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Classical and Keynesian Analysis

I. The Classical Model: This model, which traces its origins to the 1770s, was the first systematic attempt to explain the determinants of the price level and the national levels of output, income, employment, consumption, saving and investment.

1. Say’s Law: Supply creates its own demand, or desired aggregate expenditures will equal actual aggregate expenditures. People only produce more goods than they want because they want to trade them for other goods. It follows that full employment of labor and other resources would be the normal state of affairs in such economies.

2. Assumptions of the Classical Model: Supply creates its own demand, or desired expenditures will equal actual expenditures.

1. Pure Competition Exists: No single buyer or seller of a commodity or an input can affect its price.

2. Wages and Prices are Flexible: Prices, wages, and interest rates are free to move to the level dictated by supply and demand in the long-run.

3. People are Motivated by Self-Interest: There is an underlying assumption that businesses want to maximize their profits and households want to maximize their economic well-being.

4. People Cannot be Fooled by the Money Illusion: Buyers and sellers react to changes in relative prices.

3. Equilibrium in the Credit Market: When income is saved, it is not reflected in product demand. Consumption expenditures can fall short of total output when saving occurs. The classical economists argued that each dollar saved would be invested by businesses. In the credit market the interest rate equates the quantity of credit demanded with the quantity of credit supplied and thus planned investment equals planned saving. Saving represents the supply of credit and investment represents the demand for credit.

4. Equilibrium in the Labor Market: In the Classical Model if an excess quantity of labor is supplied at a particular wage level, the wage level is too high and some workers are unemployed. By accepting lower wages, unemployed workers will be put back to work. Only structural and frictional unemployment will exist in this model, that is there is a natural rate of unemployment.

1. The Relationship Between Employment and Real GDP: The level of employment in an economy determines, other things held constant, that economy's real GDP.

5. Classical Theory, Vertical Aggregate Supply and the Price Level: In the Classical Model long-term involuntary unemployment is impossible. Say’s law, coupled with flexible interest rates, prices, and wages, tends to keep workers fully employed so the aggregate supply curve (LRAS) is vertical at full employment. Full employment is the amount of employment that would be produced year in and year out in an economy with full information and full adjustment of wages and prices.

1. The Effect of an Increase in Aggregate Demand in the Classical Model: There will be an increase in the price level as wages rise in response to an increase in the demand for labor which is at full employment. Other input prices will also rise.

2. The Effect of a Decrease in Aggregate Demand in the Classical Model: There will be a decrease in the price level as wages fall in due to a decrease in the demand for labor which causes workers to bid down wages in response to an increase in unemployment. Other input prices will fall.

II. Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve: A horizontal short-run aggregate supply curve is called the Keynesian short-run aggregate supply curve. According to Keynes, the existence of unions and long-term contracts between workers and employers in and outside unionized environments can explain downward inflexibility of nominal wage rates. Such “stickiness” of wages makes involuntary unemployment of labor a possibility. Even in situations of excess capacity and large amounts of unemployment, the price level may not fall. There may be continuing unemployment and a reduction in the equilibrium level of real GDP per year.

III. Output Determination Using Aggregate Demand-Aggregate Supply: Fixed Versus Changing Price Levels in the Short-Run: An increase in aggregate demand using the Keynesian SRAS curve results in real GDP increasing by the amount of the increase in aggregate demand. When the price level can vary, i.e. the SRAS curve is upward sloping, then real GDP increases by less than the increase in aggregate demand because part of the increase in nominal GDP is a result of an increase in the price level.

1. Reasons for Upward-Sloping Short-Run Aggregate Supply

1. Flexibility of Hours and Work. Employers can require workers to work more hours and work harder.

2. Existing Capital Can be Used More Intensively.

3. Profits Rise If Prices Go up but Wage Rates do not. Firms will produce more as profit rise.

IV. Shifts in the Aggregate Supply Curve: There is a core class of events that causes a shift in both the short-run and long run aggregate supply curves.

1. Shifts in Both Short and Long Run Aggregate Supply: Any change in the endowments of the factors of production, and any change in the level of technology or knowledge shifts the aggregate supply curve.

2. Shifts in SRAS Only: The most obvious occurrence that causes a shift in SRAS is a temporary change in input prices.

V. Consequences of Changes in Short-Run Aggregate Demand: Aggregate demand shocks are any unanticipated shocks that cause the aggregate demand curve to shift inward or outward. Aggregate supply shock are any unanticipated shocks that cause the aggregate supply curve to shift inward or outward.

1. Effects When Aggregate Demand Falls While Aggregate Supply is Stable: A decrease in AD will decrease the price level and real GDP. If real GDP is less than full employment on LRAS, the difference between full employment and actual real GDP is defined as a recessionary gap.

2. The Short-Run Effects When Aggregate Demand Increases: The price level and real GDP increase. If real GDP is now greater than full employment on LRAS, the difference between full employment and actual real GDP is defined as an expansionary gap.

VI. Explaining Variations in Inflation: Demand-Pull or Cost-Push?

1. Demand-Pull Inflation: Inflation caused by increases in AD that are not matched by increases in aggregate supply.

2. Cost-Push Inflation: Inflation caused by decreases in short run aggregate supply.

VII. Aggregate Demand and Supply in an Open Economy: The effect of exchange rates and trade with the rest of the world has an impact on both the aggregate supply and the aggregate demand curves.

1. How a Weaker Dollar Affects Aggregate Supply: A weaker dollar increases the dollar price of imported inputs and shifts the SRAS to the left.

2. How a Weaker Dollar Affects Aggregate Demand: A weaker dollar increases the dollar price of imports and decreases the price of exports in terms of foreign currency. Thus US exports increase and imports decrease, that is, net exports increase, and the aggregate demand curve shifts to the left.

3. The Net Effect: An increase in aggregate demand and a decrease in aggregate supply will have an indeterminate effect on real GDP. If AD increases by more than SRAS decreases then real GDP will increase. If AD increases by less than SRAS decreases then real GDP will decrease. What is clear is that the price level will increase.

VIII. Some Simplifying Assumptions in a Keynesian Model: (1) Businesses pay no indirect taxes, such as sales taxes. (2) Businesses distribute all of their profits to shareholders. (3) There is no depreciation, or capital consumption allowances, so gross private domestic investment equals net investment. (4) The economy is closed. Given all these simplifying assumptions, real disposable income will be equal to real national income minus taxes.

IX. Determinants of Planned Consumption and Planned Saving: The consumption function shows the relationship between planned consumption and various levels of disposable income. Real saving and consumption decisions depend primarily on an individual’s current real disposable income.

Dissaving and Autonomous Consumption: The amount of planned consumption that does not depend at all on disposable income is called autonomous consumption. Dissaving is negative saving: it is a situation where spending exceeds income. Dissaving can occur when a household is able to borrow or use up existing owned assets.   Average Propensity to Consume and to Save: Average Propensity to Consume (APC): Consumption divided by disposable income; the proportion of total disposable income that is consumed. Average Propensity to Save (APS): Saving divided by disposable income; the proportion of total disposable income that is saved.

3. Marginal Propensity to Consume and to Save:

1. Marginal Propensity to Consume (MPC): The change in consumption divided by the change in disposable income.

2. Marginal Propensity to Save (MPS): The change in saving divided by the change in disposable income.

4. The Causes of Shifts in the Consumption Function: Whenever there is a change in non-income determinants of consumption, the consumption curve shifts upward or downward. A change in population up or down, a change in expectations, or a change in real household wealth will cause the consumption function to shift.

Personal Saving Rate: Delayed Consumption from the Federal Reserve Bank of San Francisco

X. Determinants of Investment: Investment is defined as expenditures on new plant, capital equipment, and changes in business inventories. Real gross private domestic investment in the United States has been volatile compared to real consumption, because investment decisions of business people are based on highly variable, subjective expectations of the economic future.

1. The Planned Investment Function: At all times businesses perceive an array of investment opportunities. Since each project is profitable only if its rate of return exceeds the rate of interest; it follows that as the interest rate falls, planned investment spending increases, and vice versa. The investment function is represented as an inverse relationship between the rate of interest and the quantity of planned investment.

2. What Causes the Investment Function to Shift: If non-interest rate determinants of investment change, the investment schedule will shift. Expectations of business people, changes in productive technology, and changes in business taxes cause a shift in the investment function.

XI. Savings and Investment: Planned Versus Actual: Equilibrium occurs at the intersection of the planned saving and planned investment schedules. There is no tendency for businesses to alter the rate of production or the level of employment because they are neither increasing nor decreasing their inventories in an unplanned way. When the saving rate planned by households differs from the investment rate planned by businesses, there will be an increase or decrease in real GDP in the form of unplanned inventory changes. Real GDP and employment will change until unplanned inventory changes are again zero.

XII. Keynesian Equilibrium with Government and the Foreign Sector Added

1. Government: Resource-using federal, state, and local government purchases are politically determined and can thus be considered autonomous.

2. The Foreign Sector: The level of exports depends on international economic conditions in the countries that buy US products. Imports depend on economic conditions in the United States. The difference between imports and exports is net exports.

XIII. The Multiplier: The multiplier is the number by which a permanent change in autonomous spending such as autonomous investment or autonomous consumption is multiplied to get the change in the equilibrium level of real GDP. Any permanent increase in autonomous spending will cause a more than proportional increase in real national income.

Macro Revision: Putting Things in Context

Lessons from the Great Recession: Best and Worst Monetary Policy of 2012

History of Economic Thought

What Steps Can Be Taken to Increase Savings in the US?

Percent of Total Personal Consumption Spending

Where Does the Money Go?

100 Years of Consumer Spending

How Average Americans Spend Their Money

The Millennial Consumer

How the Great Recession Has Changed Life in America

XIV. Output Growth and the Long-Run Aggregate Supply Curve: The total of all planned production for the entire economy is referred to as the aggregate supply of real output.

1. The Long-Run Aggregate Supply Curve: The long-run aggregate supply curve (LRAS) is some amount of output of real goods and services in a world in which technology is constant, the price level has not changed, labor productivity has not changed, all resources are fully employed, and people have fully adjusted to all the information they have. The curve is a vertical line relating full employment real GDP to the price level.

2. Economic Growth and Long-Run Aggregate Supply: Economic growth is shown by the LRAS curve shifting to the right over time. A long-run growth path can be derived showing real GDP at full employment over time.

XV. Spending and Total Expenditures: The spending decisions of individuals, firms, governments, and foreigners determine the total value of nominal GDP. There are two issues that need to be addressed. The first issue is, what determines the total amount that individuals, governments, businesses, and foreigners want to spend? Second, what determines the equilibrium price level and the rate of inflation? The total of all planned expenditures in the entire economy is called aggregate demand.

XVI. Aggregate Demand: The aggregate demand curve, AD, shows planned purchase rates for all goods and services in the economy at various price levels, ceteris paribus.

Aggregate Demand Curve: The aggregate demand curve shows planned purchase rates for all final goods and services in the economy at various price levels, other things constant. What Happens When the Price Level Rises? The Real-Balance Effect: The change in expenditures resulting from the real value of money balances when the price level changes. A rise in the price level decreases the real value of a given amount of money balances and planned spending will decrease. Interest Rate Effect: Higher prices result in a rising interest rate. Households spend less on consumer durables businesses spend less on capital investments, and the aggregate quantity of goods and services demanded decreases. The Open Economy Effect: Substitution of Foreign Produced Goods: An increase in the price level in the United States makes US goods relatively more expensive compared with foreign produced goods. Planned purchases of domestically produced goods will fall and planned purchases of foreign produced goods (imports) will rise. Foreigners will no longer want to purchase as much US production as before and US exports will fall. The aggregate quantity of US produced goods and services demanded falls. What Happens When the Price Level Falls: There are the same three effects when the price level falls as when it rises, they just have the reverse effect on the aggregate quantity of goods and services demanded. Demand for All Goods and Services Versus Demand for a Single Good or Service: When the aggregate demand curve is derived, the entire economic system is viewed. The aggregate demand curve differs from an individual demand curve because it shows the circular flow of income and product constructed as AD.

XVII. Shifts in the Aggregate Demand Curve: When non-price level determinants of aggregate demand change, a shift in the aggregate demand curve occurs. Any non-price-level change that increases aggregate spending on domestic goods shifts AD to the right. Any non-price-level change that decreases aggregate spending on domestic goods shifts AD to the left.

XVIII. Long-Run Equilibrium and the Price Level: Long-run equilibrium occurs at the intersection of the aggregate demand and the long-run aggregate supply curve. At this point planned real expenditures for the entire economy equal actual GDP produced by firms.

XIX. The Effects of Economic Growth on the Price Level: If LRAS increased over time and aggregate demand stayed constant, the price level would fall and there would be secular deflation. If aggregate demand increased at the same rate as LRAS, the price level would remain constant.

XX. Causes of Inflation: Inflation rates in the last 45 years have been positive but variable. Secular inflation rather than secular deflation has been the problem.

1. Supply-Side Inflation?: Inflation could be caused by a decrease in aggregate supply with a given aggregate demand curve. This cannot be the explanation of inflation for the persistent or secular inflation, because of the long-run increase in population, productivity, and real GDP, i.e. the aggregate supply curve has shifted to the right.

2. Demand-Side Inflation: If the aggregate demand curve shifts rightward over time at a pace faster than the rightward progression of aggregate supply, then persistent or secular inflation will occur.

Test Yourself: Classical and Keynesian Analysis

 

Fiscal Policy

I. Discretionary Fiscal Policy: The discretionary changing of government expenditures and/or taxes in order to achieve national economic goals, such as high employment with price stability. It is a deliberate attempt to cause the economy to move to full employment and price stability more quickly than it otherwise might.

1. Changes in Government Spending:

1. When There is a Recessionary Gap: An expansionary fiscal policy, which would cause the AD curve to shift to the right, is required. By increasing government expenditures policy makers can shift the aggregate demand curve to the right, and the price level and real GDP will go up.

 

 

 

 

 

 

 

 

 

 

2. When There is an Inflationary Gap: A contractionary fiscal policy, which would cause the AD curve to shift to the left, is required. By decreasing government expenditures policy makers can shift the aggregate demand curve to the left, the price level and real GDP will go down.

 

 

 

 

 

 

 

 

2. Changes in Taxes: Holding all other things constant, a rise in taxes creates a reduction in AD for 1 of 3 reasons: it reduces (1) consumption, (2) investment or (3) net exports.

1. When the Current Short-Run Equilibrium is Greater than LRAS: An increase in taxes will cause AD to shift inward, real GDP and the price level index falls.

2. When the Current Short-Run Equilibrium is Less than LRAS: A decrease in taxes will cause AD to shift outward, real GDP and the price level will rise.

Deflationary Fiscal Policy and Inflationary Fiscal Policy

 

V. What Do We Really Know About Fiscal Policy?

1. Fiscal Policy During Normal Times: Discretionary fiscal policy probably is not very effective at these times. Automatic stabilizers are probably the most useful.

2. Fiscal Policy During Abnormal Times: Fiscal policy can be important during these times. Consider some classic examples: the Great Depression and periods of war.

1. The Great Depression: When there is a substantial drop in GDP, such as in the Great Depression, fiscal policy can probably stimulate aggregate demand. However, there was in fact very little stimulation by government in the form of aggressive expansionary fiscal policy during this period.

2. Wartime: War expenditures have little or no direct expenditure offsets. So, war spending as part of expansionary fiscal policy usually has significant effects.

3. The “Soothing” Effect of Keynesian Fiscal Policy: The knowledge by consumers and investors that the federal government can use fiscal policy to prevent another great depression may induce more buoyant and stable expectations, thereby smoothing investment decisions.

A Nation of Government Dependents

How Do the US, Switzerland and Sweden Spend Money?

Using the Cost-Benefit Principle

What is Fiscal Policy?

Government Spending: Measuring Federal Expenditures from the Federal Reserve Bank of San Francisco

Economics Animation: Contractionary Fiscal Policy (1:22) (EA's other You Tube titles are also good.)

 

Test Yourself: Fiscal Policy

Government Deficits

I. Public Deficits and Debts: Flows Versus Stocks: The deficit is the excess of government spending over government revenues during a given period of time. The deficit is financed by the US Treasury borrowing by selling bonds to US and foreign households, businesses and governments. A. Distinguishing Between Deficits and Debts: The deficit is a flow and is the negative difference between tax receipts and total federal spending during a given time period. The federal government has a balanced budget when revenues equal spending during a given period of time. B. The Public Debt: The total accumulated public debt is a stock measured at a given point in time. It increases when there is a deficit.   II. Government Finance: Spending More Than Tax Collections: A. Historical Record of Federal Budget Deficits: Surpluses have occurred in only 13 years since 1940. In the other years the federal government has run deficits. The size of the real annual budget deficit as a percent of GDP peaked during the Reagan Administration, began rising during the first George W. Bush administration and fell in fiscal 2005. B. The Resurgence of Federal Budget Deficits: Between 2002 and 2004 federal spending increased faster than at any time since World War II. In 2001 tax rates were reduced near the end of a recession that reduced federal revenue for a time. When the economy began to grow rapidly in 2003 revenues began to grow rapidly as well. C. How did the US get $14.3 trillion in debt? And who are the creditors? Click on the thumbnail to the right.   III. Evaluating the Rising Public Debt: All federal government debt is the gross public debt. The net public debt is the gross public debt minus the debt held by government agencies.   IV. Accumulation of the Net Public Debt: The US net public debt, as a percentage of GDP, fell steadily from the end of World War II until the early 1970s when it leveled off until the 1980s. It has risen since, except for declining slightly in the period of budget surpluses from 1998–2001.   V. Annual Interest Payments on the National Debt: Around 1975 interest payments on the public debt as a percentage of GDP started rising dramatically and have declined since. Today they are about 16 percent higher than they were about a half a century ago. Foreigners currently own around 40 percent of the US public debt. A. Burdens of the Public Debt 1. How Today’s Budget Deficits Might Burden Future Generations: Future generations will have to be taxed to retire the higher public debt resulting from the present generation’s increased consumption of public goods.

2. The Crowding-Out Effect: In a full employment economy the increased level of consumption by the present generation crowds out investment and reduces the growth of capital goods leaving them with a smaller capital stock and thereby reducing their wealth. In this case future taxpayers will have higher taxes.

3. Paying Off the Public Debt in the Future: If the debt had to be paid off by raising taxes, what would mostly happen is that taxpayers would incur higher tax liabilities while bondholders, who are also mostly US taxpayers would get the money. As a generation US citizens would both pay higher taxes and receive (most of) the money back.

4. Our Debt to Foreign Residents: The percentage of the US public debt owned by foreigners is about 40 percent. If foreigners buy US government bonds, we do not owe that debt to ourselves, and a potential burden on future generations may result. If government expenditures financed by foreigners are made on wasteful projects rather than on goods and services that increase productivity and output, then a burden may be placed on future generations.

5. The Effect of Unemployment: If the economy is operating at a level substantially below full-employment real GDP, crowding out need not take place. In such a situation an expansionary fiscal policy via deficit spending can increase current consumption (of governmentally provided goods) without crowding out investment.

B. Not All Borrowing is Bad: Increased public debt is not necessarily bad if it creates a net investment for the future. Much of the analysis so far has assumed that deficit spending increases the demand for credit, while the supply of credit remains constant so interest rates rise and investment is crowded out.

VI. Federal Budget Deficits in an Open Economy: There is a link between US trade deficits and government budget deficits. By virtue of trade deficits, foreigners have accumulated US dollars and purchased US assets.

A. Trade Deficits and Government Budget Deficits: Larger trade deficits tend to accompany larger fiscal deficits.

B. Why the Two Deficits are Related: Part of the money to finance the federal government deficit must come from abroad. When the US runs large deficits, foreign dollar holders spend more on US government securities, bonds, and less on US produced goods and services, our exports. The effect is to further increase the trade deficit.

 

VII. Growing US Government Deficits: Implications for US Economic Performance

A. Which Government deficit is the “True Deficit?: There is disagreement about how the deficit is measured. The problem has to do with the use of measurements that minimize the reported deficit. The other is that the government does not track its expenditures and receipts in a business-like manner.

B. Capital Budgeting Theory: Businesses, state and local governments have operating budgets that include expenditures for current operations and capital budgets that include expenditures on investment items. The federal government has only one budget. The federal budget is a plan for federal government outlays and revenues for a specified period, usually a year.

It has been recommended that Congress set up a capital budget, removing investment outlays from its operating budget. Opponents say this would allow the government to grow even faster since the operating budget, and its deficit would be reduced and the pressure would be reduced on Congress to curtail federal spending.

C. Pick a Deficit, Any Deficit: The government figures can be used to report several different deficits. The problem is that no one number gives a complete picture of how much the government is spending over and above what it is receiving.

 

VIII. The Macroeconomic Consequences of Budget Deficits: The effects of deficits should be compared to the effects higher taxes to finance government spending. In addition the effects of a deficit when the economy is at full employment and when there is substantial unemployment.

A. Short-Run Macroeconomic Effects of Higher Budget Deficits: If there is a recessionary gap, then deficits due to higher government spending or lower taxes can increase aggregate demand and eliminate the recessionary gap. If the economy is at full employment, the increase in aggregate demand causes an inflationary gap with increased real GDP and inflation.

B. Long-Run Macroeconomic Effects of Higher Budget Deficits: Increases in aggregate demand have no effect on real GDP. They only cause inflation. An increase in government spending redistributes a larger share of real GDP to government provided goods and services.

For a Different Viewpoint: We Ignore the Debt at Our Peril

C. How Could the Government Reduce All Its Red Ink?

1. Increasing Taxes for Everyone: The office of Budget and Management estimated the 2004 budget deficit at about $521 billion. To have eliminated the deficit by raising taxes, every worker in the US would have had to pay $3,750 more in taxes.

2. Taxing the Rich: Currently 84% of federal income taxes is paid by the top 25% of families. The bottom 50% of families (below $60,000 per year) pay about 4% of federal income taxes. The top 5% pay about 57% of income taxes and the richest 1% pay about 37% of all income taxes paid. An increase in the top marginal tax rate from 35% to 45% will raise about $30 billion in additional taxes. The data do not support the notion that tax increases result in reduced deficits. Since World War II, for every dollar increase in taxes legislated, federal spending has increased $1.60.

3. Reducing Expenditures: Reduced spending will reduce the deficit. Entitlements are legislated payments that anybody who qualifies is entitled to receive. They are the most important component of the federal budget today. Entitlements, such as welfare, Social Security, Medicare, and Medicaid, change automatically without direct action by the congress.

4. Is It Time to Start Whittling Away at Entitlements?: Entitlements disburse money according to fixed formulas to citizens who fall into designated categories. Because entitlements do not require annual congressional appropriations, their cost tends to rise steadily. Entitlement programs provide guaranteed benefits for those who qualify under government transfer programs such as Social Security or Medicare.

In 1960, entitlements represented 10% of the federal budget. Today they make up more than half. In the last two decades, real spending on entitlements grew between 7% and 8% per year, while the economy grew by less than 3% per year. Entitlement programs are believed to be necessary, and it is difficult to cut government benefits once they are established.

Understanding the Federal Budget

Where the Current National Debt Comes From

US National Debt Clock

Fiscal Austerity: the Newest Fallacy of Composition

We, the Economy Films: Chapter 3: What is the role of our government?

Why is our tax system so complicated? Can a cartoon conquer a challenge like today’s tax system, with its ever-changing, 75,000 pages of laws? With retro flair, "Taxation Nation" looks into how our tax system does – and doesn’t – work.

Where do our tax dollars go? Uncle Sam takes a cut of our earnings every April. But what does he spend our hard-earned money on? The answers will truly surprise you in this vérité odyssey.

Why does the US fund foreign aid? The US spends approximately $37 billion dollars a year on foreign aid - just under 1% of our federal budget. "The Foreign Aid Paradox" zeroes in on food aid to Haiti and how it affects American farming and shipping interests as well as Haiti’s own agricultural markets. The result: a surprising study in unintended consequences.

Why do we have budget deficits and a national debt? In this free-wheeling animated film, you’ll see how Congress and public officials use and manage debt, and why it matters to you.

Test Yourself: Government Deficits