chapte9 - Chapter 9 Classical and Keynesian Theories I...

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Chapter 9: Classical and Keynesian Theories I. Classical and Keynesian theories of Aggregate Spending A. Classical Theory believes that full-employment is the employment level the economy will return to, and tends to remain at in the long run. Graphically, the pure Classical theorists would have a vertical AS curve that shows the same GDP (GDP*) associated with full-employment, at each price-level in the economy. B. Keynesian Theory holds that unemployment is the normal state of the economy and significant government intervention is required if employment/output targets are to be reached. In this view, AS is horizontal. C. The Classical reasoning: 1. Say’s law: Supply creates its own Demand. This reflects the “simple circular-flow model,” that had firms employing all the resources (which are owned by households) and the costs of these inputs is the income people use to buy all of the output firms produce. 2. Abstinence Theory of Interest: To a great extent, it is the interest rate that influences people’s savings. Money they do not spend (savings) becomes part of the supply in the market for loanable funds. The quantity (horizontal axis) is dollars lent out; the price of loanable funds is the interest rate. Business investment spending (I) is also dependent on the interest rate, which will cause S=I in the long run. 3. Classical theorists held that wages and prices would change proportionately. For example, imagine the prevailing salary is $100,000 a year, and firms have hired so many people at that cost because demand is very high, causing output to increase – and more labor hired shrinks the pool of those unemployed. This becomes an expansion that is not sustainable, above long-run potential AS, which is vertical. All the spending in the economy and the input costs getting passed on to consumers both cause prices to rise. High prices in the product market signal AD to shift left and high wage rates (input costs) cause layoffs (firm decrease output).
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In a recession Classical theorists believed a 20% reduction in wages (to $80,000) would mean a 20% decrease in prices as well. Through wage-price flexibility, output could be maintained at the long run level. D. Keynesian critique of Classical Theories (John Maynard Keynes 1883-1946) 1. Say’s Law – Does better describing the conditions in which it was written (18 th Century France) than industrialized economies. Modern economies have decentralized production but often profit makers are remote and far from the production. Many employees never buy their firm’s products, and wages have an effect on costs, but not the firm’s revenue (total sales). There are many ways to increase Demand more effectively than to push for more output to be produced. 2.
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chapte9 - Chapter 9 Classical and Keynesian Theories I...

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