UNIT 3

Classical vs. Keynesian

Ø  Classical Vs. Keynesian

v  Modern followers

-          Adam Smith, J.B Say, David Ricardo, Alfred Marshall

-          J.M. Keynes

v  Say’s Law

-          Supply creates its own demand.

-          Production = income = spending

-          Under spending is unlikely

-          Whatever output is produced, it will be demanded.

-          Demand creates its own supply.

-          Depressions refute Say’s law.

-          Underspending persists.

v  Savings and Investments

-          Savings = Investment income

-          Savings (leakage) = Investment (injection)

-          Spending > Business > Households > Spending

-          Savings does not equal Investment

-          Savings: Future needs, precaution, habit, income level, interest rate.

-          Investment: Interest rate, rate of profit, expectations

v  Loanable Funds Market: Ig = gross investment , r = interest rate, Sm = supply of money, S_LF=Savings (Supply of money), D_LF=Investment (Demand of money)

-         

-          Investment from savings, cash, checking accounts.

-          Lending creates money.

-          Sm increases.

-          Inflation/unemployment are unstable.

v  Wage/price flexibility

-          Prices/Wages are flexible downwards.

-          Prices/Wages are inflexible downwards (Ratchet Effect).

v  Supply Curve

-          Vertical

-          Horizontal

v  Output and Employment

-          AS determines output and employment.

-          AD determines output and employment.

v  Unemployment: S = Savings, I = Investments

-          Rarely exists due to wage/prices inflexibility.

-          The cause is external and war.

-          Usually exists.

-          External: War

-          Internal: S does not equal I

v  Aggregate Demand (AD)

-           AD determines price level.

-          Reasonably stable if money supply is stable.

-          AD changes due to its determinants.

-          AD is unstable even if money level is stable due to fluctuations in investment standing.

v  Basic Equation

-          MV = PQ

-          C + Ig + G + Xn = GDP

v  Role of Government

-          Monetary Rule

-          Maintain a steady money supply.

-          Laissez faire is best and economy is self-regulating.

-          Believe in fiscal policy.

-          Tax and spend

-          Active government

-          Economy is “not self-regulating”.

v  Inflation (% change Price level Increases)

-          Caused by too much money.

-Caused by too much demand.

v  How long the short run

-          Short time

-          Long time

v  is Emphasis Today

-          Microeconomics

-          Macroeconomics

v  More Information

-          -Believe competition is good

-          Invisible hand (government will regulate itself).

-          In long run, economy will balance at full employment.

-          Trickle down effect- help rich first then others.

-          AD is key, not AS.

-          Leaks and savings cause recessions.

-          In the long run, we are all dead.