CLASSICS AND KEYNES

Macroeconomics is the study of economics from an overall point of view. Instead of looking so much at individual people and businesses and their economic decisions, macroeconomics deals with the overall pattern of the economy. To star with, we will look at two main groups of economists: the Classical Economists and the Keynesian Economists. Classical economists generally think that the market, on its own, will be able to adjust while Keynesian economists believe that the government must step in to solve problems. The two camps have differing ideas on the causes and solutions of unemployment. The Classical economists believe that unemployment is caused by excess supply, which is caused by the high price level of labor. Based on supply and demand, when wages are held too high by social and political forces, demand would be low and supply would be high and that excess supply represents unemployed people. Classical economists believe that if the economy were left on its own, it would adjust to reach an equilibrium wage for workers and the economy would be at full employment.

Classical economists believe in Say's Law, which states that people supply things to the economy so they have income to demand things of the value they've supplied. Classical economists also argue that all money is always in the economy, because even when people put their income away in the form of savings in banks, stocks, etc. that money still flows back into the economy in the form of investment. When savings money flows into banks, even though it does not directly go to the industries in the form of purchases, banks loan this money to industries to invest in further development. Investmen takes the form of money to acquire new machines, labor, facilities, etc. so that businesses grow.

Fig 2.1.1-Transfer of money

Crucial to the understanding of classical economics is an understanding of how money works. Money is just something that can value goods, used to exchange those goods among individuals in an economy. The quantity theory of money is the theory dealing with money and prices. It states that the price level in an economy depends on how much money is in the economy. In classical economics, the quantity theory of money centers around the equation "(Quantity of money) x (velocity of money) = (price level) x (quantity of goods sold)." Velocity of money just means how often money is spent. The price level times the quantity of goods sold obviously equals the GDP, total production. Velocity, then, times the amount of money would equal that. A coin, for example, is passed around from person to person throughout time and each time it is spent, it generates income worth its value. The number of times that coin was passed on throughout the year is its velocity and that times its value gives how much production it represents that year. When you add all the income generated by all the money out there, you get the GDP also.

The velocity of this money depends on what the structure of an economy is like. It depends on things like where people work, where they shop, how often they shop, etc. Since no drastic economic restructuring could be expected to occur in any short period of time, this velocity is assumed to remain constant from year to year. (It does change, but this change is so incredibly slow as to be irrelevant.) Classical economics also stresses that the amount of goods and services produced is not affected by the money supply. This doctrine is the veil of money assumption. This assumption separated the world of finance (of purely monetary studies) and the rest of the economy (the production of goods and services). The veil of money theory basically says that when the money supply changes, the real economy does not because when money supply changes by a certain amount, everything else does as well. If it doubles, then prices double, and people's pay doubles too to compensate for this, so nothing really changes. Classical economics states that money supply is the force that changes the price level.

Since money supply changes prices and money supply is not affected by production, the amount of supply is independent of the price level. The amount of output is chosen by people and, according to classical economics, as long as they're no outside pressures intefering with the markets like politics, the amount of supply will always be at full employment level. Demand in the long term is not a problem because in the long term, based on Say's Law, supply generates its own demand and so there will be long-term equilibrium. As stated earlier, classical economists see the problem of unemployment as a self-solving problem like all other things. Wages will fall and then demand for labor will increase and eventually everyone who wants a job will get one.

The long-term classical model does not solve short term problems. In the short term, there are always various fluctuations that move demand and supply out of balance of each other. There must be a mechanism to equalize them again.

Fig 2.1.2-Classical adjustment model

Suppliers in the classical model never change how much they supply, they just change their prices so that people will buy them. No matter what, supply is an independent concept. Suppliers will always produce how much they want to produce at a given time. Demand, however, can move by changes to the price level so that all that is produced is actually bought.

A basic argument made by John Maynard Keynes, a famous economist during the depression era who invented the idea of Keynesian economics, was that Say's law was just plain false. In Keynes's analysis of the economy, he looked at the problems of supply and demand separately. The problem of supply is relatively simple: supply generates income. What people make are bought, and thus the value of supply is always equal to the value of income. This income is then passed on to the consumers in the form of paychecks. The consumers then spend this money to buy various products. Keynesian economics have several concepts to explain how consumers spend their income.

The money that people get are always split between consumption and savings. People who have enough money usually save some of it and spend most of it. There are two ratios Keynesian economics considers when dealing with consumption: the APC and the MPC. The APC, average propensity to consume, is a ratio telling us how much of people's income they tend to spend. The APC varies with income level. The MPC tells us what part of a change in income people tend to spend. For example, if the MPC was .5 and somebody got an increase of income of $1000, then they will spend $500 dollars of that increased income. Conversely, people will cut their spending by that ratio when they lose some income.

Fig 2.1.3-Keynesian consumption function

In this graph, we can see a graphical representation of Keynes's ideas. The blue line represents production. The red line represents how much people spend. The slope of the line, or how much the line goes upward for every increment horizontally, is the MPC, which in this case is 0.75 (how much of every extra piece of income is spent). The slope of the production line is 1 since production = income. When income is way too low, as shown in this, spending must exceed income because no matter what, there are some things that people must buy, like food. They do this through borrowing and dipping into savings, etc. Beyond a certain point, people have enough to save some of that money. APC can be represented on this graph as the ratio of the amount represented by the red line to the amount represented by the blue line at any point. Notice that this ratio changes, which makes sense in the context of Keynesian economics. At the point where spending equals production/income, the APC is 1 and at that point, people spend all the money they make.

Of course, the rest of the money, the money that is not spent, goes into savings. There is also APS and MPS, the average propensity to save and marginal propensity to save. APS is what part of income people save and MPS is what part of additional income people save. APS+APC=1 and MPS+MPC=1, as savings and spending together equal income. Savings is the part of the graph between the two lines. When spending is more than income, people save, savings represented by the difference between income and spending. When spending is more than income, people take money out of past savings, the amount represented by the difference between spending and income. Another component of Keynes's analysis was the independence of investment. Unlike classical economics, which states that all savings go into investment, Keynes said that how much people invests is simply how much they feel like investing. There are more complicated models, but to keep this simple now, investment is not changed by savings or income. To keep the model simple, we will assume that government spending and foreign trade is all independent. If you add all these factors into the spending, the red line representing total spending would be shifted upwards (the whole line, the slope is still the same).

Whenever the economy is not in equilibrium, firms change their production until equilibrium is reached. When there is more production than expenditure, there is an excess of supply, as firms are not selling everything they produce. Thus, they have to decrease production until production equals consumption on the graph. On the other hand, if there is too little supply, the portion of the graph where production is less than consumption, firms increase their production to meet the demands of customers until the two lines of output and spending meet at equilibrium. The economy is continually adjusting in the Keynesian model as various factors influence the independent factors of investment, government spending, and net export, factors outside of income and production. Interest rate changes, future predictions, and technology can affect investment. Government spending may change depending on varying political situations. Net export, too, can change with a nation's changing international position. These changes can move the spending curve up or down (again, shift as opposed to changing the slope) and thus force further adjustment of production. With his model, he explained the Great Depression: after the crash of 1929, people became scared. Invetment was cut as was spending. When this happened, companies decreased their production even more as spending decreased and this was followed by a drop of spending as income fell (income=production). This drop continued until equilibrium was reached at a point that is way below that of full employment.