Classical and

Keynesian
Economics
Chapter 11

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives

After this chapter you should be able to :

1.
2.
3.
4.
5.
6.
7.

Discuss Says law.

Analyze Classical equilibrium.
Explain and discuss the real balance, interest rate, and foreign
purchases effects.
Demonstrate the interaction between aggregate demand and
aggregate supply.
Summarize the Keynesian critique of the classical system.
Describe equilibrium and disequilibrium and distinguish
between them.
Summarize and discuss the Keynesian policy prescriptions.

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

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.

11-4

What about Saving?

The macroeconomy begins to have problems when

people save part of their incomes.

But, saving is important for future growth.

If some people save, then some things that are produced will
not be sold.
Money is leaking out of the system.
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.
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.
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

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 financial markets
to prove that I = S.
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%.

11-10

Questions for Thought and Discussion

Why does the Saving Curve slope up like a Supply

Curve?

Why does the Investment Curve slope down like a

Demand 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.)

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?
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.

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.

There was a movement along

the Labor Supply Curve.

Some workers voluntarily

decided not to offer their
labor.
11-13

Modeling Classical Equilibrium

Microeconomic (Market) Equilibrium:

Macroeconomic Equilibrium

When Aggregate Demand equals Aggregate Supply.

Characteristics of Macroeconomic Equilibrium for

Classical Economists:

When quantity demanded for a product equals quantity

supplied.

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.
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.

11-15

Three Reasons why the AD Curve

Slopes Down

Real Balance Effect

Interest Rate Effect

You feel poorer, so you spend less.

Purchasing power declines with inflation.
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.

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

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.

11-18

Long-Run Macroeconomic Equilibrium

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

Supply Creates Its Own Demand!

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 boosts to increase output.

At low levels of output, firms

can easily expand output when
prices rise.

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.

11-21

Classical View of Recessions

1.

2.

3.

Economy starts at AD1: E1 at

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

Conclusion: Its a 3-step process moving from E1 to E to E2.

No government intervention necessary. Flexible prices will pull
economy out of recession. The economy is self-adjusting!
11-22

Part II: The Keynesian Critique of the

Classical System

Until the Great Depression, classical economics was

the dominant school of economic thought.

The Great Depression undermined faith in Says Law.

John Maynard Keynes developed alternative theory of
macroeconomics:

Laissez-Faire: government should intervene in economic

affairs as little as possible.

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.

11-23

Keynes Critique of Says Law: S I

Savings and investment are not equalized by interest

rates:

Saving is not affected by interest rates. People save for future

purchases and based on income.
Business invests when it expects demand for their product. (Why
expand in recessions even if interest rates are low? Cant sell.)

If S > I, not everything being produced would be

purchased.

Supply does not create its own Demand.

11-24

Keynes Critique of Says Law:

Prices and Wages are not flexible downward

Prices are not downwardly flexible, even in a

recession. (Prices are sticky downward.)

Wages are not downwardly flexible, even in a

recession.

Big firms in concentrated industries (oligopolies) can wait out

recession without lowering their prices.
They would rather temporarily reduce output.

Labor unions with long-term contracts resist wage cuts.

If prices and wages are not flexible downward, Supply

does not create its own Demand.
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.

11-26

Modified Keynesian Aggregate Supply

Curve
1.

2.

3.

During recession, output can

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

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.

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.

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

11-29

Summary of Two Theories

Classical View

Keynesian View

Assumes flexible price

Savings depends on
interest rates
Investment depends on
interest rates
Wages flexible
Wait for Long Run

Assumes flexible demand

for output
Savings depends on
income
Investment depends on
profit expectations
Wages sticky
Fix in Short Run

Which assumptions seems more realistic to you?

11-30

Three Ranges of the Aggregate Supply

Curve

Contemporary
macroeconomists often
synthesize the two theories,
suggesting that each theory
could hold true under different
economic conditions.

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.

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.
11-33

Reaching Equilibrium

When Aggregate Demand exceeds Aggregate Supply

the economy is in disequilibrium.

When Aggregate Supply exceeds Aggregate Demand

the economy is in disequilibrium.

Planned inventories too low, so they are depleted.

Signals firms to boost output is increased to meet excess
demand.

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.

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.

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.

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 prescribed lowering Aggregate Demand to

bring down inflation.

Rather than spending money, government should reduce

spending, raise taxes, decrease money supply.

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 the dominant macroeconomic

theory until the 1970s.and it was also used to pull
economies out of the great recession.
11-38