Classical vs. Keynesian

CLASSICAL

• Followers
• Adam Smith
• J.B. Say
• David Ricardo
• Alfred Marshall
• Say's Law
• Supply creates own demand
• Production= Income= Spending
• Under spending unlikely
• Whatever output produced will be demanded
• Savings and Investment

• Savings= Investment Income
• Savings (Leakage)= Investment (Injection)
• Loan able Funds Market
• Wages/ Price Flexibility
• Downward
• Supply Curve
• Vertical
• Output and Employment
• Determined by AS
• Unemployment
• Rarely exists because of wage/price flexibility
• Cause: External (War)
• Aggregate Demand
• Determines PL
• Stable if Money Supply is Stable
• Basic Equation
• MV= PQ
• 1965-1972
• Role of Government
• Monetary Policy maintains steady Money Supply
• Laissez-faire is best
• Self Regulating Economy
• Inflation
• When the economy has too much money flowing around

Short Run last a Short Time

Microeconomics= Emphasis Today

• Other
• Competition is Good
• Invisible Hand
• Long Run- Balance= FE
• Trickle Down Effect- Help Rich 1st, Everyone Else 2nd

KEYNESIAN

• Followers
• J.B. Keynes
• Say's Law
• Depressions refute Say's Law
• Demand creates own Supply
• Under Spending Persists 
• Savings and Investments
• Savings is not equal to Investment
• Different Motivations
• Savings
• Future Needs
• Precaution
• Habit
• Income Level
• Interest Rate
• Investment
• Interest Rate
• Rate of Profit
• Expectations
• Loan able Funds Market 
• Investment from Savings, Cash, and Checking Accounts
• Lending creates Money which leads to the Supply of Money Increases
• Inflation and Unemployment are Unstable
• Wages/ Price Inflexibility
• Ratchet Effect- Prices and Wages inflexible Downward
• Supply Curve
• Horizontal
• Output and Employment
• Determined by AD
• Unemployment
• Usually exists
• Causes:
• External (War)
• Internal (Savings is not equal to Investment)
• Aggregate Demand
• Changes due to Determinants
• Unstable even if Money Supply is stable due to Fluctuations in Investment Spendings
• Basic Equation
• C+Ig+G+Xn
• 1973- Present
• Role of Government
• Fiscal Policy- Tax and Spend
• Active Government
• Economy is not Self Regulating
• Inflation
• Too much Demand

Short Run last a Long Time

Emphasis Today= Macroeconomics

• Other
• Flawed Competition
• AD is key; not AS
• Leaks+Savings=Recession
• Ratchet Effects and Sticky Wages block Say's Law
• We are doomed in the Long Run

Fiscal Policy

Fiscal Policy

• The change in Expenditures or Tax Revenue of the Federal Government
• Can either increase or decrease Taxes or Spending

Type of Budget

• Balanced Budget=Revenue = Expenditures
• Deficit= Revenue < Expenditures
• When in Deficit, Government borrows from:
• Individuals
• Corporations
• Financial Institutions 
• Foreign Entities and Countries
• Surplus= Revenue > Expenditures
• Government Debt= Sum of Deficits- Sum of Surplus
• Discretionary (Action)- 
• Expansionary 
• Combats Recession
• Increase Spending; Decrease Taxes
• Contractionary
• Combats Inflation
• Decrease Spending; Increase Taxes
• Increase/ Decrease Government Spending or Taxes to get back Fiscal Policy 
• Non Discretionary 
• Automatic/ Built-in Stabilizers- Include Unemployment Compensation and Marginal Taxes; They happen without Policy Makers

Tax Systems

• Progressive- Average Tax Rates rises with GDP 
• Proportional- Average Tax Rates remains constant as GDP Changes
• Regressive- Average Tax Rates falls with GDP
• More Progressive- More Stability 

MPC, MPS, and Spending/Tax Multiplier

Disposable Income

·         Income after Taxes or Net Income

·         DI= Gross Income- Taxes

Choices

·         With DI, Households can either

o   Consume (Spend money on Goods and Services)

o   Save (Not Spend money on Goods and Services)

Consumption

·         Household Spending

·         Ability to Consume is Constrained by

o   Amount of DI

o   Propensity to Save

·         Do Households Consume if DI= 0?

o   Autonomous Consumption

o   Dissaving

Saving

·         Household is NOT spending

·         Ability to Save is Constrained by

o   Amount of DI

o   Propensity to Consume

·         Do Households save if DI=0?

o   NO

APC and APS

·         APC= Average Propensity to Consume

·         APS= Average Propensity to Save

o   APC+APS=1

o   1-APC=APS

o   1-APS=APC

o   APC>1= Dissaving

o   –APS= Dissaving

Marginal Propensity to Consume (MPC)- Fraction of any change in DI that is consumed

·         MPC= Change in Consumption/ Change in DI

Marginal Propensity to Save (MPS)- Fraction of any change in DI that is saved

·         MPS= Change in Savings/ Change in DI

Marginal Propensities

·         MPC+MPS=1

·         MPC=1-MPS

·         MPS=1-MPC

Spending Multiplier Effect

·         Initial change in Spending Causes a larger change in AS or AD

o   Multiplier= Change in AD/ Change in Spending

·         Calculating the Spending Multiplier

o   Spending Multiplier can be calculated from MPC or MPS

o   Multplier= 1/(1-MPC) or 1/MPS

o   Spending Multipliers are positive when there is an increase in spending and negative when there is a decrease

Calculating the Tax Multiplier

·         When Government taxes, multiplier works in reverse

·         Why?

o   Because now, money is leaving the Circular Flow

·         Tax Multiplier is Negative

o   Multiplier= -MPC/ (1-MPC) or –MPC/MPS

·         If there is a Tax Cut, then the multiplier is positive, because now there is money going in the Circular Flow

Nominal Vs. Real Wages

Nominal Wages vs Real Wages

• Nominal Wages- Amount of money received by a worker per Unit of Time
• Real Wages- Amount of Goods and Services a Worker can purchase with their Nominal Wages

Sticky Wages- Nominal Wage Level that is set according to an initial price level, and it does not vary due to labor contracts or other restrictions 

Investment-

• Money Spent on Expenditures on
• New Plants (Factories)
• Capital Equipment (Machinery)
• Technology (Hardware& Software)

Cost/Benefit Analysis helps businesses make investment decisions

Expected Rate of Return helps businesses determine the benefits

Interest Costs help businesses count the cost

How do businesses determine the Amount of Investment they undertake?

• Compare Expected Rate of Return to Interest Cost
• Expected Return> Interest Cost, then invest
• Expected Return< Interest Cost, then don't invest

Real (r%) vs Nominal (i%)

• What's the Difference?
• Nominal is observable rate of interest. Real subtracts out inflation and is only known as Ex Post Facto.
• How do you Compute the Real Interest Rate?
• r%= i%- π%
• What determines the Cost of an Investment Decision?
• Real Interest (r%)
• What is the shape of the Investment Demand Curve
• Downward Sloping
• Why?
• When interest rates are high, fewer investments are profitable. When interest rates are low, more investments are profitable.

Shifts in Investment Demand (ID)

• Cost in Production
• Lower Cost, ID Shifts Right
• Higher Cost, ID Shifts Left
• Business Taxes
• Lower Business Taxes, ID Shifts Right
• Higher Business Taxes, ID Shifts Left
• Technological Change
• New Technology, ID Shifts Right
• Lack of Technology, ID Shifts Left
• Stock of Capital
• Economy Low on Capital, ID Shifts Right
• Economy High on Capital, ID Shifts Left
• Expectations
• Positive, ID Shifts Right
• Negative, ID Shifts Left

Gaps Graph

Full Employment- Full Employment Equilibrium exits where AD intersects SRAS and LRAS at the same point

Recessionary Gap- When Equilibrium occurs below Full Employment Output

Inflationary Gap- When Equilibrium occurs beyond Full Employment Output

Aggregate Supply

Aggregate Supply- The Level  of Real GDP (GDPR) that firms will produce at each price level (PL)

Long Run vs. Short Run

• Long Run
• The period of time where input prices are completely flexible and adjust to changes in the price level (PL)
• In the long run, the Level of Real GDP (GDPR) supplied  is independent of PL
• Short Run
• Period of time where input prices are sticky and do not adjust to changes in the PL
• In the short run, the GDPR supplied is directly related to the price level

Long Run Aggregate Supply (LRAS)

• The LRAS marks the level of Full Employment in the economy (can be compared to like the PPC)
• Because input prices are completely flexible in the long run, changes in PL do not change firms' real profits, and thereby do not change firms' level of output. 
• This means that the LRAS is vertical at the economy level of Full Employment.

Changes in Short Run Aggregate Supply (SRAS)

• Increase in SRAS= Shift to the Right
• Decrease in SRAS= Shift to the Left
• Key to understanding shifts in SRAS is Per Unit Cost of Production
• Per Unit Cost of Production= Total Input Cost/ Total Output

Determinants of SRAS 

• Input Prices
• Productivity
• Legal-Institutional Enviroment

Input Prices

• Domestic Resource Prices
• Wages (75% of all business costs)
• Cost of Capital
• Raw Materials (Commodity Prices)
• Foreign Resource Prices
• Market Power

Increase in Resource Prices= SRAS Shift to the Left

Decrease in Resource Prices= SRAS Shifts to the Right

Productivity

• Productivity= Total Output/ Total Inputs
• More Productivity= Lower Unit Production Cost= Shifts SRAS to the Right
• Lower Productivity= Higher Unit Production Cost= Shifts SRAS to the Left

Legal Institutional Environment

• Taxes and Subsidies
• Taxes ($ to Government) on business increase Per Unit Cost of Production= SRAS to the Left
• Subsidies ($ from Government) to business reduce Per Unit Cost of Production= SRAS to the Right
• Government Regulation 
• Government Regulation creates a Cost of Compliance= SRAS Shifts to the Left
• Deregulation reduces Compliance Costs= SRAS to the Right

Aggregate Demand

Aggregate Demand (AD)- the demand by consumers, businesses, government, and foreign countries

• C+I+G+Xn
• Changes in price level cause a move along the curve

Why is AD Downward Sloping?

1. Real-Balance Effect
• Higher price levels reduce purchasing powers of money
• Decreases the quantity of expenditures
• Lower price levels increase purchasing power and increase expenditures
2. Interest- Rate Effect
• When price level increases, lenders need to charge higher interest rates to get a real return on their loans
• High interest rates discourage consumer spending and business investment 
3. Foreign Trade Effect
• When U.S price level rises, foreign buyers purchase fewer U.S goods and Americans buy more foreign goods
• Exports fall and imports rise, causing real GDP demanded to fall (Xn Decreases)

Shifters of Aggregate Demand 

GDP= C+I+G+Xn

• Two parts to a shift in AD
• Change in C, Ig, G, and Xn
• Multiplier effect that produces a greater change than the original change in the 4 components
• Increases in AD= Shift to the Right
• Decreases in AD= Shift to the Left

Consumption

• Household Spending is affected by:
• Consumer Wealth
• More Wealth= More Spending (AD Shifts Right)
• Less Wealth= Less Spending (AD Shifts Left)
• Consumer Expectations 
• Positive Expectations= More Spending (AD Shifts Right)
• Negative Expectations= Less Spending (AD Shifts Left)
• Household Indebtedness
• Less Debt= More Spending (AD Shifts Right)
• More Debt= Less Spending (AD Shifts Left) 
• Taxes
• Less Taxes= More Spending (AD Shifts Right)
• More Taxes= Less Spending (AD Shifts Left)

Gross Private Investment 

• Investment Spending is sensitive to:
• The Real Interest Rate
• Lower Real Interest Rate= More Investment (AD Shifts Right)
• Higher Real Interest Rate= Less Investment (AD Shifts Left)
• Expected Returns
• High Expected Returns= More Investment (AD Shifts Right)
• Lower Expected Returns= Less Investment (AD Shifts Left)
• Expected Returns are Influenced by:
• Expectations of future profitability
• Technology
• Degree of Excess Capacity (Existing Stock of Capital)
• Business Taxes

Government Spending

• More Government Spending (AD Shifts Right)
• Less Government Spending (AD Shifts Left)

Net Exports

• Net Exports Are Sensitive to
• Exchange Rates (International Value of U.S Dollar)
• Strong $= More Imports and Fewer Exports (AD Shifts Left)
• Weak $= Fewer Imports and More Exports (AD Shifts Right)
• Relative Income
• Strong Foreign Economies= More Exports (AD Shifts Right)
• Weak Foreign Economies= Less Exports (AD Shifts Left)
•