Unit 5 - Models of Output Determination

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Unit 5 - Models of Output Determination

• Two Primary Schools
• of Economic Thought are
• Classical Economics (Smith, Ricardo, Von Mises,
  Say, Hayek, Hazlitt, Friedman, economic
  conservatives).
• Keynesian Economics (Keynes, Galbraith, economic
  liberals).

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Unit 5 - Models of Output Determination

• The Classical Model
• is based on Adam Smiths
• Wealth of Nations (1776).
• is the foundation for neo-classical and Austrian
  school economics, rational expectationism, and
  monetarism.
• was dominant before the 1920s. Gained in
  popularity again since the 1980s.

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Unit 5 - Models of Output Determination

• Classical Economists Believe that
• Market forces (flexible prices, wages, and
  interest rates) correct economic problems.
• Limited government involvement in the economy
  leads to maximum wealth and the highest standard
  of living.
• Artificial government stimulation of the economy
  leads to problems in the long run.

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Unit 5 - Models of Output Determination

• The Keynesian Model
• is based on the works of
• John Maynard Keynes
• (1883 1946).
• gained acceptance during the 1930s and was
  supported by almost all western economists and
  politicians during the 1950s, 1960s, and 1970s.

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Keynes said In the long run we are all dead.
Do you agree?

1. Yes
2. No
3. Not sure
4. I dont care (were all dead soon)

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Unit 5 - Models of Output Determination

• Keyness Analogy
• The economy is like an elevator. If it goes up,
  it will continue to go up for a while. If it goes
  down, it will go down and may hit the bottom,
  unless someone stops it.

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Unit 5 - Models of Output Determination

• The Keynesian Theory
• During a recession,
• Production decreases.
• Thus, layoffs increase.
• Thus, incomes and demand for products fall.
• Thus, production decreases even more.
• Thus, layoffs increase further.
• And so forth.
• During an expansion the opposite happens.

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Unit 5 - Models of Output Determination

• The Keynesian Solution
• The government must intervene (stop the
  elevator) through
• Active fiscal policy
• Active monetary policy

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Unit 5 - Models of Output Determination

• Active Fiscal Policy
• During recessions, Keynes supports
• Increases in government spending.
• Decreases in taxes.
• Of the two, Keynes prefers increases in
  government spending, because households and
  businesses may not spend their tax rebates.

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Unit 5 - Models of Output Determination

• Active Fiscal Policy
• Increases in government spending and decreases
  in taxes lead to (Keynes)
• Higher incomes
• Increases in spending
• Increases in production
• More jobs
• Higher incomes
• And so forth

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Unit 5 - Models of Output Determination

• Active Fiscal Policy
• During expansions, Keynes supports
• Decreases in government spending
• Increases in taxes

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Unit 5 - Models of Output Determination

• Active monetary policy
• During recessions, Keynes supports
• increases in the nations money supply.
• In the United States, the Federal Reserve Board
  controls the nations money supply.

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Unit 5 - Models of Output Determination

• Active monetary policy
• According to KeynesMoney supply
• interest rates
• borrowing Spending
  GDP

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Unit 5 - Models of Output Determination

• The Keynesian Multiplier
• When government increases spending,
• total spending in the economy increases by a
  multiple of the increase in government spending.

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Unit 5 - Models of Output Determination

• Multiplier Example
• Lets say a government spends 1 billion (1,000
  million) on the construction of a stadium.
• This increases construction workers incomes by
  1 billion, compared to if the government hadnt
  spent the money.
• What happens to this 1 billion?

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Unit 5 - Models of Output Determination

• Example (contd)
• Lets assume that the construction workers spend
  80 (800 million) of their additional income. We
  say that their Marginal Propensity to Consume
  (MPC) is 80.
• Lets say they spend it on clothes.

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Unit 5 - Models of Output Determination

• Example (contd)
• This generates 800 million in additional income
  for the clothes suppliers.
• What happens to the 800 million?

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Unit 5 - Models of Output Determination
512
640

• Example (contd)
• Lets assume the clothes producers spend 80 of
  their additional income on food.
• This generates 640 million in additional income
  for food suppliers.
• What will the food suppliers do with the
  additional income? You get the picture.

800
1,000
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Unit 5 - Models of Output Determination

• Example (contd)
• Thus, total spending in the economy increases by
  (in millions)
• 1,000 800 640 512 5,000

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Unit 5 - Models of Output Determination

• Example
• 5,000 million is 5 times 1,000 million.
• 1,000 is the initial government spending
  change.
• Keynes called this factor 5 the multiplier.

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Unit 5 - Models of Output Determination

• The Change in Total Spending in the Economy
• According to Keynes
• The additional total spending in the economy
  multiplier x the change in initial spending.
• Or total spending m x initial spending.

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Unit 5 - Models of Output Determination

• The Formula for the Multiplier
• Multiplier 1 / (1 MPC)
• Or,
• Multiplier 1 / MPS
• Where MPS Marginal Propensity to Save

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Unit 5 - Models of Output Determination

• Multiplier Example 1
• If the MPC .8, then
• m 1 / (1 .8) 1/(.2) 5.

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If the MPC is .9, then the multiplier is

1. 1
2. 2.
3. 3
4. 4
5. 5
6. 7.5
7. 10

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Unit 5 - Models of Output Determination

• Multiplier Example 2
• If the MPC .9, then
• m 1 / (1 .9) 1/(.1) 10.

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If the MPC is .75, then the multiplier is

1. 1
2. 2
3. 3
4. 4
5. 5
6. 7.5
7. 10

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Unit 5 - Models of Output Determination

• Multiplier Example 3
• When the MPC .75, then
• m 1 / (1 .75) 1/(.25) 4.

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If the MPS is .2, the multiplier is

1. 1
2. 2
3. 3
4. 4
5. 5
6. 7.5
7. 10

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Unit 5 - Models of Output Determination

• Multiplier Example 4
• If the MPC .75, and the government increases
  spending by 2,000, by how much will total
  spending change?
• Remember,
• total spending m x initial spending.
• Thus, total spending 4 x 2,000.
• Thus, total spending 8,000.

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If the MPC is .9, and government increases
spending by 20, what is the change in total
spending in the economy?

1. 10
2. 18
3. 100
4. 200
5. 1,000

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Unit 5 - Models of Output Determination

• Recessionary and Inflationary Gaps
• are the differences (negative and positive,
  respectively) between what GDP is now and what
  GDP is at full employment.

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Unit 5 - Models of Output Determination

• Recessionary and Inflationary Gaps Example
• By how much should the government increase
  government spending if current GDP is 5,000, and
  full employment GDP is 6,000, and the MPC .80?
• Answer X times 5 1,000. X 200.

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If current GDP is 10,000 and full employment GDP
is 12,000, and the MPC is .8, by how much should
government increase spending to eliminate the
recessionary gap?

1. 200
2. 300
3. 400
4. 500
5. 1,000
6. 2,000

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Unit 5 - Models of Output Determination

• Recessionary Gaps and Inflationary Gaps Example
• Answer to the previous question
• The equation to use is
• Change in GDP multiplier x change in
  government spending.
• So 2,000 5 x 400.

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Will a change in government spending cause a
change in real GDP?

1. Yes, both in the short and long run
2. Yes, but only in the short run
3. Yes, but only in the long run
4. Not sure

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Unit 5 - Models of Output Determination

• Evaluation of the Keynesian Theory
• Lets evaluate the effects of government
  spending.
• If the government increases spending, how does
  it pay for this?

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Unit 5 - Models of Output Determination

• Evaluation of the Keynesian Theory
• The funds can come from 3 sources
• newly printed money, or
• borrowed money, or
• increase in taxes

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Unit 5 - Models of Output Determination

• Evaluation of the Keynesian Theory
• If the prints more money, it
• lowers interest rates in the short run. This
  increases borrowing and spending, and stimulates
  the economy in the short run.
• but it causes inflation and increases interest
  rates, and slows down the economy in the long run.

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Unit 5 - Models of Output Determination

• Evaluation of the Keynesian Theory
• If the government borrows the money, it
• increases funds for the government. This
  increases spending in the government sector.
• but it decreases funds in the private sector.
  This decreases private sector spending.
• increases the national debt and increases future
  taxes. This slows down the economy in the long
  run.

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Unit 5 - Models of Output Determination

• Evaluation of the Keynesian Theory
• If the government increases taxes, it
• increases funds for the government. This
  increases spending in the government sector.
• but it decreases peoples incomes in the private
  sector. This decreases private sector spending.
• discourages people from working. This slows down
  the economy.

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Unit 5 - Models of Output Determination

• Evaluation of the Keynesian Theory
• Conclusion
• Keynesian policy may help the economy in the
  short run, but is harmful to the economy in the
  long run.

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Unit 5 - Models of Output Determination

• The Role of Savings
• Keynesian theory
• Savings are a leakage from our economy.
• Only increases in consumption lead to increases
  in production.

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Unit 5 - Models of Output Determination

• The Role of Savings
• Classical Theory
• Savings are important to our economy.
• Increases in savings lead to increases in funds
  for businesses.
• Businesses use these funds for research and
  technology and business expansions.

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Unit 5 - Models of Output Determination

• The Role of Savings
• Investments in research
• and technology lead
• to increases in productivity.
• This enables businesses to pay higher real
  wages. This leads to real (not artificial)
  increases in demand.

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Unit 5 - Models of Output Determination

• The Role of Savings
• Real demand increases
• are made possible by
• greater capacities to produce, and not by
  artificial increases in government spending or
  newly printed money.

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Unit 5 - Models of Output Determination

• Aggregate Demand and Supply
• Aggregate the sum of
• Aggregate demand the demand for all products
  in the economy.

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Unit 5 - Models of Output Determination

• Aggregate Demand

The Aggregate demand curve is downward sloping
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Unit 5 - Models of Output Determination

• Aggregate Supply

The aggregate supply curve is upward sloping.
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Unit 5 - Models of Output Determination

• A Shift in Aggregate Demand

According to Keynesian theory, an increase in
AD in the horizontal part of the AS
curve increases GDP.
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Unit 5 - Models of Output Determination

• A Shift in Aggregate Demand

According to Keynesian theory, an increase in
AD in the vertical part of the AS
curve increases the price level.
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Unit 5 - Models of Output Determination

• A Shift in Aggregate Demand

According to Keynesian theory, an increase in
AD in the upward part of the AS curve increases
GDP and the price level.
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Unit 5 - Models of Output Determination

• The Phillips Curve

According to Keynesian theory, there exists an
inverse relationship between inflation and
unemployment.
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Unit 5 - Models of Output Determination

• A Shift in Aggregate Supply

According to Classical theory, an increase in
AS increases GDP, and lowers the price level.
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