CLASSICAL & KEYNESIAN ANALYSIS

CLASSICAL & KEYNESIAN ANALYSIS

AGGREGATE DETERMINANTS AT A GLANCE What causes the aggregate demand curve or the aggregate supply curve to change (increase or decrease)?

Factors  that Shift Aggregate Demand Consumer spending depends on consumer confidence & on the short-term interest ratedetermined by the Fed via raising or lowering short-run interest rates in the money market. The Fed controls the nation's money supply & increases or decreases the supply as needed to slow inflation or promote economic growth). Investment spending levels depend on  long-run interest rates from the long-term capital market for loanable funds (loans >5 yrs). Businesses & individuals depend on such loans for the long-term capital projects needed for economic growth. Government spending - deficit spending, tax cuts for consumers, economic stimulus packages & etc - can increase or decrease the level of aggregate demand. Net Exports (NX) tend to be a negative value for the US due to our practice of importing more products from, and exporting fewer products to, other countries. A change in any of these factors will cause the aggregate demand schedule to change & aggregate demand to increase or decrease.

Factors that Shift Aggregate Supply Producer & Saver Tax Policies  - LAFFER’S CURVE suggests that high taxes on producers & savers will kill the goose that lays the golden egg and implies that tax cuts for this group will result in a rightward shift of aggregate supply,  raising all boats & trickling down to benefit the rest of the economy through lower inflation & higher GDP. Input prices - prices for any land, labor or capital resource -  count as costs to the economy. Higher costs will shift aggregate supply to the left and, if sudden in nature, will cause stagflation. Lower input costs (cheaper energy, cheaper labor, etc) will shift aggregate supply to the right. Productivity increases through adopting new technologies or education reform will shift aggregate supply outward. Energy prices, if rapidly increasing, can cause stagflation. Harnessing new & cheaper energy sources shifts aggregate supply outward. Number of Suppliers - More suppliers result in a robustly competitive economy & shifts aggregate supply to the right. Few suppliers lead to a highly concentrated economy consisting of relatively few very large & powerful conglomerates, shifting aggregate supply leftward & causing stagflation. You might remember that Adam Smith's invisible hand is possible only in a competitive environment. A change in any of these factors will cause the aggregate supply schedule to change & aggregate supply to increase or decrease. Generally: Lower production costs lead to increased supply at every price (supply increases, curve shifts to right). Conversely, higher production costs lead to decreased supply at every price (supply decreases, curve shifts to left). Acts of nature usually lead to decreased supply (curve shifts to left). Government policies can lead to either increased or decreased supply … taxes will decrease supply, subsidies will increase supply. Technological changes usually lead to increased supply (curve shifts to right).

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.

A)  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.

B)  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.

C)  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.

D)  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.

E)  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.

A)  Reasons for Upward-Sloping Short-Run Aggregate Supply

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

A)  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.

B)  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.

A)  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.

B)  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?

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

B)  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.

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

B)  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.

C)  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.

A)  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.

B)  Average Propensity to Consume and to Save:

1. Average Propensity to Consume (APC): Consumption divided by disposable income; the proportion of total disposable income that is consumed.

2. Average Propensity to Save (APS): Saving divided by disposable income; the proportion of total disposable income that is saved.

C)  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.

D)  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.

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.

A)  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.

B)  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

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

B)  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.