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CLASSICAL THEORY OF MACROECONOMICSMacro economics theory and policy by DN Dwivedi & Tata McGraw-Hill1POSTULATES OF CLASSICAL THEORYThere is always full employmentThe economy is always in a state of equilibriumLaissez faire economyMoney doesnt matterSays lawTata McGraw-Hill2John Maynard Keynes

Tata McGraw-HillThe centerpiece of classical economics is Says law or LAW OF MARKETS Says law states, Supply creates its own demandThis means that somehow, what we produce supply all gets sold

Tata McGraw-HillThe Keynesian Critique of the Classical System Until the Great Depression, classical economics was the dominant school of economic thoughtAdam smith, credited by many as the founder of classical economics believed the government should intervene in economic affairs as little as possibleJohn 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 DepressionTata McGraw-HillThe Keynesian Critique of the Classical System

Keynes asked the question. What if savings and investment were not equal?

Tata McGraw-HillThe Keynesian Critique of the Classical System

Keynes disputed the view that the interest rate would equilibrate savings & investmentKeynes maintained thatSaving and investment are done by different people for different reasonsMost saving is done by individuals for big ticket itemsInvesting is done by those who run a business and are trying to make a profitThey will invest only when there is a reasonably good profit outlookEven when interest rates are low, business firms wont invest unless it is profitable for them to do so

Tata McGraw-HillThe Keynesian Critique of the Classical System

Keynes questioned whether wages and prices were downwardly flexible, even during a severe recessionStudies have indicated that prices are seldom lowered and that wage cuts (even as the only alternative to massive layoffs) are seldom acceptedKeynes pointed out that even if wages were lowered, this would lower workers incomes, consequently lowering their spending on consumer goodsTata McGraw-HillThe Keynesian SystemKeynesian theory can be summarized with the statement, Demand creates its on supply Keynes maintained that aggregate demand is the prime mover of the economyAggregate demand determines the level of output and employmentBusiness firms produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners will plan to buyTata McGraw-HillAggregate Demand Exceeds Aggregate SupplyWhen aggregate demand exceeds aggregate supply the economy is in disequilibriumOutput is increased in responseEventually, the economy approaches full capacity followed by price increasesIt appears that there are two ways to raise aggregate supplyBy increasing outputBy increasing pricesBy doing this, aggregate supply is raised relative to aggregate demand and equilibrium is restored

Tata McGraw-HillAggregate Supply Exceeds Aggregate DemandWhen aggregate supply exceeds aggregate demand the economy is in disequilibriumInventories rise and output is decreasedWorkers are laid off, further depressing aggregate demand as these workers cut back on their consumptionEventually, inventories are sufficiently depletedIn the meantime, aggregate supply has fallen back into equilibrium with aggregate demand

Tata McGraw-HillSummary: How Equilibrium Is AttainedWhen the economy is in disequilibrium, it automatically moves back into equilibriumIt is always aggregate supply that adjustWhen aggregate demand is greater than aggregate supply, aggregate supply risesWhen aggregate supply is greater than aggregate demand, aggregate supply declines

Tata McGraw-HillSummary: How Equilibrium Is Attained

Aggregate demand (C + I) must equal the level of production (aggregate supply) for the economy to be in equilibriumWhen the two are not equal, aggregate supply must adjust to bring the economy back into equilibriumTata McGraw-HillKeynesian Policy Prescriptions

Keyness position was that recessions are not necessarily temporaryThe self-correcting mechanisms of falling interest rates and falling prices and wages might be insufficient to push investment and consumption back up againTherefore it is necessary for the government to intervene by spending money

Tata McGraw-HillThe great Depression of 1930sVery High Production after WW1Decrease in price of goods and services Oversaw actual economic demandNumber of Industries suffered Didnt increase demandHigh unemployment Mass layoffHuge Wage cut UnderProduction / GDP fellDidnt improve employmentCould not stimulate DemandBig question- Why was economy sluggish?Tata McGraw-HillThe great Depression of 1930sVery High Production after WW1Decrease in price of goods and services Oversaw actual economic demandNumber of Industries suffered Didnt increase demandHigh unemployment Mass layoffHuge Wage cut UnderProduction / GDP fellDidnt improve employmentCould not stimulate DemandBig question- Why was economy sluggish?Tata McGraw-HillKeynesian MacroeconomicsHis arguments were: Due to the presence of strong labor union wage cut is not possible. Therefore Wage is sticky downwards and flexible upwardsEconomy, thus, does not operate at full employment level, but at less than full employment level. Role of government is crucial because its policy decisions can affect level of aggregate demand, which in turn affects economic growth, employment and general price levelTata McGraw-HillKEYNESIAN THEORYKeynesian economics is a theory suggested by John Maynard Keynes in which government spending and taxation is used to stimulate the economy. This theory is also called DEMAND-SIDE ECONOMICS.Tata McGraw-HillSo his theory was that the government should actively intervene in the economy to manage the level of demand.These policies are often known as DEMAND MANAGEMENT POLICIES, aptly named since the idea of them is to manage the level of aggregate demand.Tata McGraw-HillWe can see these policies in the graph below:AD1AD2AD3AD4Q1Q2Q3Q4PRICESOUTPUTIf aggregate demand is low (AD1), then government should pursue Reflationary policies, such as cutting taxes or boosting government spending to push AD higher and boost employment and output.Tata McGraw-HillWe can see these policies in the graph below:AD1AD2AD3AD4Q1Q2Q3Q4PRICESOUTPUTHowever, if aggregate demand is high (AD4), causing demand-pull inflation, then government should pursue Deflationary policies, such as increasing taxes or cutting government spending to reduce demand.Tata McGraw-HillTo explain Keynesian theory of income determination, the entire economy is divided into 4 sectors :1.Household sector2.Firms or business sector3.Government Sector4.Foreign SectorThe Keynesian theory of income determination is present in the following 3 models:2 sector model including household and firm3 sector model including household firm and government4 sector model including foreign sector with the three sector model.

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