8 Chapter Summary Tucker, Macroeconomics for Today, 5th Edn. 1. The Classical School of macroeconomic theory began with Adam Smith in 1776 (Inquiry into the Nature and Causes of the Wealth of Nations) and continued through the early part of the twentieth century (up to the great depression of the 1930s). The basic conclusion of this school was that the macro economy could be in equilibrium only at full employment output levels. The most important public policy implication of this theory is that government should do nothing to counteract a recession or depression, because market forces would automatically return the economy to its full employment (equilibrium) level of output. 2. This Classical conclusion was based on: (a) Say's Law; (b) the role of the interest rate to equilibrate saving and investment; and (c) wage and price flexibility. Say's law states that "supply creates its own demand." It is true, by definition, in a barter economy. It also is true in a money-using economy with no saving. Think about the identity of the flow of product (upper loop) of the circular flow graph, and the flow of payments to resources owners (lower loop). But, the Classical writers went even further, and argued that Say's Law would hold in a money-using economy in which household saving occurred. This would occur because households were expected to save more (out of a full employment level of GDP) when interest rates were high, and save less when interest rates were low (that is, household saving was positively related to the market rate of interest, all other things equal). This positively sloped supply schedule of savings intersected a negatively sloped investment demand function which was based on the assumption of an inverse (or negative) relationship between planned investment expenditures and the rate of interest. Higher rates of interest were expected to reduce the present values of the profits expected to flow in over time as a result of the purchase of capital goods, so that fewer investment projects were expected to be undertaken by profit-maximizing firms when interest rates were high as opposed to when interest rates were low. Hence, the market rate of interest was expected to equilibrate saving and investment so that any dollars saved by households would be returned to the circular flow by investment dollars spent by business firms. Say's law was expected to hold in a money using economy in which household saving occurred. 3. Keynes challenged the Classical theory by hypothesizing that the most important determinant of household saving was disposable income, not the rate of interest. Hence, Keynes argued that although the economy would be in equilibrium at the point where saving and planned investment were equal, the level of production at which this occurred could be far below full employment output levels. Hence, Keynes argued that the economy could be in equilibrium at any level of employment or unemployment. According to this theory, the economy would not necessarily be in equilibrium only at full employment output
levels. This implied that positive government actions, and not merely market forces, would be required to return the economy to full employment. 4. The Keynesian aggregate expenditures model asks the following questions: (a) who buys the nation's GDP? And (b) how can we forecast future values of these expenditures? The basic idea behind Keynesian theory is that aggregate expenditures determine the equilibrium level of production, so we if can predict future values of such expenditures, we also can predict the future equilibrium level of GDP. That is, business firms would maximize profits by producing more goods and services as aggregate expenditures increased. Keynes argued that four sectors buy the nation's output: households, business, government and the rest-of-the-world. Household expenditures are called consumption, and consumption was assumed to be positively (and linearly) related to the level of disposable income. Business firms investment purchased goods, and the amounts of planned investment they would undertake each year was negatively related to the interest rate. In equation form, AE = aggregate expenditures = C + I(p) where C = consumption and I(p) = planned investment expenditures. Letting Y denote both GDP and DI we have, as an example: (1) Y = C + I(p) (2) C = 30 + 4/5 Y (3) I(p) = 50 (4) By substitution we have, Y = 30 + 4/5 Y + 50 (5) Y - 4/5 Y = 80 (6) 1/5 Y = 80 (7) Y = 80/ 1/5 = 80 * 5 = 400 In this example, 400 is the equilibrium level of GDP. It is the level of output which, if produced, would be purchased by households and business firms with neither too little nor too much output being produced. If C = 30 + 4/5 Y, then at Y = 400, C = 30 + 4/5 (400) = 30 + 320 = 350. Since I(p) = 50, we have C + I(p) = 350 + 50 = 400, and that is exactly the level of GDP produced, in equilibrium. If business firms produce too much (that is, more than 400), then not all of the output will be sold. If they produce too little (that is, less than 400), there will not be enough output to satisfy the desires of households and business to buy goods and services. In the example above, 400 is Y(e), the equilibrium level of GDP, because it is the only level of output sustainable by market forces alone. 5. If Y = C + I(p) determines Y(e), then changes in C or I(p) can cause changes in Y(e). This is what we observe over the "business cycle." To understand changes in GDP over time, we have to ask why aggregate expenditures, C + I(p) would change over time. When we study these relationships, we find that the relationship between consumption and disposable income is very stable. Even though households buy about 2/3 of the GDP each year, fluctuations in GDP over time apparently are not due primarily to fluctuations in consumption spending. Investment
spending, however, tends to be very unstable. Even though investment expenditures are much smaller than consumption expenditures, as a percentage of GDP, their instability can cause cyclical fluctuations in the economy. 6. Keynes hypothesized that investment expenditures by business firms would be inversely related to the interest rate that firms paid to borrow the funds to undertake the investment. This gives rise to the "investment demand function" which depicts increased amounts of investment expenditures at lower rates of interest. In forecasting future (equilibrium) values of GDP, economists must estimate the form of the consumption function and the predicted amount of investment expenditures. In order to do the latter, it is first necessary to predict future interest rates. We will develop a theory of interest rate determination in Chapter 16. For the moment, we must simply "assume" that economists can forecast future interest rates and, given these forecasts, can predict the future value of equilibrium GPD. Keynes believed that the level of investment expenditures, while inversely related to the rate of interest, was "autonomous" (or independent of) the current level of GDP. The logical sequence is as follows: (1) predict the future value of the rate of interest; (2) using the investment demand schedule, predict the amount of investment expenditures; and (3) add these investment expenditures (a fixed amount) to consumption expenditures so that a new aggregate expenditures function may be developed. This aggregate expenditures functions indicate the total of consumption + investment expenditures predicted to occur each possible GDP level. Where this Y = C + I schedule crosses the 45 degree line in the aggregate expenditures model, the total of aggregate expenditures will be equal to total production (GDP) so that an equilibrium level of GDP is found. The C + I schedule is parallel to the consumption line because of the assumption of "autonomous" investment (so that the amount of predicted investment expenditures are the same no matter whether the amount of GDP produced is large or small.