AT LESS THAN FULL
EMPLOYMENT Since markets don’t clear.

3. GOVERNMENT INTERVENTION MAY BE DESIRABLE TO
STABILIZE THE BUSINESS CYCLE.
Fiscal and Monetary Policies.

KEYNESIAN ECONOMICS

Classical & 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
(goods, money and labor markets)
 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”

Classical & 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

Classical vs 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

Classical & 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



Understanding
the

multiplier effect
DERIVING THE MULTIPLIER ALGEBRAICALLY IN A CLOSED
ECONOMY
Recall that our consumption function is:

C = a(Y – T)

where a is the marginal propensity to consume. In
equilibrium:

Y = a(Y-T) + I + G

Now we solve this equation for Y in terms of I , G, C & T.
G I T Y a Y
C
+ + ÷ =
  
) (
DERIVING THE MULTIPLIER ALGEBRAICALLY
This equation can be rearranged to yield:

Y − aY = I + G – aT
Y(1 - a) = I + G - aT

We can then solve for Y in terms of I , G & T by dividing through
by (1 − a):
|
.
|

\
|
÷
÷ + =
a
aT G I Y
1
1
) (
15 of
38
DERIVING THE MULTIPLIER ALGEBRAICALLY
Now look carefully at this expression and think about
increasing I by some amount, ΔI, with a held constant.
If I increases by ΔI, income will increase by




Because a ≡ MPC, the expression becomes





a
I Y
÷
× A = A
1
1
MPC
I
Y
÷
=
A
A
1
1
DERIVING THE MULTIPLIER ALGEBRAICALLY
The multiplier is





Finally, because MPS + MPC ≡ 1, MPS is equal to 1 − MPC,
making the alternative expression for the multiplier 1/MPS
MPC ÷ 1
1
•marginal propensity to consume (MPC) That
fraction of a change in income that is consumed, or
spent.

•marginal propensity to save (MPS) That fraction of
a change in income that is saved.
The government purchases multiplier
Example: If MPC = 0.8, then
Definition: the increase in income resulting from a
$1 increase in G.
In this model, the govt
purchases multiplier equals 1
1 MPC
A
=
A ÷
Y
G
1
5
1 0.8
A
= =
A ÷
Y
G
An increase in G
causes income to
increase 5 times
as much!
Why the multiplier is greater than 1



Initially, the increase in G causes an equal increase
in Y: AY = AG.
 But |Y ¬ |C
¬ further |Y
¬ further |C
¬ further |Y
 So the final impact on income is much bigger than
the initial AG.
Keynesian equilbrium: Solution procedure
Start with the equation in general form:
Y = a ( Y - T) + I
p
+ G + NX
Substitute in the given numbers:
Y = 0.8 ( Y - 1000) + 1500 + 1200 + 500
Collect all the constant terms:
Y = 3200 + 0.8Y - 800
Y = 2400 + 0.8Y
Subtract 0.8 Y from both sides of the equation:
0.2 Y = 2400
Finally, multiply both sides by 1 / 0.2 = 5
Y = 5 (2400) = 12,000
SAMPLE QUESTION
The Multiplier
Rerun the previous exercise, raising planned investment by 500.
Y = 0.8 ( Y - 1000) + 2000 + 1200 + 500
Collect all the constant terms:
Y = 3700 + 0.8Y - 800
Y = 2900 + 0.8Y
Subtract 0.8 Y from both sides of the equation:
0.2 Y = 2900
Finally, multiply both sides by 1 / 0.2 = 5
Y = 5 (2900) = 14, 500
GDP is UP BY 2,500, NOT up by only 500.
Investment spending has a MULTIPLIER EFFECT of 5
SAMPLE QUESTION
Balanced Budget Multiplier with Lump-Sum
Taxes
(Cont.)
T
Y
G
Y
c
c
+
c
c
=1/(1-c) - c/(1- c) = 1
The balanced budget multiplier:
A change of 100 in both G and T also raised income by 100.
Balanced change in G and T is not macro economically neutral.
Balanced budget multiplier holds that if government
revenues and expenditure increase or decrease
simultaneously and equally, then national income will also
change in the same amount - which means that the balanced
budget multiplier equals to 1.