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Classical Economics

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Title: Classical Economics


1
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,

2
Viewpoints Models
  • Classical Economics (cont.)

3
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.

4
Viewpoints Models
  • Keynesian Economics (cont.)

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8
The Consumption Function
Planned consumption(trillions of )
45º line
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9
6
3
45º
Real disposable income(trillions of dollars)
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6
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9
Savings
Consumption
10
Viewpoints Models
  • Keynesian Economics (cont.)

11
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

12
Viewpoints Models
  • Keynesian Economics (cont.)

13
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.

14
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.

15
Viewpoints Models
  • New Classical Economics (cont.)

16
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.

17
Viewpoints Models
  • New Classical Economics (cont.)

18
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.

19
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.

20
Inflation Unemployment
  • Phillips Curve
  • Curve showing the relationship between an
    economys unemployment and inflation rates.

21
Inflation Unemployment
  • Phillips Curve (cont.)

22
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.

23
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.
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