Understanding Keynesian Economics: Selected Key Points of Ch. 9

Transcription

1 Page1 Understanding Keynesian Ecnmics: Selected Key Pints f Ch. 9 NOTE: In this lecture nte I have clarified the parts f Ch. 9, that I felt, are nt explained very clearly. This DOES NOT mean that the remaining parts f the chapter are unimprtant. Rather they are extremely imprtant, but explained well enugh in the bk. Keynesians criticize Classical Ecnmists in 4 cases : S=I Classical Schl Anytime, Saving increases, ceteris paribas and S>I, the interest rate will adjust dwnwards until S=I again Anytime Saving falls, ceteris paribas, and S<I, the interest rate will adjust upwards until S=I again. S I Keynesian Schl It may be the case that Saving increases by $100 but Investment increases by $60, even thugh interest rate has fallen t try and make S=I. This is because S and I DO NOT nly depend n interest rate. They depend n ther factrs t. Fr e.g. Saving als depends n Saving target and Investment als depends n expectatin f future prfit, the general md in the ecnmy ( ptimism vs. pessimism). Fr instance, say there is recessin in an ecnmy. Say Saving increases by $100. Say interest rate is lw at 1%. Even then I may nt increase by $100 may nly increases by $20 because in a recessin when a firm can see many ther cmpanies ging bankrupt and when peple are nt spending, firms are nt eager t invest mre and expand prductin! Say s Law hlds There is n case f underprductin r verprductin in the whle ecnmy. Thus the ecnmy autmatically ges t equilibrium. Gvernment DOES NOT need t intervene in rder t bring the ecnmy t its equilibrium. Wages are Flexible Classical Ecnmists believe that in rder t bring labur market t its equilibrium, wages will always adjust (increase r decreases) accrdingly. If the labur market is experiencing a shrtage (i.e. there is excess demand fr labur Q D >Q S ), wages will rise until until Q D =Q S If the Labur market is experiencing a surplus, (i.e. there is excess supply f Say s Law DOES NOT hld Recall that Say s Law hlds because f the belief that S will always equal I. Since, Keynes has shwn that S I always, thus Say s Law des nt hld. Hence there is a chance that there may be ver prductin r underprductin in the ecnmy Wages are sticky dwnwards Keynes believes that even thugh it is easy t increases wages, it is nt that easy fr wages t fall. This is because f the resistance frm existing emplyees and labur unins. If emplyer tries t reduce wage, emplyees and labur unins will nt accept it. They may revlt in varius ways. Als, Keynesians, frward the Efficiency Wage Therem t justify their argument that decreasing the wage beynd a certain ptimum level is nt a gd idea.

2 Page2 labur Q S >Q D ), wages will fall until Q D =Q S Prices are Flexible Classical Ecnmists believe that in rder t bring gds market t its equilibrium, prices will always adjust ( increase r decreases) accrdingly. If the Gds Market is experiencing a shrtage (i.e. there is excess demand Q D >Q S ), prices will rise until Q D =Q S If the Gds Market is experiencing a surplus, (i.e. there is excess supply Q S >Q D ), prices will fall until Q D =Q S Keynesian believe that wrkers shuld be paid an efficiency wage, which is abve the equilibrium wage in rder t ensure a certain level f prductivity and mtivatin. This als ensures that less mnitri8ng is needed since wrkers will be mtivated t wrk efficiently at a higher wage rate thus an efficiency wage abve the equilibrium wage rate may als reduce the firm s THUS, Emplyers may wish t pay this efficiency wage in rder t get a certain level f prductivity and reduce the Hence emplyers may nt wish t decrease the wage, because that may reduce wrker prductivity and thus hamper prductin targets. It may als increase Prices are sticky dwnwards Keynes believes that even thugh it is easy t increases price, it is nt that easy fr prices t fall. This is because f existence f mnplies, ligplies and duplies in the ecnmy. Recall that a Mnply is the nly prducer f a certain gd. S, they can charge very high prices and peple will still buy their prduct because there are n ther prducers. In this case, even if there is a call fr lwered prices in the ecnmy, the Mnplist will nt lwer his prices because that will take him away frm prfit maximizatin. Recall that Mnplists charge that price which ensures that MC=MR i.e. prfit is maximized. If they charge a lwer price, MC MR, i.e., prfit is NOT maximized. Fr example, say the ecnmy is in a recessinary gap. Als, suppse, the Price f Oil is at an all time high. In this case, lwering the price f il wuld enable the ecnmy t increase prductin ( since il is an input) and this increase Q t Q N. Hwever, if the il supplier is a Mnplist, he will nt reduce price, simple t blige the ecnmy and bring it ut f recessin. Lwering Price f Oil will make MC MR s prfits will nt be maximized. The Mnplist will thus NOT lwer prices. The Mnplist after all is nt there t increase sciety s benefit rather he is there t maximize his wn prfit.

3 Page3 The Keynesian AS Curve The Keynesian AS Curve is a Kinked Curve. As shwn in yur bk, in exhibit 6, it has a hrizntal part and a vertical prtin. Explaining the hrizntal prtins f AS: Belw Q N, the ecnmy is nt utilizing all its resurces. Sme resurces are lying idle As lng as the ecnmy is belw Q N, an increase in Demand leads t an increase in utput there is n increase in price. This is because, whenever peple increase their spending, prducers have abundant resurces t make use f they can thus easily increase prductin. N pressure is put n existing resurces and thus Price is nt pushed up. Explaining the vertical prtin f AS: At Q N, the ecnmy is utilizing all its resurces given its institutinal cnstraints. Once the ecnmy reaches Q N, if the AD increases ( i.e. AD shifts rightwards), there is n increase in real utput nly the price level increases. This is because at Q N, even if prducers want t, they cannt increase prductin because there are n mre resurces t make use f. Instead, as Aggregate Expenditure and thus Aggregate Demand increases, and peple start fighting ver limited amunt f real utput, they start bidding up the price that is why the price level begins t increase. Plicy Prescriptin and the Keynesian AS Curve By lking at the AS Curve alne, we can make sme deductins abut the effectiveness f Demand Side Fiscal Plicy. In the hrizntal sectin, when the ecnmy is sufficiently far away frm full emplyment level r the natural real GDP, Demand Side Fiscal Plicy is effective in increasing the real utput. An X% increase in AggregateE expenditure = an X% increases in Real GDP. Hwever, when the ecnmy reaches the natural Real GDP, Q N, Demand Side Fiscal Plicy is n lnger effective in increasing the real GDP at Q N, using Expansinary Fiscal Plicy tls merely increases the price level nt the real utput. When des an increase in AE=AD= $400 lead t an increase in Real GDP by $400? Answer: When the Ecnmy is sufficiently far away frm its natural real GDP, Q N. When the ecnmy is sufficiently far away frm Q N, an increase in AD by $400 leads t an increase in real GDP by $400 this is because prducers have enugh idle resurces which they can easily make use f in rder t increase utput. S if cnsumers demand $400 wrth f new gds, prducers are willing and able t increase utput by the same amunt. Hwever, as the ecnmy cmes clser t Q N, an increase in AE=AD=$400 may fail t increase real GDP by $400. This is shwn in the Fig 9.1 Say the natural real GDP, Q N =$1000 and the ecnmy is initially at A where Q A = 800.

4 Page4 Fig 9.1: The Keynesian Aggregate Supply Curve Price Level $400 AS $400 B A O $200 $600 $800 $ 1000 Real GDP Nw, when the AD increases by $400, prducers cannt increase real utput by $400 this is because the ecnmy has enugh resurces left t prduce gds wrth $200. Once they increase prductin by $200, the ecnmy has n mre idle resurces. It has reached its maximum prductin level f $1000. (The ecnmy cannt increase its real utput frm $800 t $1200 when the AD increases by $400 because f resurce cnstraint). S after the ecnmy reaches Q N =$1000, the remaining $200 f AD leads t an increase in Price. On the ther hand, when the ecnmy is prducing at Q N =$1000, then an increase in AE=AD=$400 leads t n increase in real utput there is nly an increase in price level. This is because the ecnmy is fully utilizing its resurces, and thus cannt increase prductin, even if it desires t. Recessinary Gap: Keynesian Perspective Accrding t Keynes, if the ecnmy is in a recessinary gap, the private sectr alne cannt bring the ecnmy ut f recessin. This may be because during a recessin, due t the pessimistic md / negative md that exists in the ecnmy, firms are unwilling t expand r pen up new peratins. SO during a recessin, firms d nt increase investment expenditure. Als, during a recessin, husehlds already faced with increased threat f unemplyment and pay cuts, are nt willing t buy new huses since buying new huses is a part f investment expenditure, this is anther reasn why Investment Expenditure may nt increase. During a recessin, husehlds are faced with increased unemplyment. With falling incme, they are unwilling t increase expenditure n durable cnsumer gds. Thus cnsumptin expenditure is als nt likely t increase during a recessin.

5 Page5 Due t these reasns, Keynes believed that the private sectr alne ( i.e. Private Investment and Cnsumptin) may nt be able t bring the ecnmy ut f a recessin. It is pssible fr the ecnmy t get stuck in a recessinary gap. Keynes said that the ecnmy may very well reach an equilibrium at B recall that an equilibrium is a state where there is n incentive t change. THE END Imprtant Cncepts in Ch. 9 that YOU MUST learn: Cnsumptin Functin Autnmus Spending vs. Induced Spending MPC and MPS Calculatin and Interpretatin Multiplier Effect Calculating and interpreting the Multiplier Understanding hw the ecnmy cmes t an equilibrium using the TE-TP framewrk If there is a change in C,I,G hw is TE affected and hw des ecnmy cme t a new equilibrium?