Classical Vs Keynenesian System
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Transcript of Classical Vs Keynenesian System
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1
TheClassicalModel
Chapter7
Lecturenotespostedonline
2
TheClassicalModel
Modelofoutputdeterminationandeconomy
wideequilibrium
Canbeusedtostudyeconomicgrowthand
businesscycles
Consideredamorecompletedescriptionofthe
longrunthantheshortrun
3
KeyBuildingBlocks
Closedeconomy(noexportsandimports)
Populatedbytwotypesofagents
Households
Firms
(Laterwillalsoaddgovernment)
4
KeyBuildingBlocks
Agentsinteractinthree markets
GoodsMarket(GM)
LoanableFundsMarket(LFM)
LaborMarket(LM)
Marketsarecompetitive
LikeinEcon101,demandandsupply
determinetheequilibriumoutcome
5
Labor Market
Goods market
Loanable Funds
MarketHouseholds Firms
AgentsandMarketsinClassicalModel
laborlabor
goods
funds for
investmentsavings
goods
6
Markets
Goodsmarket iswherefirmsselltheiroutputto
households(consumptiongoods)andotherfirms
(investmentgoods)
Loanablefundsmarket iswherehouseholdsavefundsforinterest,andfirmsseekfundstofinance
investmentprojects
Labormarket iswherehouseholdsofferlabor,
andfirmshirethemtoproducegoods
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Households
Recipientsofallfactorpaymentsbyfirms=
income
Maketwo importantdecisions:
Givenincome,decidehowmuchtosaveSand
consumeC
Giventimeendowment,decidehowmuch
labortosupplytothemarket,andhowmuch
leisuretoconsume
8
Firms
Produceoutputusingcapital(machines)and
labor(people)
Maketwoimportantdecisions:
Howmuchlabortoemploy
Howmuchtoinvestinnewmachines,thatwill
resultinmorecapitalinthefuture
9
Savings/ConsumptionDecisionofHH
Willassumehouseholdsdecidetosavea
constantfractionoftheirincome: S=sY
Impliesconsumptionisalsoaconstantfraction
ofincome:C=YS=(1s)Y
Example:s=1/3,ifincomeis150,S=50,
consumptionisC=YS=(11/3)150=100
10
ImpliedSupplyofSavings
Supplyofsavingsbyhouseholdsasfunctionof
interestrate(returnonsavings)
Interest
rate
Savings
sY
11
Labor/LeisureChoiceofHH
Assumehouseholdssupply1unitoflaboreach,
andsosupplyoflaborsimplyequalspopulation
size=L
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SupplyofLabor
Supplyoflaborbyhouseholdsasafunctionof
realwage(realcompensationoflabor)
Real
wage
Labor
L
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ProductioninFirms
Produceoutputusingcapital(machines)Kandlabor(people)L
Productionsummarizedisbyaproductionfunction
Example:
Assumedpropertiesoftheproductionfunction:
Outputincreasinginlaborandcapital
Diminishingreturnsfromlaborandcapital
Returnstoscaleareconstant
Y = KL
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PropertiesofProductionFunction
Increasinginlaborandcapital
Addlabororcapital outputwillincrease
Diminishingreturnsfromlaborandcapital
Addlaborwhilekeepingcapitalfixed outputincreases,butincrementssmallerandsmallerasyoukeepaddingmoreandmorelabor
Returnstoscaleareconstant productionprocessisreplicable doublelaborandcapital,andoutputwillexactlydouble
15
DiminishingReturnsFromLabor
Fix capital: K=10 (for example)
Labor L
Output
Same change
in labor
Big
Tiny
16
DiminishingReturnsFromCapital
Fix labor: L=10 (for example)
Capital K
Output
Same change
in capital
Big
Tiny
17
DemandforLabor
Diminishingreturnsfromlabor demandfor
labordecreasingfunctionofrealwage
GivenafixedlevelofcapitalK,each
incrementalworker
adds
less
and
less to
production
Costofhiringaworkerincreases firmsare
willingtohirefewerworkers
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DemandforLabor
Demandforlabor(forafixedlevelofcapitalK)
Real wage
(W/P)
Labor
(people)
Labor
demand
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DemandforLabor
IncreaseincapitalKshiftslabordemand
Real wage
(W/P)
Labor
(people)
Labor
demand
More
capital
20
DemandforInvestment(Funds)
Diminishingreturnsfromcapital demandfor
investmentdecreasingfunctionofinterestrate
GivenafixedleveloflaborL,eachincremental
unitofcapitaladdslessandlesstoproduction
Costoffundsincreases firmswantto
investless
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DemandforInvestment(Funds)
Demandforfunds(forafixedleveloflabor)
Interest Rate
Number of
Machines
Demand for
more
machines
22
DemandforInvestment(Funds)
Increaseinlaborforce(here=population)shifts
demandforinvestment
Interest Rate
Number of
machines
Demand for
more
machines
Population
growth
23
Recap
Sofar,determineddemandandsupplyin
Labormarket
Loanablefundsmarket
Now,needtoanswerwhatwillbetheoutcomeintheentireeconomy
24
WhatisGoingtoHappen?
Equilibriumofasystemisastateofthesystemin
whichtherearenointernalforcesinthesystem
toproduceachange
This is notan equil ibrium This is an equil ibrium
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WhatisGoingtoHappen?
Equilibriuminthismodeliswhenallmarkets
clear
Demandforlabor=supplyoflabor
Demandforinvestment=supplyoffunds
Alloutputgetssold,i.e.plannedconsumption
andplannedinvestmentequalsoutput(C+I=Y)
26
EquilibriumEmploymentL
LabormarketequilibriumdeterminesL
Real wage
(W/P)
Labor
(people)
Labor supply = L
Labor demand
L
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EquilibriumOutputY
YdeterminedbyL(capitalKpredetermined)
Output
Labor
(people)
Labor supply = L
Labor demand
Production function (at fixed level of K)
Real wage
(W/P)
Labor
(people)
Y
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Equilibrium(Planned)InvestmentI
LoanablefundsmarketdeterminesinvestmentI
Interest Rate
Investment
sY
Demand for
investment I
I=sY
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SaysLaw:SpendingPurchasesOutput
Intheclassicalmodel,alloutputgetssold
automatically,andsoC+I=Y
Wedonotneedtoworryaboutthegoods
market Followsfromasimpleaccountingidentity
impliedbythecircularflows
30
CircularFlowsintheClassicalModel
Labor Market
Households Firms
Consumption+Investment
Expenditures
Goods market
GoodsCo
nsump
tionEx
penditu
res
Goods
Loanable Funds
Market
Savings SSupply
of Funds
Investment I
Investment
Projects
Demand
for Funds
Incom
elabo
rIncome
labor
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SaysLaw:Outflows=Inflows
Labor Market
Households Firms
Consumption+Investment
Expenditures
Goods market
GoodsCo
nsump
tionExpen
ditures
Good
s
Loanable Funds
Market
Savings SSupply
of Funds
Investment I
Investment
Projects
Demand
for Funds
Incom
elabo
rIncome
labor YY=C+S
S
CC+I=C+S=Y
I=S
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SaysLaw:Outflows=Inflows
Yflowsfromfirmstohouseholds(bydefinition
Y=C+S)
Ontheexpenditureside
Sflowsout
Iflowsin
Sinceinequilibriumintheloanablefunds
marketS=I,outflows=inflows,andsoC+I=Y
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TodaysKpredetermined,butfutureKevolves
withinvestment
Capitaltomorrow=capitaltoday
depreciationofcapital+investment
Where isdepreciationrateofcapital(fraction
ofcapitalwornoutinproduction)
WhatHappenstoCapitalK?
(1 )tomorrow today
K K I= +
34
WhatHappenstoCapitalK?
Ourequilibriumisastaticequilibrium
Givencapital,wepindowninvestment,
employmentandoutput
Itraisesquestionswheretheeconomyisheading
inthefuture
Willmakecapitalpartofouranalysissoon
35
AddingGovernmenttotheModel
Keyassumptions:
GovernmenttakesawaynettaxesTfrom
householdsfactorincomeYandspendsG in
thegoods
market
on
goods
and
services
36
AddingGovernmenttotheModel
Households Firms
DisposableIncome
=Y-T
Gover
nmen
t
Expen
dituresG
Consu
mption
Expen
ditures
C
Facto
rpaym
ents=
Y
Totalexpenditures
C+I+G
InvestmentI
NetTaxesT
Government
Savings
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KeyModifications
GovernmentsavingsTG(ordeficitifnegative)
affectstheloanablefundsmarket
WhenTG>0,governmentssavesandsupplies
fundstotheLFmarket
WhenTG0
Governmentborrows intheloanablefunds
market
Budgetsurplus isasituationwhengovernment
nettaxreceiptsexceedsspendingTG>0
Governmentsaves intheloanablefunds
market
39
ModifiedLoanableFundsMarket
1.75 Trillions of Dollars
Interest Rate
E
S+T-G(private savings+ government
savings)
Total Demandfor Funds(planned
investment byprivate sector)
S+T-G=I
40
SaysLawHoldswithGovernment
Again,thinkintermsofinflowsandoutflows
Yflowsfromfirmstohouseholds
SandTflowsout
IandGflowsin
S+TG=Iinequilibriuminloanablefundsmarket
So,again,whatflowsoutS+T,flowsinasI+G,and
soC+I+G=Y
Algebraically, C+I+G=C+S+TG+G=C+S+T=Y
41
SaysLawHolds:Red =Green
Households Firms
DisposableIncome
=Y-T
Gover
nmen
t
Expen
dituresG
Consu
mption
Expen
ditures
C
Facto
rpaym
ents=
Y
Totalexpenditures
C+I+G
InvestmentI
NetTaxesT
Savings
42
NumericalExample
Suppose,G=0,T=0,s=.2,L=10,K=10,and
Y=K1/2L1/2,calculateoutputandinvestmentinthe
equilibriumoftheclassicalmodel
Assumedepreciation
rate
of
capital
=10%
(10%
ofcapitalstockwearsouteachperioddueto
aging).Whatwillbethelevelofcapitalnext
period?
Isitmoreorlessthantoday?
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Solution
Y=K1/2L1/2=10
S=s(YT)=.2x10=2
Inequilibrium,I=S+TG,andsoI=2
Ktomorrow=.9Ktoday+2=.9x10+2=11
11>10,Kisgrowing
Ktoday=10
Ktomorrow=11
44
Dynamic(Longrun)Equilibrium
45
DynamicEquilibrium
Sofar,silentaboutK
GivenpredeterminedcapitalK,determined:
output,investmentandemployment
Inotherwords,determinedstaticequilibrium
(withinaperiod)butnotdynamic(across
periods)
Ourgoal:Findoutwheretheeconomyisheading
inthefuture?
46
BasicIdea
Futureoutput,investmentandemployment
dependsontodaysinvestment
Evolutionofcapitalfromoneperiodtothenext
criticaltodeterminewheretheeconomyis
heading
47
EvolutionofCapital
Recallourassumption:
IMPLIES:FuturecapitaldependshowinvestmentI comparestodepreciationK
(1 )tomorrow today K K I= +
(1 ) ,
ands o,
tomorrow today today today
tomorrow today today
K K I K K I
K K I K
=
= + = +
48
EvolutionofCapital
Theaboveequationimplies:
I> Ktoday capitalKgrows
I
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FindingOutWhereEconomyIsHeading
Capital K
Output (determined
by productionfunction and
capital K)
L fixed = population size (always true in static equilibrium)
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FindingOutWhereEconomyIsHeading
Capital K
Output Y
Investment = sY
Constant fraction of
output
51
FindingOutWhereEconomyIsHeading
Capital K
Output Y
Investment = sY
Constant fraction of
output
52
FindingOutWhereEconomyIsHeading
Capital K
Output Y
Investment sY
Capital Depreciation K
A straight line
53
FindingOutWhereEconomyIsHeading
Capital K
Output Y
Investment sY
Investment>Depreciation InvestmentDepreciation Investment
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FindingOutWhereEconomyIsHeading
Capital K
Output Y
Investment sY
Dynamic
equilibrium
Investment>Depreciation Investment