Classical Economics

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Viewpoints Models

• Classical Economics
• Popularly accepted theory prior to the Great
  Depression of the 1930s.
• Says the economy will automatically adjust to
  full employment.
• Classical economists assume that
• Supply creates its own demand (Says Law)
• Wages and prices are flexible
• Savings always equals investment,

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Viewpoints Models

• Classical Economics (cont.)

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Viewpoints Models

• Keynesian Economics
• Based on the work of John Maynard Keynes, who
  focused on the role of aggregate spending in
  determining the level of macroeconomic activity.
• Introduced the idea that a macroeconomy seeks an
  equilibrium output level.
• Macroeconomic Equilibrium
• Occurs when the amount of total planned spending
  on new goods and services equals total output in
  the economy.
• If aggregate spending is greater than current
  production, then output, employment, and income
  will all increase, assuming that full employment
  has not been reached, and vice versa.
• Inventories
• Stocks of goods on hand.
• Allows for spending to exceed current production.

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Viewpoints Models

• Keynesian Economics (cont.)

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The Consumption Function
Planned consumption(trillions of )
45º line
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45º
Real disposable income(trillions of dollars)
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Savings
Consumption
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Viewpoints Models

• Keynesian Economics (cont.)

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Viewpoints Models

• Keynesian Economics (cont.)
• Use government expenditures and taxes to control
  the level of economic activity.
• A recession could be counteracted by increasing
  aggregate spending through
• Increasing government expenditures on goods and
  services
• Increasing transfer payments
• Lowering taxes

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Viewpoints Models

• Keynesian Economics (cont.)

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Viewpoints Models

• New Classical Economics
• Return to the basic classical premise that free
  markets automatically stabilize themselves and
  that government intervention in the macroeconomy
  is not advisable.
• Brought about by what some argued to be holes in
  Keynesian economics principles, which could not
  explain or remedy some problems of the 1970s.
• Stagflation
• Occurs when an economy experiences high rates of
  both inflation and unemployment.
• More sophisticated explanations of aggregate
  demand and aggregate supply.

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Viewpoints Models

• New Classical Economics (cont.)
• Downward-sloping aggregate demand curve was
  explained through
• Interest Rate Effect
• Interest rate moves with changes in overall
  prices.
• An inverse relationship exists between the
  interest rate and the amount people borrow and
  spend.
• Wealth Effect
• In order to maintain the same amount of
  accumulated wealth, people spend less when prices
  rise and more when prices fall.
• Foreign Trade Effect
• A direct relationship exists between changes in
  overall prices in an economy and spending on
  imports that diverts spending from domestically
  produced output.

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Viewpoints Models

• New Classical Economics (cont.)

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Viewpoints Models

• New Classical Economics (cont.)
• Aggregate supply curve could be viewed in two
  ways
• Short-run supply with three phases
• At low levels of output, the aggregate supply
  curve is perfectly horizontal.
• As output increases beyond a certain point, a
  direct relationship between prices and output is
  established.
• At high levels of output, the aggregate supply
  curve becomes perfectly vertical.
• Long-run supply
• Perfectly vertical at the natural rate of
  unemployment, the point to which the economy will
  move.

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Viewpoints Models

• New Classical Economics (cont.)

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Viewpoints Models

• New Classical Economics (cont.)
• Long Run Policy Implications
• Natural Rate Hypothesis
• Over the long run, unemployment will tend toward
  its natural rate, and policies to reduce
  unemployment below that level will be
  ineffective.
• Adaptive Expectations
• Households and businesses base their expectations
  of the future on past and current experiences.
• Rational Expectations
• Households and businesses base their expectations
  of future policies on how they think they will be
  affected by these policies.

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Viewpoints Models

• New Keynesian Economics
• Builds on the Keynesian view that the economy
  does not automatically return to full employment.
• Regards prices and wages as inflexible (or
  sticky) downward rather than flexible as other
  schools believe.
• Monetarism
• School of thought that favors stabilizing the
  economy through controlling the money supply.
• Supply-Side Economics
• Policies to achieve macroeconomic goals by
  stimulating the supply side of the market.
• Became popular in the 1980s.

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Inflation Unemployment

• Phillips Curve
• Curve showing the relationship between an
  economys unemployment and inflation rates.

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Inflation Unemployment

• Phillips Curve (cont.)

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Inflation Unemployment

• Phillips Curve (cont.)
• Three factors may help to explain shifts in the
  Phillips curve
• Structural changes in the labor force
• 1970s Increase in the labor force participation
  rates of women and teenagers who, at the time,
  had higher unemployment rates than men.
• 1980s 1990s Rate of unemployment for women
  fell, the movement of teenagers into the market
  reversed itself, and an increase in the rate of
  involuntary part-time employment.
• Cost-push inflation
• 1970s 1980s Brought about by energy price
  increases.
• Eligibility for government transfer payments
• Availability of transfer payments increases
  unemployment, and vice versa.

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Macroeconomic Viewpoints Summary

• Viewpoints Summary
• No theory is designed to explain all the complex
  relationships among the players and institutions
  of a macroeconomy.
• The economy is not composed of a set of simple
  relationships that can be easily manipulated to
  neatly solve various problems as they arise.
• Assessing economic theories would be easier if we
  lived in closed economies.
• Closed Economies
• Economy where foreign influences have no effect
  on output, employment, and prices.
• Open Economies
• Economy where foreign influences have an effect
  on output, employment, and prices.