Chapter_7 - Chapter 7 Economic Instability: A Critique of...

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Chapter 7 Economic Instability: A Critique of the Self Regulating Economy
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Review of the Classical Position • Say’s Law holds, so insufficient demand in the economy is unlikely. • Wages, prices, and interest rates are flexible. • The economy is self-regulating. • Laissez-faire is the right and sensible economic policy to implement.
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Unemployment: the result of a short-lived adjustment period. Prices and wages adjust to restore full employment Adam Smith (1723-1790) The Classical School of Economics The Keynesian School of Economics John Maynard Keynes (1883-1946) Unemployment: the result of long-term inadequate demand. Inflexible prices and wages result in persistent unemployment.
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Questioning the Classical Position: Keynes • According to Keynes, it was possible for saving to increase and aggregate demand to fall. • Individuals save and invest for a host of reasons. • Saving is more responsive to changes in income than to changes in the interest rate. • Investment is also responsive to technological changes, business expectations, and innovations in addition to the interest rate.
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Keynes on Interest Rates • Saving and investment depend on a number of factors. • The interest rate is important in determining the level of investment, but other variables, such as the expected rate of profit, can be more important.
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Keynes view of Say’s Law in a money economy
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Keynes on Wage Rates • Employees will resist an employer’s efforts to cut wages. • Wages may be inflexible in the downward direction. • The economy may not automatically cure itself of a recessionary gap. • The economy may not be self-regulating.
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The economy gets “stuck” in a recessionary gap
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New Keynesians and Wage Rates • Keynes was criticized because he didn’t offer an adequate explanation of inflexible wages. • Efficiency wage models provide a solid microeconomic explanation for inflexible wages. Efficiency Wage Models : it is sometimes in the best interest of business firms to pay their employees higher-than-equilibrium wage rates
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Keynes on Prices The internal structure of an economy is not always competitive enough to allow prices to fall. Implication: Some prices are sticky.
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Is it a Question of the Time it Takes for Wages to Adjust? Classical (New Classical and Monetarists) Economists : Wages adjust quickly enough to consider the economy self-regulating. Keynesian (New Keynesian): Wages adjust so slowly that one cannot say the economy is self- regulating.
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How long it takes for wages and prices to fall
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Keynesian Theory ASSUMPTIONS The price level is constant There is no foreign sector The monetary side of the economy is excluded.
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Saving • A household can do two things with its income: It can buy goods and services—that is, it can consume , or it can save . • Thus we have
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This note was uploaded on 11/28/2010 for the course ECON 201 taught by Professor Dr.sharma during the Spring '08 term at Ohio State.

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Chapter_7 - Chapter 7 Economic Instability: A Critique of...

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