Final Paper due Monday Midnight/8 pages
cap479
eco203_chapter_07.pdf
Part III: Determining Output and Employment: Keynesian
Macroeconomics and Fiscal Policy
The four chapters in this section will introduce you to the theory and practice of fiscal policy. Fiscal policy consists of the use of the taxing and spending powers of government to affect the level of output, employment, and prices. Chapter 7 highlights the ongoing confron- tation between economists in the classical tradition and those in the Keynesian tradition. Chapter 8 develops the Keynesian model as an explanation of why an economy might come to rest at an output level that is considerably below the full employment level and how that output level might change.
Chapter 9 develops the tools of fiscal policy, showing how govern- ment can use its taxing and spending powers to influence the levels of output, employment, and prices. This is a practical chapter that looks at not only the theory of fiscal policy but also the myriad prac- tical problems and issues raised by using the government’s budget as a macro policy tool.
Chapter 10, finally, focuses on the most significant fiscal policy issue of the last decade: the budget deficit and the national debt. This chapter looks at the source of the deficit, its impact on the national economy, and the options that exist for addressing the deficit and the national debt.
Contents
Chapter 7: Classical Macroeconomics and the Keynesian Challenge
Chapter 8: The Keynesian Model
Chapter 9: Taxes, Government Spending, and Fiscal Policy
Chapter 10: Budget Deficits and the National Debt
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Learning Outcomes
By the end of this chapter, you will be able to:
• Explain Say’s law and describe why the economy should be self-correcting.
• Understand why the product, labor, and credit markets ensure that the economy will return to the full-employment level of output.
• State the quantity theory of money and explain why an increase in the money supply leads to an increase in the price level.
• Describe limitations of the classical model and explain why the Keynesian theory took over.
• Comprehend the primary foundations of the Keynesian model.
7
Classical Macroeconomics and the Keynesian Challenge
Bettmann/Corbis
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CHAPTER 7Pre-Test
Introduction
In 2008, the two major party candidates for U.S. president spent some time discussing what the government could do in response to the turmoil in the economic markets, the series of bank failures, the number of rising foreclosures in the United States, and the tough job market. Many commentators and experts debated what could be done to try and stimulate a stagnant economy. In October of 2008, Congress passed a historic govern- ment bailout package, called the Troubled Asset Relief Program, in an effort to stop the bleeding. Barack Obama, then a senator and presidential candidate, argued that the pas- sage of this emergency rescue plan was necessary to prevent an economic catastrophe that could have cost millions of jobs and forced businesses across the country into bankruptcy (Hornick, 2008).
The 2008 presidential campaign was not the first time that “to act or not to act” was the center of a macroeconomic debate. Among economists, this often-repeated debate took place over and over between economists of the classical tradition and the Keynesian tra- dition. Among presidential candidates, the debate in 2008 was a repeat of 1932, when Franklin Roosevelt defeated Herbert Hoover during the depths of the Great Depression. Every recession or depression brings a demand from the public to “do something!” Econ- omists in the classical tradition find themselves on the defensive because “just wait and the economy will right itself’ is not a very satisfactory answer to a demand for action.
Pre-Test
1. A classical economist would say that the aggregate demand curve is vertical. a. True b. False
2. In the classical model, changes in the interest rate ensure that saving equals investment.
a. True b. False
3. According to the quantity theory of money, if the money supply doubles, prices will also increase, but not by as much.
a. True b. False
4. A Keynesian economist would argue that employment determines output. a. True b. False
5. Keynes believed that the decrease in consumption spending played a role in the Great Depression.
a. True b. False
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CHAPTER 7Section 7.1 The Classical Tradition and Say’s Law
Answers 1. b. False. The answer can be found in Section 7.1. 2. a. True. The answer can be found in Section 7.2. 3. b. False. The answer can be found in Section 7.3. 4. b. False. The answer can be found in Section 7.4. 5. b. True. The answer can be found in Section 7.5.
7.1 The Classical Tradition and Say’s Law
There are several reasons to begin the study of macroeconomic theory with the classi-cal school. First, classical macroeconomics represents the best efforts of early econo-mists to develop a theoretical system to explain the aggregate level of economic activity and to predict the effects of changes of various kinds on economic activity. Second, classical macroeconomics provided the background against which John Maynard Keynes, the great British economist, developed his new ideas. Third, the classical theory takes a long-run focus on the economy. Finally, the ideas of the classical school have received renewed attention in the economic debates of the last four decades.
The model of aggregate supply and demand, although not used until well into the 20th century, is helpful in understanding the ideas of the classical school. Remember that aggregate supply is the total amount of goods and services that firms are willing to sell at a given price level during a specific time period in an economy; aggregate demand is the total demand for final goods and services in an economy at a given time and price level. Figure 7.1 shows a vertical aggregate supply curve (AS) and a downward-sloping aggregate demand curve (AD) in the upper panel, with the aggregate production func- tion in the lower panel. Classical economists believed that the interaction of labor supply and labor demand determines the real wage and the level of employment. The level of employment (N) then determines how much total real output (Y) will be produced (out- put being the amount of goods or services produced in a given time period). In Figure 7.1, N1 is determined in the labor market (not shown). N1 is the level of employment capable of producing a real output of Y1. Output does not vary with the price level because the level of real output is determined by the interaction of labor supply and labor demand. Thus, the aggregate supply curve is vertical at Y1. The aggregate demand curve has no influence on real output. It only serves to determine the price level, P1. Shifts in aggregate demand will change the price level only.
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CHAPTER 7Section 7.1 The Classical Tradition and Say’s Law
Figure 7.1: A classical view of output, employment, and prices
The level of employment (N1) established in the labor market determines the level of real output (Y1) and thus the location of the aggregate supply curve (AS). Aggregate demand (AD) only affects the price level; it has no influence on output or employment.
Classical macroeconomics does not describe a single approach, but rather a rich and diverse group of ideas. Within that group, however, there are several recurring themes. The foundation of classical macroeconomics lay in three ideas: Say’s law, self-regulating markets, and the quantity theory of money.
0
P AS
Y
P1
Y1
AD
0
N Aggregate Production Function
Y
N 1
Y1
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CHAPTER 7Section 7.1 The Classical Tradition and Say’s Law
Say’s Law
A central idea of 19th-century classical macroeconomics was Say’s law, which says that supply creates its own demand. This law is named for Jean-Baptiste Say, a 19th-century French economist who pointed out that enough income is created in the process of pro- duction to buy everything that is produced. He agreed that individual goods can be over- produced if suppliers fail to correctly read the signals from the market. These suppliers will be penalized for producing the wrong things by incurring losses. Meanwhile, those who read the market signals correctly will be rewarded with profits. General overproduc- tion for any length of time, however, is not possible.
The statement “supply creates its own demand” means that the production of goods and services generates an amount of income equal to the value of the products produced. If firms produce output with a value of $1,000, then they also create incomes for the resources equal to $1,000. Because the income created is the same as the value of output, the produc- tion process creates the amount of income necessary to purchase the goods and services produced. Say further argued that the only reason people offer their labor or other pro- ductive resources in the resource market is to earn income to use for consumption spend- ing. Production generates income, which is all spent to purchase what was produced.
Say’s Law With Saving and Investment
This simple form of Say’s law implies that a market economy will not be subject to severe or prolonged periods of overproduction. Say himself realized that this view was rather simplistic. What would happen if households let part of their income leak out of the cir- cular flow in order to save, instead of spending it all on consumption? If people save a part of their incomes, spending can be less than the value of what is produced. This level of spending results in unsold goods. As producers pile up inventories, they cut back on production and lay off workers. Output falls and unemployment rises. Thus, Say’s law is not correct if there is any saving.
The circular flow model offers a good way to visualize this objection to Say’s law. In the circular flow diagram in Figure 7.2, firms produce $1,000 in products and generate $1,000 in incomes. Households, however, choose to save $200 of their income, so there is not enough spending to purchase all the output. Left with unsold products ($200 worth) on their hands, firms will decrease production and employment.
Say had an answer for that objection. Household saving would flow into banks and be lent to business firms that would inject it back into the income stream as investment. In an economy with small government and foreign sectors, saving (defined as income not spent, or deferred consumption) and investment (defined as the capital outlay or expenditure of money for income, profit, or the purchase of something of value) would be equal. In the national income accounts, investment consists of some combination of business plants and equipment, residential construction, and changes in inventories. In our example, the $200 of unsold output, or change in inventories, is the investment that matches the saving of households. Thus, actual, or realized, saving has to be equal to realized investment. In Figure 7.2, $200 in realized saving is matched by $200 in realized investment in the form of added inventory.
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CHAPTER 7Section 7.1 The Classical Tradition and Say’s Law
Key Ideas: Summarizing Say’s Law
• Say’s law, named for Jean-Baptiste Say, says that supply creates its own demand. • In theory, enough income is created in the process of production to buy everything that is
produced. • According to Say’s law, savings and investment would be equal in an economy with small
government and foreign sectors.
Figure 7.2: Saving—a problem?
When business firms produce $1,000 in goods and services, they generate $1,000 in incomes to the resources. If $200 of this income is saved, only $800 is spent for goods and services, and $200 of goods remain unsold. As firms build up inventories of unsold goods, they cut production. Incomes fall and unemployment rises.
Defining unsold output as inventory investment merely balances the accounts. It does not result in an equilibrium level of output and employment. Even in Say’s time, economists recognized the distinction between a balancing of accounts and the concept of macroeco- nomic equilibrium. Macroeconomic equilibrium is the level of output at which there is no tendency to change. The amount that buyers wish to buy is exactly equal to what is being produced. If firms build up unwanted inventories, their initial response may be to cut prices. However, after cutting prices to unload excess inventories, firms are likely to cut back production in the next period. Then the size of the flows of income and output will shrink.
PRO DUCT MARKET
RESOURCE MAR KET
$200 of Unsold Inventory
$200 in Saving
Purchase of $800 in Goods and Services
$1,000 in Resource Incomes
$1,000 in Goods and
Services
$1,000 in Resource
Income
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CHAPTER 7Section 7.2 Self-Regulating Markets
7.2 Self-Regulating Markets
Classical economists believed that equilibrium would be reached and maintained at a level consistent with full employment by the actions of three self-regulating markets. These markets were the product market, the labor market, and the credit market. If these three markets functioned properly, Say’s law would hold, in the sense that the sum of planned spending for consumption and for investment would be enough to purchase all that was being produced. Classical economists believed that full employment of resources was almost a sure thing in a market economy if markets were allowed to operate freely and given enough time. A free market generally means that prices are deter- mined by supply and demand with very little, if any, government intervention. The clas- sical economists did not claim that the economic system would always operate at a level of full employment. Occasional problems of overproduction and unemployment would occur. These problems, however, would be quickly eliminated by self-regulating markets.
Self-regulating markets are markets in which automatic forces move the economy to a new equilibrium whenever there is a shift in supply or demand. Equilibrium will be restored by adjustments in either prices or output, or both, without any government intervention. Classical economists believed that the same kind of corrective forces that restore equi- librium in markets for single products are also at work in aggregate markets. Although temporary shortages or surpluses are possible in either individual or aggregate markets, a lasting general shortage or surplus of aggregate output is not possible.
The Product and Labor Markets
The two primary markets in the circular flow diagram are the product market (upper flow) and the resource market (lower flow). The labor market is the largest part of the resource market. Classical economists believed that flexible prices and wages in the prod- uct and labor markets were the first line of defense against unemployment and recession.
The labor market played a central role in the classical model. The supply and demand for labor together determined both the wage level and the amount of labor employed. If there were unemployed workers, the quantity supplied must be more than the quantity demanded. This was a clear indication that the market price (the wage) was too high for equilibrium.
If firms find that they have unsold output, they can dispose of it by cutting prices. The idea of cutting prices when there is a surplus of wheat, tablets, or plane tickets is familiar. How do price and wage adjustments work when there is an excess of output in general? Figure 7.3 shows the usual aggregate demand curve and a classical (vertical) aggregate supply curve. In this diagram, there is an excess of aggregate supply over aggregate demand at price level P1, resulting in unsold output. The unsold output is reflected in the fact that Y1 exceeds Y2 (distance AB). This diagram seems to suggest that if all firms cut prices, the price level will fall to P1. Output will remain at the full-employment level, Y1.
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CHAPTER 7Section 7.2 Self-Regulating Markets
Figure 7.3: Excess aggregate supply
Excess aggregate supply (AB in this diagram) will put downward pressure on the price level, either directly or through wages and the labor market. The process will continue until full-employment output is restored.
Aggregate Production Function
YY1Y2
P
P1
P2
AS
A B
YY1Y2
AD
0
0
N 1
N 2
N
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CHAPTER 7Section 7.2 Self-Regulating Markets
Suppose, however, that firms respond to the pil- ing up of unwanted inventories by cutting output to Y2 instead of cutting prices. Then employment will fall to N2. There will be excess labor in the labor market. Competition among workers for jobs will drive down both real and nominal wages (wages with and without adjustments for changes in the price level). With lower wages, a wheat farmer or tablet manufacturer will find it possible to produce the same output at lower cost. Firms will choose to hire more workers at the lower wages. Although sellers will have to cut prices to sell the extra output, they can afford to because of lower labor costs. The fall in output is temporary because flexible wages and prices will always restore output to the full-employment level.
You may have noticed a subtle flaw in this rea- soning. If all firms cut prices to sell excess out- put, they will have to cut wages in order to avoid losses. When producers of toothpaste cut the price of their product and the wages of their workers, the wage cut has almost no impact on the market for their product. The firms’ workers make up a very small part of the total toothpaste market. What is true of a single good, however, is not necessarily true of aggregate output. If all firms cut wages, the workers (who are also the customers) will have less purchasing power with which to buy the output. Therefore, sales will fall in real terms.
The Credit Market
Flexible wages and prices in the labor and product markets were not the only weapons in the classical armory. The classical answer to the problem of general overproduction was to recognize that, in addition to a product market and a resource market, there is a third market—the credit market. The credit market, sometimes referred to as the market for loanable funds, is where the saving of households is used to provide funds for business investment. A self-regulating credit market was another important part of the classical explanation of why unemployment and unsold output would not persist. Through the credit market, household income that is saved flows into the hands of business firms, which in turn spend it on investment. The interest rate is the price of borrowing and pro- vides the incentive to lend. Changes in the interest rate assure that planned saving and planned investment spending will be equal.
Supply and Demand for Loanable Funds Figure 7.4 shows how the credit market works to make saving available to finance invest- ment. In the classical view, the supply of credit (loanable funds) comes from household’s decisions to save. The demand for credit reflects the desire by business firms to borrow
Photodisc/Thinkstock
Firms with unsold goods can cut prices to increase sales.
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CHAPTER 7Section 7.2 Self-Regulating Markets
for investment purposes. The supply curve has a positive slope. This slope indicates that saving is directly related to the interest rate. People save (give up some spending) only if there is an incentive to do so. The interest rate is the incentive for saving. By saving now, individuals can earn interest and accumulate larger sums of money to spend in the future. When the interest rate rises, saving will increase because the same amount of current sav- ing will provide more future consumption. Thus, a higher interest rate will call forth more saving, or a greater supply of loanable funds. Lower interest rates, on the other hand, will lead to less saving, or a smaller supply of loanable funds. There is less incentive to save at lower interest rates.
Figure 7.4: The classical view of the credit market
In the classical view, changes in the interest rate ensure that the quantity of loanable funds supplied (saving) and the quantity demanded (investment) will be equal (at Q1) when the interest rate is i1. There will be a surplus of loanable funds at higher interest rates, such as i2, and a shortage at lower rates, such as i3.
The demand curve in Figure 7.4 shows the amount of loanable funds borrowers want at various interest rates. It has the familiar negative slope. The price of borrowing is the interest rate that firms pay to obtain credit. Investment spending increases when the inter- est rate declines. It decreases when the interest rate rises. Projects or purchases of invest- ment goods that would be profitable at lower rates of interest may not look as attractive at higher interest rates. Thus, planned investment spending will be lower at higher rates of interest.
0 Quantity of Loanable Funds(Saving = Investment)
Saving (Supply of Loanable Funds)
Investment (Demand of Loanable Funds)
Interest Rate
i 2
i 1
i 3
Q1
Surplus of Loanable Funds
Shortage of Loanable Funds
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CHAPTER 7Section 7.3 The Quantity Theory of Money
7.3 The Quantity Theory of Money
The classical idea that the workings of markets will eliminate unemployment is one that is still widely held. Classical economists believed that individual prices were explained by the market forces of supply and demand. Even they would have agreed, however, that a more complex explanation is needed for the determination of the general price level.
Key Ideas: The Invisible Hand in the Macroeconomy
• Self-regulating markets are markets in which automatic forces move the economy to a new equilibrium whenever there is a shift in supply or demand.
• At the equilibrium wage rate, the quantity of labor supplied is equal to the quantity of labor demanded.
If there is excess labor in the labor market, competition among workers for jobs will drive down both real and nominal wages.
• At the equilibrium interest rate, the quantity of planned saving is equal to planned investment spending.
At higher interest rates, the quantity of loanable funds supplied exceeds the quantity demanded, pushing the interest rate down.
At lower interest rates, the quantity of loanable funds demanded exceeds the quantity supplied, causing the interest rate to be bid up.
• Either supply or demand can shift and create disequilibrium. Natural forces will restore the economy to equilibrium in a self-regulating market.
The Role of Interest Rates According to classical economists, the interaction of borrowers and lenders in the credit market should establish an equilibrium interest rate. At this interest rate, the quantity of planned saving will be equal to planned investment spending. This interest rate, in Fig- ure 7.4, is determined by the intersection of the saving and investment curves. At higher interest rates, such as i2, the quantity of loanable funds supplied exceeds the quantity demanded. The surplus of saving over planned investment spending will push the inter- est rate downward towards i1. At lower interest rates, such as i3, the quantity of loanable funds demanded exceeds the quantity supplied. This shortage causes the interest rate to be bid up to i1 as would-be borrowers compete for the limited amount of credit.
Either supply or demand can shift and create disequilibrium. Either way, natural forces will restore equilibrium in a self-regulating market. Suppose a fear of recession or a high level of consumer debt causes people to suddenly become thriftier. The amount of saving will increase at every possible interest rate. That is, the saving curve will shift to the right. The new equilibrium interest rate will be lower than i1. An increase in saving puts down- ward pressure on the price of loanable funds. The lower interest rate leads to an increase in the amount of investment spending. Thus, changes in the interest rate ensure that any income not spent on consumption will be channeled into desired investment.
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CHAPTER 7Section 7.3 The Quantity Theory of Money
Global Outlook: The Quantity Theory and Zimbabwean Inflation
One of the reasons people are afraid of inflation is that they expect it to develop into hyperin- flation. Hyperinflation is when prices increase rapidly as a currency loses its value, and inflation
hits very high rates. It is relatively rare, occurring mostly after wars, revolutions, or other disasters. Hyper- inflations have occurred in Germany after World War I, Hungary after World War II, and several Latin American countries in the past four decades. However, they only occur under extreme circumstances (“Hyperinflation,” 2010). A recent example of a country that has experienced hyperinflation is Zimbabwe.
Zimbabwe experienced inflation and hyperinflation between 2003 and 2010 due to civil war, discrimi- natory land reforms, lenient economic policies, and corrupt political leadership. Its living standards plummeted, unemployment skyrocketed to 85%–90%, and the Zimbabwean dollar lost practically all of its value (Hanke & Kwok, 2009). How did this once productive country become so ruined?
In 2008, Zimbabwe reached the second greatest hyperinflation rate in history, estimated at 90 sextillion percent (90,000,000,000,000,000,000,000%). The country was in such political and economic turmoil that it was a prime situation for hyperinflation. Nevertheless, any kind of inflation can be interpreted in terms of the equation of exchange. If the price level is rising rapidly, something has to be happening to the other components of the equation of exchange (the velocity of money, V; the money stock, Ms; and the GDP, Y).
Expansion of the money supply is an important part of the explanation of hyperinflation in Zimbabwe. Like citizens of other countries, Zimbabweans get their currency from the printing presses of their central bank. When Gideon Gono, the governor of the Reserve Bank of Zimbabwe, ordered the print- ing presses to print more money, this sent the whole country into a tailspin. Hyperinflation, however, rarely occurs without some other element besides monetary expansion. In the case of Zimbabwe, the second important element was a decline in real output. The inflation rate was stable until President Robert Mugabe’s land reforms took land from white citizens and redistributed it to black citizens, caus- ing food production and revenues to drop dramatically. The land reforms and surge of currency into the Zimbabwean economy wiped out export earnings and decreased manufacturing output—food output capacity fell by 45%, and manufacturing output fell by 29% in 2005, 26% in 2006, and 28% in 2007 (Hanke & Kwok, 2009). In the equation of exchange, when an increasing money supply (Ms) encounters falling real output (Y), there is a double source of upward pressure on the price level. If, for example, the money supply expanded by 50% while output fell by 10%, the price level would rise by a percentage equal to 6 3 V, with V being the velocity of the money.
Once inflation sets in, citizens spend their money quickly before it declines in value. Even with interest rates as high as 85%, lenders are unwilling to tie up their money for very long because the purchasing power they get back is so much less than what they lend. Workers spend their wages on the way home for fear they will be worth less when they wake up the next morning.
The classical explanation of the price level is based on the equation of exchange and the quantity theory of money. The quantity theory of money states that changes in the price level are proportional to changes in the money supply. This theory, like many theories in macroeconomics, developed as a way to explain certain economic events.
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CHAPTER 7Section 7.3 The Quantity Theory of Money
The Equation of Exchange
Classical economists believed that there was a very simple relationship between the money supply, the price level, and the level of output:
Ms 3 V 5 P 3 Y
This relationship is called the equation of exchange. The idea behind this relationship is that the value of spending must be equal to the value of what was bought. Ms is the money supply, and V is the velocity of money, or the number of times the average dollar is spent per year. Thus, Ms 3 V equals total spending. For example, if the money supply is $2,000 and V 5 3, then total spending is $6,000. If dollars turn over more often, then the same amount of spending could be supported by a smaller money supply. For example, with V 5 5, the same $6,000 in spending could be sustained by a money supply of only $1,200. Classical economists generally believed that velocity (V) was quite stable. Therefore, any change in the money supply would result in a proportional change in spending (P 3 Y).
If Y is at the equilibrium levels determined by Say’s law and self-regulating markets, this equation becomes an explanation of the link between the money supply and the price level. For example, what is the effect of a 2% increase in the money supply on inflation? In the long run, output and velocity remain relatively constant. Thus, the equation becomes 2% 3 V 5 x 3 Y. In this case, a 2% increase in the money supply would result in a 2% increase in inflation.
Inflation and the Quantity Theory of Money
The quantity theory of money, like many theories in macroeconomics, developed as a way to explain certain economic events. Among the early writers on this theory was the Scottish philosopher David Hume (1711–1776). Hume was interested in the very practical problem of explaining the inflation that followed the European discovery of the Americas.
Gold and silver were the main forms of money in Europe until the 19th century. Europe- ans first arrived in the Americas in the late 15th century, and several European nations colonized the Americas in the next two centuries. Spain seized the gold and silver of the Aztecs in Mexico and the Incas in Peru and brought it to Europe. As this gold and silver flowed in, Spaniards went on a spending spree. They bid against other potential buyers and drove up the prices of goods and services all over Europe. Hume and other theorists sought to explain the link between the inflow of money and the rising price level.
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CHAPTER 7Section 7.3 The Quantity Theory of Money
Figure 7.5: A 17th-century shift in the demand curve for woolens
An inflow of gold and silver from the Americas led Europeans to increase their demand for various goods, such as woolen goods. The rightward shift of the demand curve from D1 to D2 drove up the price of woolen goods from P1 to P2. Quantity increased along the supply curve from Q1 to Q2 in response to the higher price.
Although these early theorists did not have the tools of demand and supply, their reason- ing can be expressed in those terms. In the supply and demand diagram of Figure 7.5, an inflow of gold and silver has caused the demand for woolen goods to increase while the supply curve remains unchanged. In the 17th century, the newly wealthy Spanish demanded more woolens from both Spanish and English suppliers. Of course, the people who sold woolens then had extra money, so they too demanded more goods of all kinds. As demand for a broad range of products increased, aggregate demand shifted to the right, as shown in Figure 7.6.
0
Price of Woolen Goods
Quantity of Woolen Goods
P2
P1
Q 1 Q 2
D 1
D 2
S1
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CHAPTER 7Section 7.3 The Quantity Theory of Money
Figure 7.6: Adjusting to an inflow of money
The general increase in demand for goods drives up both prices and costs. The rise in costs shifts the aggregate supply curve to the left. Both P and Y increase, but equilibrium output ultimately returns to Y1. When all prices have adjusted (the supply curve has shifted as well as the demand curve), there will have been no change in real output but an increase in the price level to P3.
As long as money was flowing into Spain and from there to the rest of Europe, prices were destined to go on rising. Aggregate demand kept shifting to the right. Rising demand spilled over from Spain to other countries, causing aggregate demand to increase in all of these countries. Thus, the money inflow to Spain led to higher price levels throughout Europe.
Changes in the Money Supply and Changes in the Price Level
When would such a rise in the price level come to an end? If the inflow of money never stopped, classical economists could see no end to rising prices. However, suppose the money inflow did end. After the economy adjusted to changes in the price level, the equi- librium quantity of real output would be the same as before the inflow of money. The inflow of gold and silver to Europe in the 17th century did not increase any of the econo- my’s productive resources or improve its technology. Thus, there was no reason why total output would change once the economy adjusted fully to the larger money supply.
0
P
Y
P2
P1
Y*
AD1
AD2
AS
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CHAPTER 7Section 7.3 The Quantity Theory of Money
With more money but no more real output, classical economists argued, the increase in the price level would be proportional to the increase in the money supply. A money supply that was twice as large would lead to a price level that was twice as high. A money supply that was four times as large would mean a price level that was four times as high. Land prices and wages would also rise in proportion to increases in the money supply.
Changes in the price level may not be exactly proportional to the rise in the money sup- ply. While the money supply is rising, other things that affect the price level may also be changing. For example, the productivity of labor may rise. Like most economic predic- tions, those based on the quantity theory are subject to ceteris paribus conditions.
The insight that the long-run level of prices is directly related to the money stock was a notable insight of classical economics. To the question “How much will the price level change when the money supply increases?” it gives a reasonably precise answer: The price level changes in proportion to the change in the money supply. However, the quan- tity theory could not predict how long it would take the price level to change. Further- more, you should have noticed in Figure 7.5 that output of a particular good will initially increase when demand increases. (Figure 7.6 shows that this also holds for goods in general.) Thus, in the short run, changes in the money supply may affect real output as well as the price level. In the long run, real output returns to the level that existed before the added money came into the system.
How much will output increase at the start? How long will it take output to settle back to its old level? Classical economists could not find answers to these questions in the quan- tity theory. The quantity theory offered an explanation for long-run changes in the price
level, but did little to explain the short-run effects of changes in the money supply on real output and employment.
The Quantity Theory and Money Demand
The quantity theory of money underwent some changes in the late 19th century because of the work of British economist Alfred Marshall (1842– 1924). One of Marshall’s most important contribu- tions was to reinterpret the equation of exchange (Ms 3 V 5 P 3 Y) as a theory of the demand for money. The demand for money is the amount of money that people want to hold in the form of cur- rency or checking account balances. The demand for money is not that different from the demand for other goods and services. People demand money because it is useful in making market transactions. Holding money has a price, however. Choosing to hold money means giving up the things that it could buy or giving up the interest that could be earned if it were converted into other kinds of
iStockphoto/Thinkstock
Even today, currency is necessary for many market or interpersonal transactions.
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CHAPTER 7Section 7.3 The Quantity Theory of Money
financial assets. Money is also unique in certain respects, especially in its almost total accep- tance in transactions for all other goods and services. Thus, although the demand for money is similar to the demand for other goods and services, money plays a special role in a market economy.
Marshall argued that people normally want to hold part of their wealth in the form of money. He assumed that the amount of wealth that individuals choose to hold in the form of currency or checking account balances (as opposed to stocks, bonds, and other finan- cial assets) is positively related to their incomes. The higher a person’s income, the higher the average amount of money balances that person will want to hold to meet day-to-day transaction needs. For the economy as a whole, the total demand for money should be positively related to the aggregate level of income and output.
Marshall observed that the public had to hold whatever amount of money was being sup- plied. That is, actual Md had to equal actual Ms. If the money supply is $1,000, then the public collectively has to hold (demand) $1,000. Based on this observation, Marshall rear- ranged the equation of exchange, obtaining
Md 5 k 3 P 3 Y 5 k 3 GDP
Money supply has been replaced by money demand because in equilibrium the two should be equal. The velocity of money, V, has been replaced by k on the other side of the equation, because k 5 1/v by definition. Marshall explained k as the fraction of income people desire to hold in the form of cash balances. Like V, the size of k depends on such factors as how often people get paid and have to make payments and what other forms of assets are available. Marshall expected that k, like V, would be fairly stable over long peri- ods of time. If one accepts the classical arguments that Say’s law is valid and markets are self-regulating, then Y will be stable at the full-employment level. In that case, Marshall’s revised equation of exchange becomes an explanation of what determines the price level.
Classical economists favored a strictly laissez-faire approach to most markets. Many of them did agree, however, that regulation of the money supply would help control ups and downs in output and employment. If a temporary decline occurred in output, falling prices and wages could be avoided by expanding the money supply. An increase in the money supply could lead to at least a short-run improvement in the level of real output as well as (or instead of) a rise in the price level.
The quantity theory of money, Say’s law, and the idea of self-regulating markets provided a complete classical model of macroeconomics. This model explained the level of employ- ment, output, and prices. According to this model, recessions would be temporary and self-correcting. Thus, the role of the government should be limited to careful management of the money supply.
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CHAPTER 7Section 7.4 The Keynesian Revolution
Policy Focus: Keynes and the Politics of the Keynesian Revolution
John Maynard Keynes was born in Cambridge, England, the son of a well-known economist who taught at Cambridge University. The young Keynes grew up in an atmosphere of intense debates over the pub- lic policy issues of the day. He divided his life between teaching at Cambridge and active involvement in government and business affairs. He worked for the British treasury, where he rose rapidly during World War I. In fact, Keynes was a British delegate to the Paris Peace Conference, which drafted and signed the peace treaties ending World War I in 1919. He was disillusioned by the negotiations at the conference and the harsh conditions imposed on the losers, especially Germany.
In his book The Economic Consequences of the Peace, Keynes argued that the harsh economic condi- tions imposed on Germany would lead to more problems with that country in the future. This book ended Keynes’s employment by the treasury because he criticized British policy. He returned to Cam- bridge and turned to business, making a great deal of money with shrewd investments. He managed the investment funds of King’s College at Cambridge, to the college’s great benefit. Keynes wrote essays on policy topics and biographical essays on many people, including economists, as well as a treatise on the theory of probability.
Along with his other activities, Keynes did some revolutionary work in macroeconomics. During the 1920s, he wrote the two-volume Treatise on Money, which was published in 1930 after the beginning of the Great Depression. The Treatise was basically a quantity theory approach to macro problems in the spirit of Keynes’s teacher, Alfred Marshall. By the time the Treatise was published,
Key Ideas: Elements of Classical Macroeconomic Theory
• Employment is determined by the forces of supply and demand in the labor market. • Output is determined by equilibrium in the labor market. • The aggregate supply curve is vertical at the full-employment level of output. • The price level is determined by the supply of and demand for money. • An economy always tends toward the full-employment level of output because enough income
is created during production to purchase the output (Say’s law), and self-regulating markets correct temporary disequilibria.
• In the product market, falling prices ensure that all output is sold. • In the labor market, adjustments in wages clear the labor market. • In the credit market, changes in interest rates make saving equal to investment.
7.4 The Keynesian Revolution
In the 19th century, the main critics of the quantity theory of money were the business cycle theorists. They called attention to the reality of ups and downs in the economy. The classical model showed with perfect logic that prolonged unemployment was impossible; actual unemployment seemed to defy the model by lasting for long periods of time. The classical model said that output would always be at, close to, or tending toward the full-employment level; but real world experience showed that large and prolonged deviations from the full-employment level of output not only were possible but occurred with alarming frequency.
(continued)
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CHAPTER 7Section 7.4 The Keynesian Revolution
When Keynes attacked the ideas of the classical school in The General Theory of Employ- ment, Interest, and Money (1936), he was attacking the mainstream of 19th-century economic thought. In doing so, he ignored some important work by other economists, such as Henry Simons and Irving Fisher, who were working in the classical tradition. The ideas that Keynes criticized were those that drove the macroeconomic policies of his time. His contributions changed the policy approach to recessions and depressions for decades to follow.
The Great Depression challenged the classical model with the reality of a long depression and high unemployment. In The General Theory, Keynes attacked the classical model in two important ways. First, he identified some flaws in the model. Second, unlike the busi- ness cycle theorists, he offered a well-developed alternative model of the macroeconomy. This model was the basis for the Keynesian revolution, the change in macroeconomic theory and policy that occurred when Keynes’s ideas displaced the classical explanation of how output and employment are determined. The Keynesian model begins with aggre- gate demand and works from there to employment, instead of the other way around.
Keynes on Say’s Law
Keynes was critical of Say’s law. Classical economists argued that the existence of saving by households and investment by firms did not invalidate Say’s law because changes in the interest rate will ensure that planned saving is equal to planned investment at the
Policy Focus: Keynes and the Politics of the Keynesian Revolution (continued)
Keynes was unhappy with this approach and had begun what he called his “long struggle” to see macro questions from a different perspective. The new view he was working toward was contained in The Gen- eral Theory of Employment, Interest, and Money, published in 1936. This book presented an alternative macroeconomic model aimed at explaining how economies had fallen into the Great Depression and how they could get out of it.
Keynes’s ideas were considered radical by many at the time. Keynes himself considered his proposals conservative. During a period when communism, fascism, and other antimarket philosophies were very popular, Keynes saw his economic policy as a way to rescue the market economy from its most serious weakness—persistent and recurring downturns in output and employment. Recessions and depres- sions offered fertile ground for socialist or communist proposals to shift to a more centrally planned economy. Keynes wanted to salvage the market economy by reducing its tendency to go into recessions.
After World War II, Keynesian ideas were more widely accepted. The Keynesian revolution was a huge political and economic success. The Great Depression had brought a great deal of suffering, and clas- sical economic theory offered no immediate relief. Classical economists advised people to wait until prices fell, markets readjusted, and equilibrium was restored. In short, their policy was to do nothing until, in the long run, the economy returned to its full-employment equilibrium. Keynes offered a policy that could make things better in the short run. This option was much more appealing to both politicians and people who were unemployed. At the same time, Keynes offered frustrated economists a plausible explanation of the Great Depression. Today, most government officials still adhere to at least part of the Keynesian view. They believe it is better to do something about economic conditions than to wait for the economy to correct itself—especially if the correction may not take place until after the next election!
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CHAPTER 7Section 7.4 The Keynesian Revolution
full-employment level of output. If planned saving is always exactly offset by planned investment, then all output will be sold to willing buyers for either consumption or investment. In that case, overproduction or lasting unemployment is not possible. Keynes argued that even though the interest rate does influence planned saving and planned investment, other important influences can keep the credit market from perfectly match- ing these two flows.
Keynes identified several reasons why individuals save besides the desire to earn inter- est: (1) to build reserves in case of unforeseen future needs, (2) to develop a nest egg for retirement, (3) to establish a financial base for an increased standard of living in the future, (4) to gain economic independence, (5) to build reserves for speculative purposes, (6) to leave an inheritance, and (7) to satisfy the urge to accumulate. These motives, he argued, generate considerable saving that is relatively independent of the interest rate.
Keynes also argued that the interest rate was only one influence on investment decisions. He argued that firms invest in new plants and equipment only if they expect to make a profit. Based on their expectations of the profit from a given investment project, busi- nesses often borrow even when interest rates are high or refuse to borrow when they are low. According to Keynes, final demand by consumers, the size and age of existing capital stock, and new technology all play more important roles than the interest rate in deter- mining investment.
Because both saving and investment respond more strongly to other influences than to the interest rate, Keynes argued, planned saving could exceed planned investment at the full- employment level of output. Thus, Say’s law would be invalid. According to the classical model, if planned saving exceeds planned investment, the interest rate will fall. Keynes said that a fall in interest rates may have little effect on either saving or investment, but excess saving will lead to a decline in the level of output and income. Thus, if credit mar- kets fail to work as the classical model describes, severe depression and unemployment can persist for long periods in a market economy.
Keynes on Self-Regulating Markets
According to classical theory, temporary overproduction and unemployment in individ- ual markets would be eliminated as unemployed workers competed for jobs and drove down wages. To a firm, falling wages mean lower costs. The firm could profitably cut prices and increase sales. Falling wages and prices would eliminate overproduction and restore full employment.
Keynes argued that neither the product nor labor market would adjust quickly and auto- matically to eliminate unemployment and overproduction. He believed that labor unions and large corporations had enough market power to keep wages and prices from falling. Faced with rising unemployment, labor unions would fight to keep wages from declin- ing in order to protect their members who were still working. Without declining wages, business firms would not be willing to cut their prices. Furthermore, when facing over- production, large corporations are likely to choose to reduce production levels rather than prices. Price cutting risks cutthroat price competition. Keynes felt that in a mature, capi- talist economic system, it would be difficult to reduce either prices or wages. According
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CHAPTER 7Section 7.4 The Keynesian Revolution
to him, prices and wages are “sticky downward.” Because prices and wages are not fully flexible, there will be no automatic adjustment process in product and labor markets to restore full-employment equilibrium.
Finally, Keynes pointed out that even if wages and prices could fall, the result would not necessarily be to restore output to the full-employment level. Falling prices mean that buyers can purchase more output, but falling wages mean that workers can buy less. In a macroeconomy, supply and demand are not entirely independent because they are parts of the same circular flow.
Keynes on the Quantity Theory of Money
Keynes admitted that the quantity theory of money was useful in describing the long-run movement of the economy from one equilibrium to another. He saw the theory as much less useful in the short run. The quantity theory was based on the assumption that, in the equation of exchange, the velocity of money was stable. That is, V was constant. Data from the early 1930s, as well as other periods, showed that this assumption did not hold in the short run. (Some economists prior to Keynes, such as Henry Simon and Irving Fisher, did not share this simplistic view. They recognized the instability of velocity over the course of the business cycle, and recommended active changes in the money supply to offset changes in velocity and keep the price level and real output stable.)
Keynes pointed out that a theory that only explains what happens in the long run is not very useful. He was more interested in developing a theoretical model to explain short-run economic activity and recommending policies to improve short-run economic conditions.
The velocity of money (and therefore k) was especially unstable during the Great Depres- sion. Between 1929 and 1933, V fell sharply and k increased. (Remember that k 5 1/v.) A rise in the value of k meant that the amount of money people wanted to hold, relative to GDP, had increased. The quantity theory of money offered no explanation for the sudden increase in the demand for money implied by the sharp drop in V.
Building on Marshall’s analysis of money demand, Keynes reasoned that the demand for money was strongly influenced by more than the level of GDP. In addition to demanding money for making transactions, as Marshall claimed, people also want to hold money as a safeguard against changes in interest rates on bonds and other financial assets. If interest rates are low, people will avoid buying bonds and hold more of their wealth in the form of money while waiting for interest rates to rise. When interest rates are low, the opportunity cost of holding money is also low. Thus, very little is sacrificed by holding money instead of bonds or other securities. In addition, people who buy bonds when interest rates are low run a risk of locking in those rates and being stuck with low-yield assets when the rates rise.
When market interest rates are high, people will prefer to hold more of their wealth in interest-earning securities and less in money because the opportunity cost of holding money is high. Much interest is lost by holding money, which earns little or no interest, instead of interest-earning assets. In addition, if interest rates are high compared to the immediate past, people will expect them to fall rather than to rise further. Buying securities when inter- est rates are high enables the holder to lock in those rates for the life of the assets.
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CHAPTER 7Section 7.5 The Keynesian Alternative
Key Ideas: Keynesian Criticisms of the Classical Model
• Say’s law is not necessarily valid. Just because enough income is created does not mean it will be spent.
• Self-regulating markets do not necessarily guarantee full employment. • In the credit market, saving and investment are influenced by much more than the rate of
interest. • In the labor market, unions and other influences can make it difficult to adjust wages down-
ward. If wages do fall, that will also reduce demand. In the product market, large corporations may cut output rather than prices.
• Instead, in the Keynesian model, employment is determined by output. • Output is determined by the intersection of the aggregate supply and demand curves
(by demand for final output). The aggregate supply curve can be horizontal.
Keynes called the motive for holding money as an asset the “speculative demand for money.” Today many economists prefer the term asset demand for money, which is the demand for money to hold in order to protect oneself against losses due to changes in interest rates. The asset demand for money is negatively related to interest rates. The motive for holding money identified by Marshall is called the transactions demand for money—the demand for money in order to make purchases and carry out other day-to- day market transactions. Transactions demand is positively related to income. Keynes added a third source of demand for money, called the precautionary demand for money, which is cash for a rainy-day or emergency fund. Since this demand is also related to the level of income, later economists combined it with transactions demand.
Keynes argued that the interest rate would strongly influence the demand for money. If the interest rate declined, the quantity of money demanded relative to GDP (P 3 Y in the equa- tion of exchange) might increase, even if GDP were stable or declining. In the equation of exchange, this change in people’s desire to hold money would appear as an increase in k or a decline in V. Thus, changes in V and k during the Great Depression could be explained by including the interest rate as an important influence on the demand for money.
7.5 The Keynesian Alternative
Keynes criticized the quantity theory because it neglects the role of interest rates and fails to explain short-run changes in V and k. He argued that Say’s law was not valid and that long periods of overproduction and unemployment were pos- sible. Without Say’s law and self-regulating markets, no automatic forces would bring the economy back to equilibrium during a recession. Without a stable velocity of money, even an increase in the money supply might not work. Having criticized the classical view of the way the macroeconomy worked, Keynes offered a different model. In his view, only government intervention could bring the economy out of a downturn as severe and pro- longed as the Great Depression.
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CHAPTER 7Section 7.5 The Keynesian Alternative
During the Great Depression, the U.S. economy experienced severe and lasting unemployment, along with falling prices and a sharp decline in real output. Table 7.1 shows some of the dramatic changes in spending, output, and unemployment between 1929 and 1939. Classical theory could not account for such conditions. In developing an alternative theory, Keynes and his followers focused on the question “What determines the level of employment in a mar- ket economy?” They knew that if they could explain employment, the same model would explain unemployment.
Table 7.1: Consumption and investment expenditures during the great depression (in billions of dollars)
Year Consumption Expenditures
Investment Expenditures
Total GDP Unemployment Rate
1929 79.0 16.2 103.9 3.2%
1930 71.0 10.3 90.4 8.7%
1931 61.3 5.5 75.8 15.9%
1932 49.3 0.9 58.0 23.6%
1933 46.4 1.4 55.6 24.9%
1934 51.9 2.9 65.1 21.7%
1935 56.3 6.3 72.2 20.1%
1936 62.6 8.4 82.5 16.9%
1937 67.3 11.7 90.4 14.3%
1938 64.6 6.7 84.7 19.0%
1939 67.6 9.3 90.5 17.2%
1940 71.9 13.2 100.4 14.6%
1941 81.9 18.1 125.5 9.9%
Source: Council of Economic Advisers. (2012). Economic report of the president. Washington, DC: U.S. Government Printing Office.
Bettman/Corbis
The Great Depression in the United States: an employment agency crowded with men seeking work.
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CHAPTER 7Section 7.5 The Keynesian Alternative
Building Blocks of the Keynesian Model
In attempting to identify the cause of employment, Keynes reasoned as follows:
1. The level of employment is directly related to the level of production, or output (Y). 2. In a market economy, planned spending on the output of the business sector will
determine the level of production. Firms adjust their levels of production to meet demand for their products. Put simply: Supply adjusts to demand. (In contrast, Say’s law said that supply creates its own demand.)
3. Because employment depends on production and production responds to spend- ing, the level of employment in a market economy depends on the level of planned spending in the economy.
Note how Keynes reversed the sequence of events from the classical model. In the classi- cal model, the labor market determined employment, and employment determined the level of output. Therefore, the position of the aggregate supply curve is vertical. Recall from Chapter 6 that the aggregate supply curve can be very flat, even horizontal, if many resources are unemployed (the economy is operating inside its production possibilities curve). The Keynesian model of the Depression economy has ample unemployed resources and a horizontal aggregate supply curve. If aggregate supply is constant (horizontal), then aggregate demand determines the level of output. In turn, the level of output determines the level of employment. Aggregate demand, which determined only the price level in the classical model, has the starring role in Keynes’s model. It determines the level of real output. In Figure 7.7, the price level is given at P1 and aggregate demand determines the level of output, Y1. Output, in turn, determines the level of employment, N1.
Keynes and Policy Solutions to Unemployment
Consider how this model might apply to the situation in the 1930s. Unemployment was high because planned spending was too low to generate the level of output (Y* in Figure 7.7) that would result in full employment (N*). Thus, too little spending was identified as the cause of unemployment. To reduce unemployment, planned spending had to increase. In the language of aggregate supply and aggregate demand (a model developed after Keynes), aggregate demand had to shift to the right.
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CHAPTER 7Section 7.5 The Keynesian Alternative
How could aggregate demand be shifted to ensure a level of output that would result in higher employment and lower unemployment? Keynes’s answer goes back to the circular flow model. He identified the groups of purchasers (households, firms, government, and
Figure 7.7: A Keynesian view of aggregate supply and aggregate demand
When there are unemployed resources, the aggregate supply curve is horizontal. Aggregate demand determines the level of real output (Y1). The price level (P1) is not affected by the changes in demand. The level of real output (Y1) determines the number of workers needed to produce it (N1) through the aggregate production function in the lower graph.
0
P
AS
Y
P1
Y1 Y*
AD
0
N Aggregate Production Function
Y
N 1
N*
Y1 Y*
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CHAPTER 7Section 7.5 The Keynesian Alternative
the foreign sector) in the spending stream and considered what determines the amount of planned spending by each group. Keynes was very interested in determinants of planned consumption spending and planned investment spending. (If Keynes were still alive in the 2000s, he would have added net export spending.) He concluded that some- times these two sources of spending would be inadequate to lead the economy to the full-employment level of output. At such times, the government, as a third major spend- ing sector, should step in and boost planned spending (and aggregate demand) to the desired level.
What determines planned consumption and investment spending? According to Keynes, consumer spending (and saving) depends primarily on the level of income. Keynes believed that household spending habits are relatively stable and that households will spend a specific fraction of any increase in income. Investment demand, or planned investment spending, however, is much less stable. Investment depends on such fac- tors as expectations, interest rates, and changes in final consumer demand. Expectations are especially prone to sharp swings. Thus, Keynes believed that investment spending would shift a great deal and would be the major source of changes in output and employ- ment. Government can offset those changes by increasing its spending when investment demand is low and by cutting it back when investment demand is high.
This emphasis on determinants of planned spending highlights a basic difference between the Keynesian and classical models. In the classical model, investment and saving both depend on the interest rate, which ensures that saving is equal to investment in the cir- cular flow. In the Keynesian model, however, the interest rate plays a much smaller role. The interest rate has little influence on investment. Investment is instead dominated by changing expectations about final sales and consumer demand. The interest rate also has almost no effect on saving (which responds mainly to income). Because investment and saving are determined by different forces, there is no reason to expect that planned saving will be equal to planned investment. Therefore, there is no reason to expect the economy to move automatically toward equilibrium at a full-employment level of output.
The Keynesian Explanation of the Great Depression
The Great Depression resulted from many complex forces and cannot be explained by a single cause or event. Since the Depression, many economists have looked for explana- tions and key causes. These causes include the Smoot-Hawley Tariff of 1930, international monetary problems relating to the collapse of the gold standard, long-wave business cycles, and the Federal Reserve’s mismanagement of the money supply. At the time, how- ever, economists trained in the classical tradition could not explain what was happening. Keynes was able to offer a direct and plausible explanation of why planned spending by consumers and investment by firms fell so dramatically from 1929 to 1933, as was shown in Table 7.1. He also explained why the economy did not recover automatically, as classi- cal macroeconomics predicted.
Keynes observed that, after several years of rising consumption and investment spending during the 1920s, the rate of expansion began to slow. With enough plants and equipment to meet current demand, firms reduced their levels of investment spending, leading to a decline in output and employment. When employment declined, household income declined. Consumption spending also declined. Falling consumption further discouraged
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CHAPTER 7Section 7.5 The Keynesian Alternative
Key Ideas: The Keynesian View of the Great Depression
• According to Keynes, government intervention was necessary to bring the economy out of a downturn as severe and prolonged as the Great Depression.
• Unemployment was high because planned spending was too low to generate the level of out- put that would result in full employment.
Therefore, too little spending was the cause of unemployment. To reduce unemployment, planned spending had to increase. In the model of aggregate demand and aggregate supply, this means that aggregate
demand needed to shift to the right. • Keynes explained that the government should have intervened in the market economy by
using its power to tax and spend to increase aggregate demand.
investment spending because of firms’ expectations of poor future sales. Investment spending fell further, causing more declines in employment, income, and consumption spending. The spiral continued, and output and sales plummeted.
Consumer spending fell because there were fewer jobs and less income. Business firms reduced output because they could not sell their products. They were not spending for investment because they had little confidence in the future. In fact, firms were so pessimis- tic about the future that they were not even replacing machinery as it wore out. To many people, it seemed as though the whole system had broken down.
This view of what was happening also suggested that the way to end the Great Depres- sion was simple: The government should intervene in the market economy by using its power to tax and spend to increase aggregate demand. That is, the government should spend more, reduce taxes, or both. Keynes’s prescription was followed to a very limited extent until World War II. Table 7.1 shows that the process of recovery was very slow, especially in employment. Consumption, investment, and total GDP did not reach the pre-Depression levels of 1929 until 12 years later, in 1941. Unemployment remained high until the war was fully under way in 1942.
Preparations for war forced the U.S. government to increase its defense spending. Con- gress chose to raise taxes, but by less than the amount needed to pay for the war. By 1943, the unemployment rate in the United States had fallen to 1.9%. Keynesian economic policy of increasing spending more than taxes had finally ended the Great Depression, but not as Keynes expected. The massive increase in government spending in the 1940s was not simply an exercise in Keynesian macroeconomic policy. It occurred in order to pay for World War II.
How would Keynes explain the Great Recession of 2007–2009? Would Keynesian theory provide a solution for 8.2% unemployment, a 0.3% decrease in prices, and a 1.9% growth rate of GDP (Bureau of Economic Analysis, 2012)? The next chapter provides the foundation for the Keynesian model before the theory can be tested with more recent economic data.
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CHAPTER 7Post-Test
Conclusion
The 2007–2009 recession had a somewhat happier ending than the one that began in 1929. Although the 2007–2009 recession was a serious economic wake-up call to the United States, the government stimulus package and the Federal Reserve’s ability to manipulate interest rates helped end it sooner rather than later. Compared to the expe- rience of the Great Depression, the 2007–2009 recession was much shorter and far less severe. Was this the result of following Keynesian policies? How would the economy have fared under a classical “wait and see” prescription?
Post-Test
1. Adherents of Say’s law would maintain that a. demand creates its own supply. b. people work in order to earn income to spend on consumption. c. people work in order to earn income to save. d. demand is unaffected by supply. e. the labor supply is perfectly elastic.
2. The classical macroeconomic model implies that a. full employment is unlikely because markets are slow to clear. b. changes in the price level ensure that saving is equal to investment. c. full employment is likely because of self-regulating markets. d. output varies with the price level. e. the government can stabilize the economy.
3. A basic feature of self-regulating markets is that a. overproduction and unemployment cause prices and wage rates to increase. b. flexible wages and prices eliminate unemployment and overproduction. c. overproduction never occurs. d. an increase in saving causes an increase in the interest rate and a decrease in
investment spending. e. rising unemployment causes wage rates to rise, reducing the demand for labor.
4. According to classical macroeconomic theory, the self-regulating credit market ensures that
a. unemployed workers will compete for existing jobs and force down the wage rate.
b. credit is extended only to those who are considered good risks. c. income that is saved by individuals will be borrowed by businesses and spent
for investment purposes. d. the supply of loanable funds is inversely related to the interest rate. e. saving only goes into productive investment spending.
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CHAPTER 7Post-Test
5. The quantity theory of money was originally worked out to explain a. the Great Depression of the 1930s. b. the inflation in Europe following the conquest of the Americas. c. the economic effects of the French Revolution. d. the perpetual trade surplus advocated by mercantilist theory. e. the variations in the velocity of money.
6. According to the equation of exchange and the quantity theory of money, an increase in either velocity or the money supply will
a. cause GDP to rise. b. not affect the price level. c. cause the price level to fall. d. cause GDP to fall. e. cause both the price level and GDP to fall.
7. Which of the following statements best describes business cycle theorists? a. They were concerned with fluctuations in the level of output and prices but
not of employment. b. They were concerned with fluctuations in the level of output, prices, and
unemployment. c. They were primarily concerned with the short run. d. They were primarily concerned with the long run. e. They were concerned with fluctuations in the level of output, prices, and
unemployment, mainly in the short run.
8. Keynes believed that if planned savings were greater than planned investment, then a. real output would fall. b. real output would increase. c. interest rates would fall. d. interest rates would increase. e. interest rates would fall and real output would stay the same.
9. Keynes believed that the correct role for government during a depression was to a. shift aggregate supply. b. increase the money supply. c. shift money demand. d. increase government spending or cut taxes. e. balance the budget.
10. Which of the following statements was NOT part of Keynes’s criticism of classi- cal macroeconomic theory?
a. Although investment decisions are influenced by interest rates, there are other factors that play a role in such decisions.
b. The expected rate of profit plays a key role in investment decisions. c. Labor unions and large corporations help make prices flexible and
self-regulating. d. Neither labor markets nor product markets can be counted on to be
self-regulating. e. The quantity theory of money is not useful in describing short-run adjust-
ments in the economy.
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CHAPTER 7Critical Thinking Questions
Answers 1. b. people work in order to earn income to spend on consumption. The answer can be found in Section 7.1. 2. c. full employment is likely because of self-regulating markets. The answer can be found in Section 7.1. 3. b. flexible wages and prices eliminate unemployment and overproduction. The answer can be found in
Section 7.2. 4. c. income that is saved by individuals will be borrowed by businesses and spent for investment
purposes. The answer can be found in Section 7.2. 5. b. the inflation in Europe following the conquest of the Americas. The answer can be found in Section 7.3. 6. a. cause GDP to rise. The answer can be found in Section 7.3. 7. e. They were concerned with fluctuations in the level of output, prices, and unemployment, mainly in
the short run. The answer can be found in Section 7.4. 8. a. real output would fall. The answer can be found in Section 7.4. 9. d. increase government spending. The answer can be found in Section 7.5. 10. c. Labor unions and large corporations help make prices flexible and self-regulating. The answer can be
found in Section 7.5.
Key Ideas
1. The view of the classical school was that the economy always tends towards the full-employment level of output. The classical aggregate supply curve is verti- cal. Changes in aggregate demand affect only the price level. Deviations from the full-employment level of output are temporary and self-correcting because of Say’s law, which states that enough income will be created in the process of production to purchase all that is produced.
2. Any temporary overproduction or unemployment will be corrected through price adjustments in the self-regulating product, resource, and credit markets. The interest rate ensures that planned saving is equal to planned investment.
3. The quantity theory of money explains how changes in the money supply are translated through household behavior into changes in the price level or real output. In the classical model, the velocity of money (V) and real output (Y) are constant. According to the equation of exchange, M 3 V 5 P 3 Y, changes in the money supply lead to proportional changes in the price level.
4. Keynes criticized the three central elements of classical theory: Say’s law, the quantity theory of money, and self-regulating markets. He argued that factors other than interest rates determine saving and investment, that prices and wages can be sticky downward, and that the demand for money is unstable.
5. Keynes stressed the role of planned spending in determining the levels of output and employment. He argued for government intervention to deal with persistent recession and unemployment.
Critical Thinking Questions
1. Why is the classical aggregate supply curve vertical? Why is the Keynesian aggregate supply curve horizontal?
2. What was revolutionary about Keynes’s ideas? 3. According to classical economists, how do interest rates help to ensure that the
economy will always return to the full-employment level of output?
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CHAPTER 7Critical Thinking Questions
4. What reason did Keynes give for the instability of money velocity? 5. Sometimes the Keynesian revolution is described as a switch from “supply
creates its own demand” to “demand creates its own supply.” Explain this statement.
6. Why, according to Keynes, do self-regulating markets not solve the problem of falling output?
7. In the equation of exchange, suppose V is stable (constant) with a value of 4, and the money supply is $200 billion. What combinations of P and Y are possible? Identify about a dozen combinations, and plot them on a graph. Does your graph look like an aggregate demand curve? Why or why not?
8. Suppose the money supply in Question 7 increases to $300 billion. Identify some new possible combinations of P and Y. Plot the new combinations. Which way has the curve shifted?
9. Marshall’s form of the equation of exchange is Md 5 k 3 P 3 Y. Let k 5 1/4. Sup- pose the money national income is $3,000. What must the money supply be in order to be equal to the money demand? Suppose the money supply increases to $1,000. What must the value of total output be? What are some possible divisions of that total between P and Y?
10. Keynes argued that k was not stable, especially in the short run. Suppose when you increase the money supply to $1,000 in Question 9, k rises from 1/4 to 1/3— that is, people decide to hold a larger fraction of their money income in cash balances. What happens to P 3 Y when Ms increases in this case? What does that imply for monetary policy?
11. The variables V and k are not calculated directly but are inferred from the values of Ms and P 3 Y (nominal GDP). Given the following data on money supply and GDP (both in billions of dollars), compute Y and k for the United States for the years shown:
Year Money Supply GDP
2000 1,126.9 9,951.5
2001 1,140.3 10,286.2
2002 1,196.17 10,642.3
2003 1,273.8 11,142.2
2004 1,344.3 11,853.3
2005 1,371.5 12,623.0
2006 1,374.5 13,377.2
2007 1,372.4 14,028.7
2008 1,434.7 14,291.5
2009 1,637.3 13,939.0
2010 1,742.1 14,526.5
2011 2,010.0 15,094.0
Source: Federal Reserve Bank; U.S. Bureau of Economic Analysis
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CHAPTER 7Critical Thinking Questions
12. Using the data from Table 7.1, compute the ratio of consumption to GDP and the ratio of investment to GDP for each year. Present the data as a graph. What con- clusions can you draw about which form of spending is more stable?
13. Indicate whether each of the following statements about the Great Depression would be likely to be made by a business cycle theorist, a classical economist, or a Keynesian:
a. “Left alone, the economy would have corrected itself.” b. “Unequal distribution of income meant that the rich bought too little and the
poor could not buy the rest, leaving a glut of unsold goods.” c. “Instability of investment means that the government has to step in to stabilize
demand.” 14. If you expect interest rates to rise, will you hold money in cash or buy bonds?
Why? What if you expect interest rates to fall? 15. Suppose there are 100 million workers in the economy, and full employment
is defined as 96% of them being employed. Also suppose that, given current technology, each $10 billion in output employs one million workers. What is the full-employment level of output? If actual output is $850 billion, what would you expect the unemployment rate to be?
16. Suppose an economy has suffered 2 years of falling output and rising unemploy- ment. How would this be explained by an economist in the classical tradition? A Keynesian? What would each recommend doing?
17. Suppose that in the last 6 months, real output has fallen by 3%, with a sharp rise in unemployment. What would a classical economist recommend as policy? Why? What would a Keynesian recommend?
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