Classical and Keynesian Economics

Transcription

1 Classical and Keynesian Economics The term Classical Economic Theory refers to a body of thought (not one economic theory in particular) on how a capitalistic economic system's component parts work. In fact, up until the late 1920's in the U.S. and other capitalistic economies the Classical School had an answer to any economics question or inquiry that may have arisen. Developments in a capitalistic economy like unemployment, inflation, sluggish economic growth, the behavior of wage rates and prices, etc., were to be successfully addressed and otherwise explained away with an application of Classical Economic Theory. Classical Economics had all of the proverbial "answers" to economic questions and problems, again, up until the late 1920's. Classical Economics had a number of things to say about the mechanical, structural, and operational characteristics of a capitalistic economic system. The table below will identify a number of these characteristics and it should assist in "building" the Classical Model. Economic Characteristic The Nature of Capitalistic Economies and Say's Law Views on Unemployment; Views on "full employment" The Classical View Capitalistic economies are essentially stable. They tend to be stable over the long run. Short term fluctuations might take place but eventually the economy will make its own internal corrections. All that an economy need do is to produce a level of output which will, in turn, produce an amount of income sufficient enough to clear all of that output. No overproduction or underproduction will result and full employment will exist. The most important type of economic activity that can take place is the production of output. All unemployment is voluntary. If someone is unemployed it is through their own choice. The Classical economist might suggest to an unemployed person: "The economy has created plenty of jobs...you are simply asking for too high of a wage rate...if you really want a job, simply take a job at a prevailing wage rate."

2 The Ability of an Economy to "Fix" Itself Capitalistic economies have a natural tendency to be at "full employment" over the long run. If any unemployment does exist, this is a short-run phenomenon that will eventually disappear. The capitalistic economy as a number of "self -adjusting mechanisms" in place the result of which is to cause economic problems to simply "go way"...all one need do is to wait and allow these mechanisms to work themselves out. The Nature of Wage Rates The Nature of Economy-Wide Prices Wages are said to be "flexible" in both the upward and downward directions. If the business sector can't find enough labor, all it need do is to be ready and willing to pay a higher wage rate to attract workers. If, on the other hand, a surplus or over supply of labor exists, i.e., unemployment exists, wage rates will tend to fall. Again, if someone wants to remain employed all they need do is accept the now lower wage rate. If the business sector produces too much output (relative to the economy-wide level of expenditure) the unsold output will be purchased because of the downward flexibility of the economy's overall price level. A drop in the price level will "clear" the unsold output. In the alternative if too much spending takes place (relative to the amount of output the economy produces) the "shortage" of goods and services will dis-

3 appear because the economy's price level will rise inducing firms to offer more output. The Nature of Aggregate Demand (AD) Aggregate Supply (AS) The Nature of Saving The Nature of Investment The economy's aggregate quantities demanded of U.S. output is inversely related to whatever happens to the economy-wide price level. Increases in the price level cause smaller quantities of the nation's output to be purchased, consumed, or "taken off the market" and vice versa. These relationships exist because of the so-called "effects" discussed in the text.(see the AD Curve) The quantities of output that the nation's business sector offers for sale is not at all impacted by the price level in the long run. (See the "vertical " AS curve); However, in the short run, firms will, in the face of rises in the economy's price level, increase the amount of output they might make available for sale and vice versa. (See the upwardsloping AS curve.) Saving is only affected by the interest rates to be earned from that saving. High rates of interest paid will result in a higher volume of saving. Low rates of interest will cause the volume of saving to be low. The amount of saving in an economy will necessarily equal the business sector's level of investment over the long run. Investment expenditure is only affected by the rate of interest firms must pay to borrow funds for those capital goods. An indirect relationship exists between interest rates and investment spending. The

4 amount of investment will be exactly equal to the volume of saving over the long run. The Role of the State Laissez Faire...Because capitalistic economies are relatively stable and because they have a tendency to achieve unemployment and stable price levels and because it has its own "self-adjusting mechanisms" in place the role of the state is very limited. "Wait for the long-run" was a message for govt. to take a hands off approach in solving economic problems. Up until the late 1920's the Classical School's prescription for any kind of economic problem was simply: "Wait", any or all economic problems will correct themselves...all we need to do is to wait for the long run and inflation, unemployment, overproduction, underproduction, too much saving/not enough saving, too much/not enough investment, etc., will be corrected...there is no need for government to interfere with what goes on in the economy. In the case of the U.S. economy and others in the 1920's, they experienced actual decreases in real GDP and increasing rates of unemployment. In fact, for the period U.S. Real GDP was 40% lower in 1934 compared to what is was in For the same time period, the nation's stock of capital goods was also 40% lower in 1934 compared to what is was in Finally, the U.S. unemployment rate reached 24.9% of the workforce. The response from the Classical School? "All we have to do is wait for the long run...these problems are only temporary...in the long run these will go away." The Keynesian Response: (What Keynes Had To Say About the Classical School of Thought and the State of Capitalistic Economies) His Most Famous Quote: "In the long run we're all DEAD." Keynes essentially "pulled the theoretical rug out from under the Classical School in disagreeing with its basic tenets.

5 Your challenge is to use the matrix/table below (with its Economic Characteristics column) to construct the so-called "Keynesian Model". The construction of this model will require that you make use of the Keynesian Critique of the Classical System discussion in the text. Economic Characteristic The Keynesian View The Nature of Capitalistic Economies and Say's Law Views on Unemployment; Views on "full employment" The Ability of an Economy to "Fix" Itself The Nature of Wage Rates The Nature of Economy-Wide Prices The Nature of Aggregate Demand (AD) Aggregate Supply (AS) See the "Ranges of the AS Curve" and the "Modified AS Curve" The Nature of Saving The Nature of Investment The Role of the State

6 The Keynesian Aggregate Expenditure Model Essentially, Keynes took Say's Law and "flipped it over". The result was the proverbial focal point of Keynesian economics. Instead of production being the most important type of economic activity and the producer/firm being the "center of the universe", Keynes argued that spending is the most important type of economic activity and the spender/households are the centerpiece of the model. He argued as well that capitalistic economies are not automatically predisposed to produce a level of output where full employment and price level stability are automatic. He suggested that economies sometimes reach and remain at levels of output where "disequilibrium" is in place and that they might remain there for indefinite time periods with persistent unemployment. Finally, he suggested that waiting for those "self adjusting mechanisms" to kick in was folly. Keynes was the first to suggest that the cure for a stagnant recession laden economy was an increase in economy-wide levels of expenditures. Households and their consumption and saving decisions along with business firms and their investment expenditures were the source of an "expenditure stimulus". The response from the business/producing sector to these higher levels of spending was to produce and offer more goods and services for sale. Further, if households and firms were reluctant to spend more, thus providing the desired stimulus, the government should not simply adopt a hands off approach, hoping that the stagnant economy recover from a recession. Instead, the government should, in a proactive manner, pursue a combined tax and spending policy towards increasing the level of expenditure to achieve full employment. These types of policies should be implemented until, and only until, the economy achieves an equilibrium level of output where full employment is in place. The basic message the Aggregate Expenditures Model delivers is that there is a direct causal relationship between economy-wide expenditures and the level of GDP/output the economy might produce. As such, in the case of a recession -laden economy, increases in economy-wide expenditures will result in increases in GDP, with accompanying increases in employment and incomes. Decreases in economy-wide expenditures (whatever might be the cause) would result in decreases in the production and offering for sale of the nation's GDP. Please note that this why the aggregate expenditures (AE) curve is upward sloping. Changes in particular types of expenditures would be graphically illustrated by upward and downward shifts of the AE curve.