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Chapter 11 Analyzing Macro Equilibrium

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I. Overview of Classical and Keynesian economics

    A. Classical economics
          1. Dominated philosophically during the late 18th, 19th and early 20th centuries.
          2. First defined by Adam Smith in The Wealth of Nations in 1776.
          3. Two primary beliefs
              a. Full employment was a norm of capitalism.
              b. Laissez-faire (hands-off) government policy was best.
     B. Keynesian economics
         1. Macro equilibrium could settle at an unacceptable level of unemployed resources.
         2. Government intervention could be required to fully employ resources.

II. Classical economics
      A. Basic philosophy
          1. The economy is self-adjusting, government doesn't have to interfere. 
         2. Except for unusual circumstances (war, speculative crises), full employment would be the norm.
     B. Two basic theories
         1. Say's Law
             a. Supply created enough factor income to clear the market 
                 1) Inventories will not accumulate.
                2) A slow down to use excess inventory, which causes unemployment, was not necessary.
             b. Savings is not a leakage because interest rates adjust to insure saving is borrowed and invested (spent).
                 1) Leakage describes the loss of a variable required to maintain a state of equilibrium (stable level of economic activity).
                2) Interest rates drop when savings increase to insure savings is invested and there isn't leakage.
        2. Price-Wage flexibility
             a. During periods of slow economic activity wage rates would fall and everyone wanting to work could find work.
             b. All factor prices, not just wages, would adjust downward and all factors would be fully employed. 
                "Real" factor prices would therefore remain constant.

     
 
III. Keynesian economics
      A. The Great Depression discredited classical economics.
      B. John Maynard Keynes
          1. Wrote The General Theory of Employment, Interest, and Money (1936). 
          2. Disagreed with Say's Law: savings may not be invested.
              a. Interest rates are not the sole determinate of savings and investing.
              b. Saving and investment are done by different people with different motives. Saving may not 
                  equal investment causing goods to go unsold and inventories to increase.
              c. Saving is based upon "liquidity preference," the need to hold money
                  1) Transactionary Motives: for every day use.
                  2) Speculative Motives: save because prices may drop (Japan in late 1990's).
                  3) Precautionary Motives: save due to uncertainty (when a recession is expected).
              d. Investment decisions are based upon profit expectations and interest rates
              e. Money balances (savings) are also important in determining aggregate demand.
        3. Disagreed with price-wage flexibility: prices would adjust downward insuring all resources are fully employed.
            a. Resource prices are inflexible downward meaning resource prices may not adjust and unemployment may persist.
            b. Wages are sticky downward because of unions, monopoly power of corporations, and government policies.
         4. As a result, government involvement may be required to keep AD high enough to maintain full employment.

IV. Classical vs Keynesian equilibrium
       A. Classical explanation
            1. Prices are flexible, output is stable.
            2. Changes in AD cause prices to change, AS determines Real GDP.

       
       B. Keynesian explanation
            1. Output adjusts, prices are stable.
            2. Changes in AD cause changes in employment and Real GDP.

       C. Aggregate supply over the business cycle

           1. QU represents a recessionary level of Real GDP.
           2. QF represents a full-employment level of Real GDP.

       D. Manipulating equilibrium
            1. Classical economists didn't see a need.
            2. Keynesian economists want to manipulate AD by changing C + I + G + XN to maintain noninflationary full employment.

V. General Equilibrium and Economic Efficiency  from UC Berkely

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