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Principles Of Economics

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1 Principles Of Economics
Power Point Presentation Chapter 13 Keynes and Keynesian Macroeconomic Policy April 5, 2007 © J. Patrick Gunning

2 What Is Macroeconomic Policy
Macroeconomic problems: 1. How to promote economic growth. 2. How to maintain an acceptable level of unemployment. 3. How to maintain an acceptable level of inflation. Macroeconomic policy refers to government policy that attempts to “solve these problems.”

3 Birth Of The Idea Of Macro Policy
The unemployment of the great depression. Followed by WWII. In 1946, would the depression and its unemployment return? The Employment Act of 1946 was passed.

4 A Shift Of Faith The act gave the executive branch of the U.S. government the power and responsibility to try to carry out macroeconomic policy. The Employment Act signified that, for many citizens, a faith in unrestricted free enterprise had been replaced by a faith in government guidance of free enterprise.

5 Types Of Macroeconomic Policies Since 1946
1. Keynesian economics ( s). 2. Monetarism (began to influence policies beginning in the 1970s). 3. Supply-side economics (mid-1970s to 1990s).

6 Two Parts of This Chapter
1. The Economics of Keynes. 2. Keynesian economics: the macroeconomic policy proposed by economists who roughly followed the economics of Keynes.

7 New Topic: The Economics Of Keynes
Keynes: famous economist at Cambridge University in England. Wrote The General Theory Of Employment, Interest And Money (1936). Difficult-to-read book about unemployment and output in a recession.

8 First Point: Keynes’s Hypotheses About Real Output And Business Cycles
Keynes made two important points: 1. Real output may not reach its potential because there may be less than the optimal amount of entrepreneurship. 2. Business cycles are likely to be more severe than neoclassical economists believed because: A. Entrepreneurs' investment is unstable. B. Wages are rigid. C. Lenders may speculate on the rate of interest.

9 Real Output Less Than Its Potential
Real output gap: a gap between the actual real output and potential real output. Keynes believed that there would be a real output gap due to risk averseness. Risk averse: the characteristic of a person who is less willing to choose a prospect for gain with an uncertain payoff than to choose on one with a certain payoff. Risk averseness is measured by comparing the expected payoff of each prospect.

10 Risk Averseness Consider two prospects for gain:
A: a 100 % probability of receiving $100. B: a 50 % probability of receiving $200. B is more risky because the probability of receiving it is lower. Which would you prefer? If you prefer A, you are risk averse. If you prefer B, you are a risk preferrer. If you are indifferent, you are risk neutral. Risk premium: the amount of money that a person demands in order to compensate him for accepting an alternative that is more risky than other. An example.

11 Second Point: The Business Cycle Is Likely To Be More Severe Than We Think
Three reasons: 1. Entrepreneurs’ errors. 2. Rigid Wages. 3. Speculation by Lenders (the liquidity trap).

12 1. Entrepreneur Errors Entrepreneurial investment may exaggerate the amplitude of the business cycle because entrepreneurs may exhibit “follow the leader” over-optimism or over pessimism. Entrepreneurs are subject to mass psychology. They may jump on the bandwagon and follow the crowd instead of making decisions based on a sound assessment of revenues and costs.

13 2. Rigid Wages Keynes: the presence of rigid wages cause unemployment to be higher during a business cycle than one might think on the basis of demand and supply analysis. Workers may be happy to accept increases in pay during an expansion but unwilling to accept decreases during a contraction. Union leaders may resist an employer’s proposal to decrease wages. The employer may have no option but to lay off workers, causing unemployment.

14 3. Speculation By Lenders
The hypothesis: speculation by lenders may stop complete coordination in markets for loanable funds.

15 How Coordination Occurs
Review of a normal adjustment to a decrease in demand for loanable funds. Suppliers reduce the interest rate and the quantity of loanable funds. See figure 13-1.

16 Figure 13-1

17 Lender Psychology May Block Coordination In The Loan Market
If you were a lender and expected the loanable funds rate to rise on one-year loans, you may not want to lend. If every lender was like you, no lending would occur. Consider figure 13-2.

18 Figure 13-2

19 Rate Cannot Fall Below 2%
Suppose that once the rate fell to 2%, everyone expects it to rise in the near future. Then it could not fall to 1% even though the supply of loanable funds curve shows that some lenders would be willing to lend at 1%. Because lenders speculate on the rate of interest, at 2% the supply of loanable funds would go to zero.

20 Keynes’s Idea In Terms Of Liquidity
Liquidity: the character of an asset based on the extent to which it can be easily exchanged for goods. Money is the most liquid asset. When the interest rate falls to 2%, lenders want more liquid assets than the one-year loans.

21 Liquidity Trap Liquidity trap: the hypothesis that below some rate of interest, lenders would make no loans because they expect that the rate would rise. The loanable funds market in figure 13-2 is in a trap because below a certain rate of interest, lending would cease.

22 Keynes Assumption About The Loanable Funds Market
Keynes did not assume, as we have done, that there are many loanable funds markets, each with a different length and starting time. The liquidity trap hypothesis did not consider the short-term loan market.

23 Keynes’s Corrective Policy
To assure that business firms remain profitable during a recession. This can be done by stabilizing aggregate spending.

24 New Topic: Keynesian Economics
The Employment Act of 1946 led the president to form a Council of Economic Advisors. Keynes died in 1946. Members of the Council, interpreters of Keynes, and their colleagues developed a set of principles for carrying out macroeconomic policies. Around 1950, these principles were included in the first textbooks that distinguished macroeconomics as a separate field of study.

25 Macroeconomics And Microeconomics As Defined In The Textbooks
Macroeconomics: the study of “the economy as a whole” and the policies that could be used to guide it. Microeconomics: the study of markets and prices.

26 Macroeconomic Equilibrium
Keynesian macroeconomic model: a model of aggregate demand and aggregate supply of Keynesian real output produced during a period of time. Macroeconomic equilibrium: the price level and level of Keynesian real output at which aggregate demand equals aggregate supply.

27 Aggregate Demand Aggregate spending: spending on Keynesian real output. Keynesian real output: final products produced during a period of time, including services. It does not refer to unfinished products or to used goods. Aggregate demand (curve): the amount of spending on Keynesian real output that we assume would occur at different price levels.

28 Components Of Keynesian Spending
The class divisions of and the names assigned to the classes are based roughly on who spends on the final products. 1. Consumption spending (C): spending by households on finished goods and on services. 2. Investment spending (I): spending by business on newly-produced capital goods, increases in business inventories of finished products, and spending by households on new houses (Households spend on this. It is an exception.) 3. Government spending (G): spending by governments.

29 Graph of Aggregate Demand Curve

30 Why Aggregate Spending Might Be Higher At Lower Price Levels
1. Consumer spending might be higher because households are likely to feel that they can afford to buy more goods at lower prices. 2. Businesses investment spending is likely to be higher because when the price level is low, interest rates are also low.

31 Aggregate Demand Curve vs. Ordinary Demand Curve
The ordinary demand curve for a consumer good refers to the marginal consumer’s evaluation of an additional unit. The ordinary derived demand curve for a resource refers to the marginal entrepreneur’s belief about the additional revenue he can earn from employing one more unit. The aggregate demand is unrelated to these. It is the total real output on which spending is assumed to occur at different levels of prices. More spending is assumed to occur at lower price levels.

32 Aggregate Supply Aggregate supply: the amounts of different finished goods and services produced during a period of time. The goods and services are produced by business firms and by government agencies. Aggregate supply (curve): the amount of Keynesian real output that is produced by producers of products at different price levels plus the real amount of government production.

33 Graph of Aggregate Supply Curve

34 Why Aggregate Supply Might Be Higher At Higher Price Levels
Possibility 1: firms produce a larger output at higher price levels than they produce at lower price levels. Possibility 2: firms charge higher prices for higher quantities of goods, perhaps because they must do so in order to hire more resources.

35 Aggregate Supply Curve vs. Ordinary Supply Curve
The ordinary supply curve is a marginal cost curve. It represents the cost to the marginal entrepreneur of producing the next unit. It also represents the utility foregone when resources are not used to help cause other goods to be produced and consumed.

36 Model Of Macroeconomic Equilibrium: Figure 13-3

37 Explanation of Figure 13-3
Macroeconomic equilibrium (figure 13-3): the combination of price level and real output at which aggregate demand equals aggregate supply, i.e., where the aggregate demand curve and the aggregate supply curve cross. Firms would not want to produce a larger quantity than qe.

38 Adjustment In Price Level And Real Output If The Macroeconomy Is Out Of Equilibrium
At p1 in figure 13-3, producers would produce goods that they cannot sell. At such a price level, consumers would feel too poor to buy all the consumer goods that have been produced. The price level would tend to fall leading businesses to cut back production. At p2 in figure 13-3, producers will have produced a lower real output than the spending that consumers, businesses, and the government want to do. The price level would tend to rise leading business investment to increase, thereby increasing real output.

39 Demand And Supply Shocks
Demand shock: a shift in the aggregate demand curve – households, firms or government want to spend more or less than before at each price level. Cause? A change in confidence, perhaps due to a change in housing prices or a change in the stock market, a particularly cold winter, or a storm-prone summer. Supply shock: a shift in the aggregate supply curve – firms want to supply more or less than before at each price level. Cause? A disaster that affects energy supplies, a major technological advance.

40 Effects Of A Demand Shock: Figure 13-4

41 Effects Of A Supply Shock: Figure 13-5

42 Two Kinds Of Macroeconomic Policy
Fiscal policy. Monetary policy.

43 Fiscal Policy To Affect Equilibrium Real Output
Fiscal policy: increases and decreases in government spending and consumer taxation. Expansionary fiscal policy: reducing taxes and/or raising government spending. Contractionary fiscal policy: raising taxes and/or reducing government spending.

44 Expansionary Fiscal Policy
Keynesians believed that this policy could maintain real output and employment at high levels. It could insure that firms would not make losses. They believed that it can prevent a contractionary phase in the business cycle and, therefore, prevent the unemployment rate from falling below a target level. Reducing taxes raises consumer spending (C). Both this and increased government spending (G) raise aggregate demand.

45 Contractionary Fiscal Policy
Keynesians believed that this policy can prevent or moderate the expansionary phase of a business cycle and control inflation. Raising taxes would reduce consumer spending (C). Both this and a reduction in government spending (G) would reduce aggregate demand.

46 Popular Keynesian Beliefs About Fiscal Policy
1. Keynesians believed that expansionary fiscal policy can prevent or moderate the contraction phase of the business cycles and, therefore, maintain real output at a high level and reduce unemployment. 2. Keynesians believed that contractionary fiscal policy can prevent or moderate the expansionary phase of a business cycle and, therefore, help control inflation.

47 Full Employment Equilibrium
The goal of Keynesian fiscal policy is full employment equilibrium. Full employment equilibrium: a macroeconomic equilibrium at which a target level of unemployment is achieved – also called full employment GDP (gross domestic product). GDP, adjusted for inflation, is a statistical measure of real output.

48 Three Models Of Full Employment Equilibrium: Figure 13-6

49 Actions Needed To Achieve Full Employment Equilibrium
Left panel: full employment economy – no action necessary. Center panel: unemployment economy – expansionary fiscal policy needed to achieve full employment equilibrium. Right panel: inflation economy – contractionary fiscal policy needed to achieve full employment equilibrium.

50 Keynesian Views On Negative Supply Shocks
1. Expansionary fiscal policy can offset the effects of negative demand shocks. 2. Expansionary fiscal policy can offset the effects of negative supply shocks.

51 Mediating The Effects Of Negative Shocks
Beginning with a full employment equilibrium, assume that there is a negative demand shock. The center panel of figure 13-6 can be used to represent the resulting unemployment economy. To mediate the effects, the government could raise aggregate demand. The same reasoning applies to a negative supply that shifts a full employment economy to an unemployment economy.

52 Monetary Policy To Help Achieve Full Employment Price Stabilization
Two types of monetary policy: 1. Expansionary monetary policy: central bank policy that is intended to raise aggregate spending by increasing business investment spending (I). 2. Contractionary monetary policy: central bank policy that is intended to reduce aggregate spending by reducing business investment spending (I).

53 Keynesian Views On Monetary Policy
1. If the economy is an unemployment economy, expansionary monetary policy can increase investment demand and raise the equilibrium real output to the full employment level. 2. If the economy is an inflation economy, contractionary monetary policy can reduce investment demand and reduce the equilibrium real output to the full employment level, thereby reducing the price level.

54 An Analogy: Bringing A Pot To Its Boiling Point
If it overheats, turn down the heat. If it is not hot enough turn up the heat.

55 Knowledge Needed to Achieve Keynesian Goals
The problem of timing and placing the Keynesian policy so that it exactly offsets the demand or supply shock. Government agents must know when a shock is likely to occur. Government agents must know the particular industries that are effected, the nature of the effects, and when they will occur.

56 Problems in a Democracy
Fiscal policy requires legislation which, in a democracy, may take a long time to pass. Monetary policy is easier to put into effect. However, its affects are much broader. It cannot pinpoint specific industries. Improperly timed and placed fiscal or monetary policy could have effects that are just the opposite of those desired by the Keynesians.

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