1. Classical and Keynesian Economics 11-1 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Aggregate Supply Aggregate supply is the total supply of goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing to sell at a given price level in an economy

3. Aggregate Demand Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and price level. It specifies the amounts of goods and services that will be purchased at all possible price levels

4. Part I: The Classical Economic System The centerpiece of classical economics is Say’s law – Say’s law states, “Supply creates its own demand” – This means that somehow, what we produce – supply – all gets sold – The Classical economics theory is based on the premise that free markets can regulate themselves if left alone, free of any human intervention.

5. Why Does Anybody Work? People work because they want money to buy things – People who produce things are paid. They spend this money on what other people produce – As long as everyone spends everything that he or she earns, the economy is OK But, the economy begins to have problems when people save part of their incomes – People do save, and saving is crucial to economic growth Without saving, we could not have investment – the production of plant, equipment, and inventory 11-5 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

6. The Aggregate Demand Curve Aggregate demand is the total value of real GDP that all sectors of the economy are willing to purchase at various price levels 11-19 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Aggregate Demand Curve (in trillions of dollars) The level of aggregate demand varies inversely with the price level. As the price level declines, people are willing to purchase more and more output. Alternatively, as the price level rises, the quantity of output purchased goes down

7. The Long-Run Aggregate Supply Curve 11-26 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Run Aggregate Supply curve (in trillions of dollars) Why is the curve a vertical line? The classical economists made two assumptions: (1) In the long run, the economy operates at full employment; (2) In the long run, output is independent of prices

8. The Keynesian Critique of the Classical System Until the Great Depression, classical economics was the dominant school of economic thought – Adam smith, credited by many as the founder of classical economics believed the government should intervene in economic affairs as little as possible John Maynard Keynes asked, “If supply creates its own demand, why are we having a worldwide depression?” – John Maynard Keynes advocated massive government intervention to bring an end to the Great Depression 11-30 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

9. Keynesian Policy Prescriptions The Classical position summarized – Recessions are temporary because the economy is self-correcting Declining investment will be pushed up again by falling interest rates If consumption falls, it will be raised by falling prices and wages – Because recessions are self-correcting, the role of government is to stand back and do nothing 11-47 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

10. Keynesian Policy Prescriptions Keynes’s position was that recessions are not necessarily temporary – The self-correcting mechanisms of falling interest rates and falling prices and wages might be insufficient to push investment and consumption back up again – Therefore it is necessary for the government to intervene by spending money How much money? As much money as it takes – When the government spends more money, that’s not the same thing as printing more money. Generally it borrows more money and then spends it Keynes would have prescribed lowering aggregate demand to bring down inflation 11-48 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

11. Contrary to Say's law, which is based on supply, Keynesian economics stresses on the importance of effective demand. Effective demand is derived from the actual household disposable incomes and not from the disposable income that could be gained at full employment, as the classical theories state