1. Viewpoints & Models
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,

2. Aggregate Supply and Aggregate Demand in Classical Economics
Viewpoints & Models
Classical Economics (cont.)
FIGURE 9-1
Aggregate Supply and Aggregate Demand in Classical Economics

3. Viewpoints & Models Keynesian Economics Stocks of goods on hand.
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.

4. Total Output
Total Spending
Injections – Leakages
Economic Condition
$0.00
0.75
0.50
1.00
1.25
1.50
2.00
1.75
2.50
-0.50
3.00
2.25

5. Total Output
Total Spending
Injections – Leakages
Economic Condition
$0.00
0.75
Expansion
0.50
1.00
1.25
0.25
1.50
0.00
Equilibrium
2.00
1.75
-0.25
Contraction
2.50
-0.50
3.00
2.25
-0.75

6. Total Output and Total Planned Spending (Trillions of Dollars)
Viewpoints & Models
Keynesian Economics (cont.)
TABLE 9-1
Total Output and Total Planned Spending (Trillions of Dollars)

7. 3.00
2.50
2.00
1.50
1.00
0.50

8. The Consumption Function
Planned consumption (trillions of $)
45º line 12
Saving C 9
Dis-saving 6 3
45º
Real disposable income (trillions of dollars) 3 6 9 12

9. Savings
Consumption

10. Equilibrium in the Macroeconomy
Viewpoints & Models
Keynesian Economics (cont.)
FIGURE 9-2
Equilibrium in the Macroeconomy

11. Viewpoints & Models 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

12. Changes in Macroeconomic Equilibrium
Viewpoints & Models
Keynesian Economics (cont.)
FIGURE 9-3
Changes in Macroeconomic Equilibrium

13. Viewpoints & Models 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.

14. 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.

15. Aggregate Demand in the New Classical Model
Viewpoints & Models
New Classical Economics (cont.)
Aggregate Demand in the New Classical Model

16. Viewpoints & Models 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.

17. Aggregate Supply in the New Classical Model
Viewpoints & Models
New Classical Economics (cont.)
FIGURE 9-5
Aggregate Supply in the New Classical Model

18. Viewpoints & Models 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.

19. Viewpoints & Models New Keynesian Economics Monetarism
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.

20. Inflation & Unemployment
Phillips Curve
Curve showing the relationship between an economy’s unemployment and inflation rates.
FIGURE 9-6
A Phillips Curve (Hypothetical Data)

21. Inflation & Unemployment
Phillips Curve (cont.)
FIGURE 9-7
Annual Rates of Unemployment and Inflation in the United States
for 1960–2000 and Representative Phillips Curves

22. Inflation & Unemployment
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.

23. Macroeconomic 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.

24. 1. The equilibrium level of output is:
a. $1 trillion.
$4 trillion.
$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:
b. $2 trillion.
c. $6 trillion.

25. True or
False
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.