•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 (Say’s Law)

–Wages and prices are flexible –Savings always equals investment,

Viewpoints & Models

• Classical Economics (cont.)

Viewpoints & Models

FIGURE 9-1Aggregate Supply and Aggregate Demand in Classical

Economics

•Keynesian Economics John Maynard Keynes, aggregate spending helps determine the level of

macroeconomic activity. Macroeconomy seeks an equilibrium output level.

•Macroeconomic Equilibrium– Amount of total planned spending on new

goods and services equals total output in the economy.

If aggregate spending > current production, then output, employment, and income will all increase.

•Inventories

– Stocks of goods on hand.– Allows for spending to exceed

current production.

Viewpoints & Models

http://www.youtube.com/watch?v=d0nERTFo-Sk

http://www.youtube.com/watch?v=dOnERTFo-Sk

Total Output

Total Spending

Injections – Leakages

Economic Condition

$0.00 0.75

0.50 0.50

1.00 1.25

1.50 1.50

2.00 1.75

2.50 -0.50

3.00 2.25

Total Output

Total Spending

Injections – Leakages

Economic Condition

$0.00 0.75 0.75 Expansion

0.50 1.00 0.50 Expansion

1.00 1.25 0.25 Expansion

1.50 1.50 0.00 Equilibrium

2.00 1.75 -0.25 Contraction

2.50 2.00 -0.50 Contraction

3.00 2.25 -0.75 Contraction

• Keynesian Economics (cont.)

Viewpoints & Models

TABLE 9-1

Total Output and Total Planned Spending (Trillions of Dollars)

3.002.502.001.501.000.50

0 1.00 2.00 3.00

3 6 9

Planned consumption(trillions of $)

Real disposable income

(trillions of dollars)

6

9

12

3

12

45º

45º line

C

Dis-saving

Saving

SavingsSavings

ConsumptionConsumption

• Keynesian Economics (cont.)

Viewpoints & Models

FIGURE 9-2Equilibrium in the Macroeconomy

• 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

Viewpoints & Models

• Keynesian Economics (cont.)

Viewpoints & Models

FIGURE 9-3Changes in Macroeconomic Equilibrium

• 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.

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.

Viewpoints & Models

• New Classical Economics (cont.)

Viewpoints & Models

Aggregate Demand in the New Classical Model

• 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.

Viewpoints & Models

• New Classical Economics (cont.)

Viewpoints & Models

FIGURE 9-5Aggregate Supply in the New Classical Model

• 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.

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.

Viewpoints & Models

• Phillips Curve Curve showing the relationship between an

economy’s unemployment and inflation rates.

Inflation & Unemployment

FIGURE 9-6A Phillips Curve (Hypothetical Data)

• Phillips Curve (cont.)

Inflation & Unemployment

FIGURE 9-7Annual Rates of Unemployment and Inflation in the United States

for 1960–2000 and Representative Phillips Curves

• 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.

Inflation & Unemployment

• 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.

Macroeconomic Viewpoints Summary

1. The equilibrium level of output is:a. $1 trillion.b. $4 trillion.c. $6 trillion.d. none of the above.

2. Injections into the spending stream exceed leakages from the spending stream by approximately $0.5 trillion at an output level of:a. $1 trillion.b. $2 trillion.c. $6 trillion.d. none of the above.

3. The classical economists believed changes in wages and prices would help to ensure that the economy would operate at full employment.4. The classical economists thought that supply creates its own demand and investment spending always equals saving.5. In the Keynesian model, total spending in the economy will be less than total output if leakages from the spending stream are less than injections.6. In the Keynesian model, if leakages from the spending stream are greater than injections, total output will decrease.7. In the new classical model, aggregate supply is upward sloping in the short run, and perfectly vertical at the natural rate of unemployment in the long run.