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Money & Output

Determination

Models of Money & Output Determination

The Classical Model:

is based on Adam Smiths


Wealth of Nations (1776).
is the foundation for neo-classical and Austrian
school economics, rational expectationism, and
monetarism.
was dominant before the 1920s. Gained in
popularity again since the 1980s.

Classical Economists Believe that:

Market forces (flexible prices, wages, and interest rates)


correct economic problems.
Output increases when the price level is higher than expected.
Expected money changes in the money supply change the
expected price level.
Only unexpected changes in the money supply affect real
output in this model.
Evidence shows that expected and unexpected money
supply changes affect current output.
Limited government involvement in the economy leads to
maximum wealth and the highest standard of living.
Artificial government stimulation of the economy leads to
problems in the long run.

Money and Output:


The New Classical Model Diagram

The Keynesian Model:

is based on the works of


John Maynard Keynes
(1883 1946).
gained acceptance during the 1930s and was
supported by almost all western economists and
politicians during the 1950s, 1960s, and 1970s.

Keynes said: In the long run we are


all dead. Do you agree?
1.
2.
3.
4.

Yes
No
Not sure
I dont care (were
all dead soon)

Keyness Analogy

The economy is like an


elevator. If it goes up, it will
continue to go up for a while.
If it goes down, it will go down
and may hit the bottom,
unless someone stops it.

The Keynesian Theory


During a recession,
Production decreases.
Thus, layoffs increase.
Thus, incomes and demand for products fall.
Thus, production decreases even more.
Thus, layoffs increase further.
And so forth.
During an expansion the opposite happens.

The Keynesian Solution

The government must intervene (stop the


elevator) through:
1. Active fiscal policy
2. Active monetary policy

The Keynesian Multiplier


When government increases spending,
total spending in the economy increases by a
multiple of the increase in government spending.

Multiplier Example
Lets say a government spends $1 billion ($1,000
million) on the construction of a stadium.
This increases construction workers incomes by
$1 billion, compared to if the government hadnt
spent the money.
What happens to this $1 billion?

Example (contd)
Lets assume that the construction workers spend
80% ($800 million) of their additional income. We
say that their Marginal Propensity to Consume
(MPC) is 80%.
Lets say they spend it on clothes.

Example (contd)
This generates $800 million in additional income
for the clothes suppliers.
What happens to the $800 million?

Example (contd)

$512
$640
$800
$1,000

Lets assume the clothes producers spend 80% of


their additional income on food.
This generates $640 million in additional income
for food suppliers.
What will the food suppliers do with the
additional income? You get the picture.

Example (contd)
Thus, total spending in the economy increases
by (in millions):
$1,000 + $800 + $640 + $512 + = $5,000

Example
$5,000 million is 5 times $1,000 million.
$1,000 is the initial government spending change.
Keynes called this factor 5 the multiplier.

The Change in Total Spending in the Economy


According to Keynes:
The additional total spending in the economy = multiplier
x the change in initial spending.
Or:
total spending = m x
initial spending.

The Formula for the Multiplier


Multiplier = 1 / (1 MPC)
Or,
Multiplier = 1 / MPS
Where MPS = Marginal Propensity to Save

Multiplier Example
If the MPC = .8, then
m = 1 / (1 .8) = 1/(.2)

= 5.

Evaluation of the Keynesian Theory


Lets evaluate the effects of government
spending.
If the government increases spending, how does
it pay for this?

Evaluation of the Keynesian Theory

The funds can come from 3 sources:


newly printed money, or
borrowed money, or
increase in taxes

Evaluation of the Keynesian Theory

If the government prints more money, it:


lowers interest rates in the short run. This increases
borrowing and spending, and stimulates the economy in
the short run.
but it causes inflation and increases interest rates, and
slows down the economy in the long run.

Evaluation of the Keynesian


Theory

If the government borrows the money, it:


increases funds for the government. This
increases spending in the government sector.
but it decreases funds in the private sector.
This decreases private sector spending.
increases the national debt and increases
future taxes. This slows down the economy in
the long run.

Evaluation of the Keynesian


Theory

If the government increases taxes, it:


increases funds for the government. This
increases spending in the government sector.
but it decreases peoples incomes in the
private sector. This decreases private sector
spending.
discourages people from working. This
slows down the economy.

Evaluation of the Keynesian Theory

Conclusion:
Keynesian policy may help the economy in
the short run, but is harmful to the economy
in the long run.

Aggregate Demand and Supply


Aggregate = the sum of
Aggregate demand = the demand for
all products in the economy.

Aggregate Demand

The Aggregate
demand curve
is downward
sloping

According to
Keynesian theory,
an increase in AD
in the vertical
part of the AS curve
increases the
price level.

A Shift in Aggregate Demand

According to
Keynesian theory,
an increase in AD
in the upward
part of the AS curve
increases GDP and
the price level.

The Phillips Curve

According to
Keynesian theory,
there exists an
inverse relationship
between inflation
and unemployment.

A Shift in Aggregate Supply

According to
Classical theory,
an increase in AS
increases GDP, and
lowers the price
level.