TWO VIEWS OF THE ECONOMY

Size: px

Start display at page:

Download "TWO VIEWS OF THE ECONOMY"

Rosemary Harper
5 years ago
Views:

1 TWO VIEWS OF THE ECONOMY Macroeconomics is the study of economics from an overall point of view. Instead of looking so much at individual people and businesses and their economic decisions, macroeconomics deals with the overall pattern of the economy. To star with, we will look at two main groups of economists: the Classical Economists and the Keynesian Economists. Classical economists generally think that the market, on its own, will be able to adjust while Keynesian economists believe that the government must step in to solve problems. The two camps have differing ideas on the causes and solutions of unemployment. The Classical economists believe that unemployment is caused by excess supply, which is caused by the high price level of labor. Based on supply and demand, when wages are held too high by social and political forces, demand would be low and supply would be high and that excess supply represents unemployed people. Classical economists believe that if the economy were left on its own, it would adjust to reach an equilibrium wage for workers and the economy would be at full employment. CLASSICAL ECONOMICS Classical economists believe in Say's Law, which states that people supply things to the economy so they have income to demand things of the value they've supplied. Classical economists also argue that all money is always in the economy, because even when people put their income away in the form of savings in banks, stocks, etc. that money still flows back into the economy in the form of investment. When savings money flows into banks, even though it does not directly go to the industries in the form of purchases, banks loan this money to industries to invest in further development. Investmen takes the form of money to acquire new machines, labor, facilities, etc. so that businesses grow. Fig Transfer of money

2 Crucial to the understanding of classical economics is an understanding of how money works. Money is just something that can value goods, used to exchange those goods among individuals in an economy. The quantity theory of money is the theory dealing with money and prices. It states that the price level in an economy depends on how much money is in the economy. In classical economics, the quantity theory of money centers around the equation "(Quantity of money) x (velocity of money) = (price level) x (quantity of goods sold)." Velocity of money just means how often money is spent. The price level times the quantity of goods sold obviously equals the GDP, total production. Velocity, then, times the amount of money would equal that. A coin, for example, is passed around from person to person throughout time and each time it is spent, it generates income worth its value. The number of times that coin was passed on throughout the year is its velocity and that times its value gives how much production it represents that year. When you add all the income generated by all the money out there, you get the GDP also. The velocity of this money depends on what the structure of an economy is like. It depends on things like where people work, where they shop, how often they shop, etc. Since no drastic economic restructuring could be expected to occur in any short period of time, this velocity is assumed to remain constant from year to year. (It does change, but this change is so incredibly slow as to be irrelevant.) Classical economics also stresses that the amount of goods and services produced is not affected by the money supply. This doctrine is the veil of money assumption. This assumption separated the world of finance (of purely monetary studies) and the rest of the economy (the production of goods and services). The veil of money theory basically says that when the money supply changes, the real economy does not because when money supply changes by a certain amount, everything else does as well. If it doubles, then prices double, and people's pay doubles too to compensate for this, so nothing really changes. Classical economics states that money supply is the force that changes the price level. Since money supply changes prices and money supply is not affected by production, the amount of supply is independent of the price level. The amount of output is chosen by people and, according to classical economics, as long as they're no outside pressures intefering with the markets like politics, the amount of supply will always be at full employment level. Demand in the long term is not a problem because in the long term, based on Say's Law, supply generates its own demand and so there will be long-term equilibrium. As stated earlier, classical economists see the problem of unemployment as a self-solving problem like all other things. Wages will fall and then demand for labor will increase and eventually everyone who wants a job will get one. The long-term classical model does not solve short term problems. In the short term, there are always various fluctuations that move demand and supply out of balance of each other. There must be a mechanism to equalize them again.

3 Fig Classical adjustment model Suppliers in the classical model never change how much they supply, they just change their prices so that people will buy them. No matter what, supply is an independent concept. Suppliers will always produce how much they want to produce at a given time. Demand, however, can move by changes to the price level so that all that is produced is actually bought. KEYNESIAN ECONOMICS A basic argument made by John Maynard Keynes, a famous economist during the depression era who invented the idea of Keynesian economics, was that Say's law was just plain false. In Keynes's analysis of the economy, he looked at the problems of supply and demand separately. The problem of supply is relatively simple: supply generates income. What people make are bought, and thus the value of supply is always equal to the value of income. This income is then passed on to the consumers in the form of paychecks. The consumers then spend this money to buy various products. Keynesian economics have several concepts to explain how consumers spend their income. The money that people get are always split between consumption and savings. People who have enough money usually save some of it and spend most of it. There are two ratios Keynesian economics considers when dealing with consumption: the APC and the MPC. The APC, average propensity to consume, is a ratio telling us how much of people's income they tend to spend. The APC varies with income level. The MPC tells us what part of a change in income people tend to spend. For example, if the MPC was.5 and somebody got an increase of income of $1000, then they will spend $500 dollars of that increased income. Conversely, people will cut their spending by that ratio when they lose some income.

Fig 2.1.3-Keynesian consumption function In this graph, we can see a graphical representation of Keynes's ideas. The blue line represents production. The red line represents how much people spend.

4 Fig Keynesian consumption function In this graph, we can see a graphical representation of Keynes's ideas. The blue line represents production. The red line represents how much people spend. The slope of the line, or how much the line goes upward for every increment horizontally, is the MPC, which in this case is 0.75 (how much of every extra piece of income is spent). The slope of the production line is 1 since production = income. When income is way too low, as shown in this, spending must exceed income because no matter what, there are some things that people must buy, like food. They do this through borrowing and dipping into savings, etc. Beyond a certain point, people have enough to save some of that money. APC can be represented on this graph as the ratio of the amount represented by the red line to the amount represented by the blue line at any point. Notice that this ratio changes, which makes sense in the context of Keynesian economics. At the point where spending equals production/income, the APC is 1 and at that point, people spend all the money they make. Of course, the rest of the money, the money that is not spent, goes into savings. There is also APS and MPS, the average propensity to save and marginal propensity to save. APS is what part of income people save and MPS is what part of additional income people save. APS+APC=1 and MPS+MPC=1, as savings and spending together equal income. Savings is the part of the graph between the two lines. When spending is more than income, people save, savings represented by the difference between income and spending. When spending is more than income, people take money out of past savings, the amount represented by the difference between spending and income. Another component of Keynes's analysis was the independence of investment. Unlike classical economics, which states that all savings go into investment, Keynes said that how much people invests is simply how much they feel like investing. There are more complicated models, but to keep this simple now, investment is not changed by savings or income. To keep the model simple, we will assume that government spending and foreign trade is all independent. If you add all these factors into the spending, the red line representing total spending would be shifted upwards (the whole line, the slope is still the same). Whenever the economy is not in equilibrium, firms change their production until equilibrium is reached. When there is more production than expenditure, there is an excess of supply, as firms are not selling everything they produce. Thus, they have to decrease production until production

5 equals consumption on the graph. On the other hand, if there is too little supply, the portion of the graph where production is less than consumption, firms increase their production to meet the demands of customers until the two lines of output and spending meet at equilibrium. The economy is continually adjusting in the Keynesian model as various factors influence the independent factors of investment, government spending, and net export, factors outside of income and production. Interest rate changes, future predictions, and technology can affect investment. Government spending may change depending on varying political situations. Net export, too, can change with a nation's changing international position. These changes can move the spending curve up or down (again, shift as opposed to changing the slope) and thus force further adjustment of production. With his model, he explained the Great Depression: after the crash of 1929, people became scared. Invetment was cut as was spending. When this happened, companies decreased their production even more as spending decreased and this was followed by a drop of spending as income fell (income=production). This drop continued until equilibrium was reached at a point that is way below that of full employment. FISCAL POLICY Fiscal policy is one concept strongly advocated by Keynes. After all, Keynesian economists are those who support government regulation. Fiscal policy, then, is government regulation of its own spending and taxes to influence a country's economy. Fiscal policy works as government spending and taxes can provide an initial shock to the economy that triggers adjustments. Increasing taxes, for example, would cut down on people's disposable income and slow the economy in an effort control it. On the other hand, lowering taxes can give people more money to spend and thus provide a boon to the economy. Increasing government spending, too, can give suppliers an incentive to increase production and thus increase income. There are two types of fiscal policy, depending on what the goal is. Expansionary fiscal policy means an increase in overall spending in the economy is represented by an upward shift of the expenditures graph. On the other hand, contractionary fiscal policy is represented by a downward shift of the consumption graph. Using mathematical and graphical analysis, it's possible to predict the affects of government fiscal policy. As the graph of expenditures shifts up and down, we can find the point of intersection with the production graph to find the new equilibrium income. PROBLEMS WITH FISCAL POLICY There are certain problems associated with fiscal policy. Government policy is affected by its spending. When spending is greater than income, there is a deficit. When income is greater than spending, there is a surplus. The deficit/surplus affects income, and income is affected by it. When the government is running a deficit, it can not increase spending. Also, when a government must increase spending, a tax increase is sometimes in order as well, having the opposite affect on the economy. Besides the government deficit/surplus problem, there is the trade deficit/surplus problem. When people's income increases, they tend to import more, measured in MPM, marginal propensity to import. For example, if the MPM was.2 and income in the economy rose by 100 monetary units, then imports will increase by 20 monetary units. When there is too much importing, an economy risks running a trade deficit, which can have serious

6 consequences for the economy. The trade balance is affected by and affects the income level. Fiscal policy making is about deciding what kind of policy is needed, dealing with government inefficiency (governments generally tend to act slowly in economics), and dealing with the government's own financial liabilities and debts. In general, fiscal policy helps to stabilize the economy so that the economy does not experience sharp and uncontrollable swings of expansion and recession. Fiscal policies slow both processes. FINANCIAL BASICS The financial sector of the economy is important in that it is the market of money and money is the medium of exchange through which all goods and services are traded in all economies. Financial assets are assets owned by an owner under the condition that the issuer of the asset meet certain obligations. If you own a financial asset, than that means that someone gave you that asset and that person owes you in some way. There are many different types of financial assets, which we will go into later. There are also financial institutions, or insitutions set up for the purpose of trading and holding financial assets. Within financial institutions, there are depositary institutions, which are institutions set up to store money in checking and savings accounts. For example, banks are depositary institutions. You save money there in savings and checking accounts so you can save money until you need it. Financial assets are all traded on financial markets, whose sole purpose is the trading of financial assets. Primary financial markets sell new assets that have been freshly issued while secondary financial markets facilitate trade of assets that have already been distributed into the financial markets. TYPES OF ASSETS There are several types of financial assets. They can roughly be divided into those sold in money markets and those sold in capital markets. Those sold in money markets have a maturity of less than one year. Those sold in capital markets have a maturity of more than one year. Financial assets mature, meaning their value increases over time. Many have maturity dates, meaning that their value will be paid back after a certain amount of time. A CD is one kind of financial asset. A CD is a certificate of deposit. You put money into a bank with a set interest rate and after an agreed amount of time, you are free to retrieve that money from the bank. Interest is a percentage of the original value of the asset that is charged as long as that asset is out there. Interest increases exponentially. For example, if a 2% interest is put on $1000, compounded monthly, then that asset is worth $1020 the next month, and $ the month after that. The interest is applied to the immediately previous value of the asset, not the beginning value of the asset. Bonds and stocks are also important types of financial assets. A bond is a guarantee that promises that a loaned amount of money will be paid back in a given amount of time with a given amount of interest charged. A stock, however, is a different type of asset. A stock has no

7 maturity date. A stock is a share in the ownership of a business. Once you own that piece of the business, you keep it until you decide to sell the stock to someone else. Having ownership in the company also means you are entitled to a share of its profits and also theoretically in the decisions the company makes. CLASSICAL AND KEYNESIAN VIEWS OF FINANCE The financial sector is crucial in the macroeconomic debate between classical economists and Keynesian economists. The classical economists, as explained previously, believe that all income flowing from business to the people always go back to business in a perfect loop, because the money that does not go back in the form of spending goes back in the form of investment. This is where the financial sector comes in. Classical economics states that the financial sector efficiently turns all savings into investment for growing business. However, on the other hand, Keynesian economists disagree. As stated before, they do not think that the finance operates completely smoothly. Rough financial markets can have repercussions in the real world, generating wild business cycles. Again, this shows the conflict between Keynesians and classicals. Classicals find that there's no need for government regulation in the smoothly operating market while Keynesians see government regulation to being crucial to maintain stability in the naturally volatile financial world. CLASSICAL VIEW OF INFLATION In the classical view of inflation, the only thing that causes inflation is, in reality, changes in the money supply. Remember the classical quantity theory of money: (money supply) x (velocity) = (price level) x (amount of output). And remember that the classics assume that velocity and output are independent and relatively constant. Thus, as money supply rises, that naturally ups the price level, too, and increase in price level is inflation. The classical economists believe that there is a natural rate of unemployment, the equilibrium level of unemployment of the economy. That is the long-term Phillips curve. Remember that the long-term Phillips curve is vertical because there inflation is not related to unemployment in the long-term. Unemployment, therefore, will just be at a given level, no matter at what point inflation is at. In the classical view, the point where the short-term Phillips curve intersects the long-term Phillips curve is the expected inflation. To the left side of that point, actual inflation is higher than expected and to the right, actual inflation is lower than expected. Basically, unemployment below natural unemployment leads to inflation higher than expected and unemployment higher than natural unemployment leads to inflation lower than expected. KEYNESIAN VIEW OF INFLATION As opposed to the Classics, who view inflation as a problem of ever-increasing money supply, Keynesians concentrate on the institutional problems of people increasing their price levels. Keynesians argue that firms raise wages to keep their workers happy. Firms then have to pay for that and keep making a profit by subsequently raising the prices.

8 This causes an increase in both wages and prices and demands an increase of money supply to keep the economy running. So, the government then issues more and more money to keep up with inflation. This differs from the classical model. Classics view changing money supply as affecting inflation while Keynesians view inflation as the cause of changing money supply.

The Goods Market and the Aggregate Expenditures Model

The Goods Market and the Aggregate Expenditures Model Chapter 8 The Historical Development of Modern Macroeconomics The Great Depression of the 1930s led to the development of macroeconomics and aggregate