Some History: Classical Economics and Keynes

  • Classical economics- Adam Smith in 1776 (dominated thinking until the 1930s).
    • full employment is normal in a market economy
    • endorses the laissez-faire("let it be") policy where the government is hands off
      • laissez-faire refers to a purely free market economy
      • Zero laissez-faire economies exist today or have ever existed.
      • According to Smith, supply and demand in a market economy act as an "invisible hand," guiding prices and wages to where they should be for productive efficiency, allocative efficiency, and a healthy economy.
  • Then in the 1930s John Maynard Keynes proposed that capitalism is vulnerable to recessions that happen often, bringing about unemployment.
  • He believed that it was necessary to have active economic policy to prevent or act against recessions and to stop resources from standing idle.
The Classical View
  • the aggregate supply curve is verticaland is the sole determinant of the level of real output
    • located at full employment level of real GDP
    • the economy will operate at its potential level of output because of
      • 1) Say's Law: the very act of producing goods generates income equal to the value of the goods produced/the production of any output automatically provides the income needed to buy that output, or basically that supply creates its' own demand
      • 2) responsive, flexible prices and wages
    • But individual products have upsloping supply curves, and when lower prices make production less profitable firms hire less workers and produce less. But in the classical view it is stresses that a drop in product prices will cause a drop in input prices, keeping profits and output stable.
  • Stable Aggregate Demand\
    • Classical economists theorize that money underlies aggregate demand
    • The amount of real output that can be purchased depends on 1) the quantity of money households and businesses possess and 2) the purchasing power of that money as determined by the price level
    • The purchasing power of the money used is the amount of goods and services that single note can buy. If something moves down on the vertical axis the price falls and so the purchasing power of the dollar rises.
    • The aggregate demand curve will remain stable as long as the nation's monetary authorities maintain a constant supply of money.
    • with a fixed money supply, the price level and real output are inversely related (McConnell and Brue)
  • Keynesian economics- John Maynard Keynes in 1930s
    • Keynesian economists want a mixed economy, part private part public sector
    • Active government policy is needed to help the economy, because of the view that a laissez-faire economy would have recurring ressions with high levels of unemployment
    • Keynesians believe that real output can remain under full employment. This is when they say government should get involved and create fiscal and monetary policies to shift the AD curve back to full employment.
    • laissez-faire capitalism brings about recessions and unemployment.
    • Government discretion, then, is necessary and required in order for an economy to achieve prosperity, full employment, and full production capacities.
The Keynesian View
  • Product prices and wages are inflexible downward over long periods.
    • Horizontal aggregate supply curve.
    • When full is met the aggregate supply curve becomes vertical.

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At full employment, suppliers are not able to produce output beyond this capacity - this is why the Keynesian long-run AS is vertical.

In the short run, output can vary, but prices, remaining sticky downward, will not fluctuate until it reaches the intermediate stage of the curve (denoted by the part of the curve included in the area between the red lines).

The Monetarist View
  • Monetarism focuses on the money supply and hold that markets are highly competitive. It says that a competitive market system gives the economy a high degree of macroeconomic stability.
  • Monetarist argue that the price and wage flexibility provided by competitive markets would cause fluctuations in AD to alter product and resource prices rather than output and employment.
  • Monetarist beliefs are closely related to classical economics but in a new form.
  • Monetarists as well as Mainstream advocates, claim that macro instability comes from the aggregate demand side of the economy, not the aggregate supply side.
They also believe that government has contributed to the economy’s business cycles through mistaken attempts to achieve stability.
  • A stable economy would occur when the government does not interfere with the economy
  • Says the government prompts a downward wage flexibility, through pro-union legislation, and minimum wage laws
New Classical View of Self Correction
  • Rational expectations theory- the idea that businesses, consumers, and workers expect changes in policies or circumstances to have certain effects on the economy and, in pursuing their own self-interest, take actions to make sure those changes affect them as little as possible. (McConnell, Brue 344).
  • New classical economics- when the economy diverges from its full employment output, internal mechanisms will automatically move it back to that output. (McConnell, Brue 344).
  • self corrections of the economy are better than active fiscal and monetary policy changes
  • Price-level Surprises: unexpected changes in price level that cause temporary changes in real output (McConnell and Brue 345).
  • In RET, unanticipated price-level changes cause changes in real output in the short run but not in the long run(McConnell and Brue 347).
  • this perspective is that associated with the vertical long-run Phillips curve
Equation of Exchange
  • The fundamental equation of monetarism is the equation of exchanges.
  • Equation od exchange: MV=PQ
  • M: is the supply of money.
  • V. the velocity of money.
  • Velocity: the average number of times per year a dollar is spent on final goods and serves. ( monetarists believe velosity is relatively stable)
  • P: Is the price level, or more specifically, the average price at which each unit of physical output sold.
  • Q: The physical volume of all goods and serviced produced.
  • MV: represents the total amount spent by purchasers of output.
  • PQ: represents the total amount received by sellers of that output.
  • The dollar value of total spending has to equal the dollar value if the total output.
Real-Business-Cycle View
  • the real-business-cycle theory says that changes in fluctuations in the business cycle come from changes in technology and resource availability (McConnell and Brue 342)
    • macro instability occures on AS curve not AD curve
  • Fluctuations in real factors affect productivity which shifts the LRAS curve.
    • Example: A decline in production occurs because of increasing oil prices. This makes operating certain machinery extremely expensive. The decline in productivity implies a decline in real output. This would then cause the LRAS curve to shift left .
  • Changes in the supply of money resond to the changes in the demand for money (McConnell and Brue 342)
    • The decline in the money supply then reduces aggregate demand (McConnell and Brue 342)


Coordination Failures
  • coordination failures occur when "people fail to reach a mutually beneficial equilibrium because they lack a way to coordinate their actions" (McConnell and Brue 343)
  • an example of this from the book is when people see its raining and don't go to a party because they think nobody will show up. Going would benefit everyone, but because of coordination failure, everybody stays home (McConnell and Brue 343)
  • rational expectations theory- the idea that buisness, consumers, and workers expect changes in policies to have certain effects on the economy and take actions so those changes wont hurt them as much.

Efficiency Wage
  • Workers contracts play a role in the inability of the price level and nominal wages to shift downward easily.
  • Additionally a business may not desire to reduce the nominal wages, because workers may become less motivated to work and reduce the quality of their work.
  • There is the idea that at a business may decide to pay its employees at a wage higher than the general market-wage.
    • The workers will therefore have a greater incentive to work harder, so that they can keep their job.
    • Since the workers are motivated to work, the business does not need to have as much supervision to make sure that all employees are working. This reduces costs that business has to pay to these supervisors.
    • The employees will be less likely to leave the job, and the business will not need to spend as much money trying to find new employees and then making sure that they have the proper skills. The business will also not have to teach the new employee skills required for the job. This will reduce costs.
  • This is referred to as the efficiency wage, because the production costs for each unit of output have decreased. An increase in wages above the marker wage can in the end result in lower costs faced by the business.
    • For example, if the market wage is $65 a day for a given job, and at that job an employee produces 20 units of the output, but at $70 dollars a day the employee produces 25 units of output, the business would choose to offer the second wage, because the proportional cost for the amount of outputs produced is less for the $70 wage. It would cost the business $3.25 for each unit of output considering the first wage, while it would cost only $3 for each unit of output considering the second wage (McConnell and Brue 346).. [1]

Insider-Outsider Theory

  • Insiders are defined as those that do not go unemployed during a recession, and outsiders are those that do get unemployed during a recession. (McConnell & Brue 347)
  • The Insider-Outsider theory states that even if outsiders are willing to work at a lower wage than insiders, they will not replace insiders because employers do not want take the chance of hiring a new worker and losing an already established worker (McConnell & Brue 347)
  • Insiders tend not to cooperate with new workers (outsiders) that undercut their pay (McConnell, Brue 347).
  • This lack of cooperation can lead to a lower level of productivity and thus lower the firm's profits, even more of an incentive not to hire outsiders (McConnell, Brue 347).
  • Outsiders are usually left unemployed and have to remain dependent on unemployment compensation, saving, etc. to make ends meet because they often refuse to work for lower wages and this causes harrassment from insiders (McConnell, Brue 347).
  • The theory implies that wages are inflexible downward, even during a recession. (McConnel & Brue 347)
  • The economy may eventually self-correct in this scenario, but not as quickly as economists would like (McConnell and Brue 347).

Rules or Discretion?

These conflicting beliefs about the causes of instability and how quickly the economy will correct itself lead us to a difficult questions regarding macro policy.
  • Should the government stick to strict policy rules to keep itself from interfering and causing instability in an economy that otherwise would have been stable?
  • Or should the government cautiously intervene with discretionary fiscal and monetary policy as necessary to stimulate and stabilize an economy that would be unstable if left on its own?

In Support of Policy Rules
According to Classical Economists, strict policy rules would indeed keep the government's clumsy hands tied in order to prevent them from inadvertently causing more harm than help to the economy when attempting to "manage" aggregate demand.

Increased Macro Stability
  • A tight money policy has reduced inflation by 10.2% in 193 (McConnell and Brue, 350).
  • During the 1990-1991 recession, an easy money policy allowed the economy to recover (McConnell and Brue, 350).
  • In 1988, an expansionary fiscal policy reduced the rate of unemployment by 4.2% (McConnell and Brue, 350).
  • The economy remained on a noninflationary, full-employment growth path in the 1990's because of tightening of monetary policy (McConnell and Brue 350).
  • In 2001 and 2002 the economy was in bad shape due to issues such as the collapse of internet firms, decline in investment and stock values, and the effects of the 9/11 attacks. The economy was able to slowly recover because of expansionary fiscal and monetary policy (McConnell and Brue 350).

  1. ^ McConnell, Campbell R., and Stanley L. Brue. Economics: Principles, Problems, and Policies. Sixteenth ed. New York: McGraw-Hill, 2005. Print.