Unit - I Classical, Keynesian and Post Keynesian Macroeconomics.pptx

Classical Output, and Employment, Full Employment equilibrium. Keynesian Theory of Output and employment

1. Advance macroeconomics ECOP301T

2. Unit – I: Classical, Keynesian and post Keynesian Macroeconomics Classical Theory of output and employment – Full employment equilibrium – AD-AS Model – Keynesian Theory of output and employment – under employment equilibrium – Effective Demand-Hicks Hansen IS-LM-BP Model.

3. Classical Macroeconomics: Output and Employment Macroeconomics originated in 1930s after the great depression in 1929. The problems of great depression added urgency to the study of macroeconomic questions. The book containing the theory, “The General Theory of Employment, Interest and Money” by J M Keynes published in 1936. J M Keynes termed “ Classicals ” to refer all the economists who had written macroeconomic issues before 1936. They are; Adam Smith, Wealth of nations 1776 David Ricardo, Principles of Political Economy 1817 John Stauart Mill, Principles of Political Economy 1848 A Marshall, Principles of Economics 1920 A C Pigou, Principles of Economics 1933.

4. Classical Macroeconomics: Equilibrium Output and Employment Classical and Neoclassicals differ on Microeconomic issues However, they are same on the macroeconomic issues Classical economists emphasized the importance of real factors in determining the wealth of nations They believe on the free market mechanism concepts Money plays the role of facilitating transactions as the medium of exchange They also mistrusted the role of government Stressed the role of individual self interest in solving macroeconomic issues.

5. Classical Theory of Employment and Output - Outline The Production Function The Demand for Labour The Supply of Labour Labour Market Equilibrium

6. The Production Function The production function summarizes the relationship between total output and total input assuming a given technology. Y = F(K, N) Parameters; y = total output K = stock of capital N = quantity of labour

7. The Demand for Labour How much labour do firms want to use? Firm owners are the purchasers of labour (demand for labour) Assumptions Hold capital stock fixed—short-run analysis Workers are all alike Labour market is competitive Firms maximize profits

8. Demand for labour MC = marginal labour cost (labour is the only input) MC = w/MPN Where w = wage and MPN = number of units produced by additional units of labour. With the condition of profit maximization as MC = P; P = W/MPN Or W/P = MPN Or W = MPN.P (MRPN) So, the firm owner will hire up to the point where revenue obtained from additional output produced by one more worker (MPN.P) is equal to the money wage paid to the worker.

9. Aggregate Demand and Aggregate Supply Aggregate Demand (AD): It refers to the total demand for all final goods and services produced in an economy at a given price level and during a specific period.  Aggregate Supply (AS): It refers to the supply of products that companies produce and plan to sell at a certain price in a given period.

10. Derivation of Keynesian aggregate supply ….. Y = f (K, L ) In short run…… Y = f (K, L ) MPP L = ∆ Y / ∆ L

11. Aggregate Demand Function: Two-sector Model Only two components: i) Aggregate demand for consumer goods ( C ) ii) Aggregate demand for investment goods ( I ) AD = C + I In the short run AD = C + I

12. Keynesian Theory of Employment and Output

13. Keynes’ main criticism of the classical theory was on the following two grounds: (a) The classical prediction that full-employment equilibrium will be achieved in the long-run was not acceptable to Keynes, who wanted to solve the short-run problem of unemployment. According to Keynes, in the long-run there is no problem; in the long-run, we are all dead. (b) Keynes criticised the classical assumption of self-regulating economy. The great depression of 1930s led Keynes to believe that full employment equilibrium in the economy was not be automatically achieved in the short period; and that government intervention was necessary to tackle the problem of the economy.

14. Features of Keynesian Theory of Employment: ( i ) It is general theory in the sense that– (a) it deals with all levels of employment, whether it is full employment, widespread unemployment or some intermediate level; (b) it explains inflation as readily as it does unemployment, because basically both situations are a matter of volume of employment, and (c) it relates to changes in the employment and output in the economic system as a whole . (ii) Keynesian theory of employment is a short-run theory which attempts to analyse the short-run phenomenon of unemployment. He assumed constant all those strategic variables which remain stable and change very little in the short-run. (iii) Keynesian theory is based on empirical foundations and has important policy implications. (iv) Keynes did not have much faith in the policy of laissez faire and automatic adjustment of the economic system. On the contrary, he advocated government intervention to reform the capitalist system.

15. Assumptions of the Theory: ( i ) Keynes confines his analysis to the short-period. (ii) He assumes that there is perfect competition in the market. (iii) He carries out his analysis in the closed economy, ignoring the effect of foreign trade. (iv) His analysis is a macro-economic analysis, i.e., it deals with aggregates. (v) He assumes the operation of the law of diminishing returns or increasing costs. (vi) The government is assumed to have no part play either as taxer or a spender, i.e., the fiscal operations of the government is not explicitly recognised. (vii) He assumes that labour has money illusion. It means that a worker feels better when his wages double even when prices also double, thus leaving his real wage unchanged.

16. Variables of the Theory: The variables used by Keynes in his theory can be broadly divided into three groups: 1. Given Elements: 2. Independent Variables (or Causes): 3. Dependent Variables (or Effects):

17. 1. Given Elements: First there are variables which have been assumed as given because they change so slowly that their effects in short run can be ignored. They are– (a) the quality and quantity of labour and capital stock; (b) techniques of production; (c) degree of competition; (d) consumer tastes; (e) the structure of the society. 2. Independent Variables (or Causes): Independent variables are the behaviour patterns of the society. In other words, they represent the basic functions or relationships. There are four independent variables: ( i ) The consumption function; (ii) The investment function or the marginal efficiency of investment schedule; (iii) The liquidity preference function; (iv) The quantity of money fixed by the monetary authority.

18. 3. Dependent Variables (or Effects): The dependent variables of the Keynesian system are– (a) the level of employment, output and income, and (b) the rate of interest. Keynes makes rate of interest an independent variable. But, according to Hansen, rate of interest is a determinate, and not a determinant. Rate of interest along with national income together are mutually determined by the above mentioned four independent variables.

19. The main propositions of the theory are given below: ( i ) Total employment = total output = total income. As employment increases, output and income also increase proportionately. (ii) Volume of employment depends upon effective demand. (iii) Effective demand, in turn, is determined by aggregate supply function (representing costs of entrepreneurs) and aggregate demand function (representing receipts of entrepreneurs). It is determined at the point where aggregate demand and aggregate supply are equal. (iv) Keynes assumed aggregate supply function as given in the short period and regarded aggregate demand as the most important element in his theory.

20. (v) Aggregate demand function is governed by consumption expenditure and investment expenditure. (vi) Consumption expenditure depends upon the size of income and the propensity of consume. Consumption expenditure is fairly stable in the short-period because propensity to consume does not change quickly. (vii) Investment expenditure is governed by marginal efficiency of capital (i.e., profitability of capital) and the rate of interest. Unlike consumption expenditure, investment expenditure is highly unstable. (viii) The marginal efficiency of capital is determined by the supply price of capital assets on the one hand and the prospective yield on the other. Prospective yield, in turn, depends upon future expectations. This explains why the marginal efficiency of capital and hence investment expenditure fluctuates.

21. (ix) Rate of interest is a monetary phenomenon and is determined by the demand for money (liquidity preference) and the quantity of money. Liquidity preference depends upon three motives - transaction motive, precautionary motive, and speculative motive. Quantity of money is regulated by the monetary authority. (x) The essence of the whole theory of employment is that employment (= output = income) depends upon effective demand. Effective demand expresses itself in the whole of total spending of the community, i.e., consumption expenditure and investment expenditure. A fundamental principle is that as income of the community increases, consumption will increase, but by less than the increase in income. Thus, in order to increase the level of employment, investment must be increased. Investment must be high enough to fill the gap between income and consumption. (xi) Original Keynesian analysis considers private consumption and private investment expenditure only and does not take into account government expenditure. But, in modern times, government expenditure is also a significant determinant of effective demand. Government expenditure is considered the most effective weapon to fight unemployment.

22. Determination of the Equilibrium Level of Employment by Effective Demand The amount of employment is measured along the X-axis and the receipts or proceeds obtained at various levels of employment are measured along the Y-axis. As said above, aggregate supply curve shows the revenue or receipts which must be received by the entrepreneurs so as to provide employment to a given number of men, whereas aggregate demand curve shows proceeds or receipts which entrepreneurs actually expect to receive at different levels of employment and production. These aggregate demand and the aggregate supply curves determine the level of employment in the economy. Given that the perfect competition prevails in the economy, then so long as opportunities to earn profits or make money exist, the entrepreneurs will increase the level of employment. The opportunities to make profits exist if aggregate demand price is greater than the aggregate supply price for a given number of employment.

23. Therefore, so long as aggregate demand price exceeds aggregate supply price, the entrepreneurs will go on employing extra men. When at a level of employment aggregate demand price becomes equal to aggregate supply price, then after this it will be no more profitable to employ men. Since beyond this point aggregate supply price will exceed aggregate demand price, the cost of production incurred on employing a certain number of people will not be covered.

24. Equilibrium level of employment is determined by the intersection of aggregate demand curve and the aggregate supply curve, where the amount of money which the entrepreneurs actually expect to receive from employing a certain number of men is equal to the amount of money which they must receive. In other words, the employment of labour will be in equilibrium at the level at which aggregate demand price equals aggregate supply price. It will be seen from the above Figure that aggregate supply curve and aggregate demand curve intersect at point E and therefore ON₂ level of employment is determined. It will be noticed that at less than ON₂ level of employment, aggregate demand curve AD lies above the aggregate supply curve AS showing that it is profitable to expand the amount of employment. However, beyond ON₂ amount of employment, the aggregate demand curve AD lies below aggregate supply curve AS , which shows that it is no more profitable to employ extra men beyond ON₂ . We, therefore, conclude that ON₂ is the equilibrium level of employment which is determined by aggregate demand curve AD and aggregate supply curve AS .

25. Under-employment Equilibrium It is not necessary that the equilibrium level of employment is always at full employment. Equality between aggregate demand and aggregate supply does not necessarily indicate the full employment level. The economy can be in equilibrium at less than full employment or, in other words, an under-employment equilibrium can exist. The classical economists denied that there could be an equilibrium at less than full employment, because they believed that supply would always create its own demand and therefore no problem of deficiency of aggregate effective demand would be experienced. Keynes demolished the classical thesis of full employment both on theoretical grounds and on the basis of illustrations from real life.

26. It will be seen from below Fig. that in the situation of equilibrium at the employment level ON₂ , the N₂N F persons remain unemployed. Thus equilibrium at E represents an under-employment equilibrium (or, in other words, less than full-employment equilibrium). It is important to note that N₂N_F persons are involuntarily unemployed : they are willing to work at the existing wage rates but are unable to find jobs. It is important to remember that, according to Keynes, this unemployment is due to deficiency of aggregate demand. This unemployment will be removed and full-employment equilibrium will be reached if through increase in investment demand or increase in consumption, or increase in both, aggregate demand curve shifts upward so that it intersects the aggregate supply curve at point R as depicted in this Fig. It will be seen that with the intersection of aggregate demand and aggregate supply curves at point R , equilibrium is established at full-employment level ON F

27. IS-LM-BP MODEL

28. IS-LM-BP MODEL The IS-LM-BP model (also known as IS-LM- BoP or Mundell-Fleming model) is an extension of the IS-LM model, which was formulated by the economists Robert Mundell and Marcus Fleming, who made almost simultaneously an analysis of open economies in the 60s. In addition to the balance in goods and financial markets, the model incorporates an analysis of the balance of payments.

29. What is IS-LM-BP curve? First the IS curve, which represents the equilibrium in the goods market, is defined. Secondly, the LM curve, which represents the equilibrium in the money market. Thirdly, the BP curve, which represents the equilibrium of the balance of payments.

30. IS curve: the market for goods and services In an open economy, the equilibrium condition in the market for goods is that production (Y), is equal to the demand for goods, which is the sum of consumption, investment, public spending and net exports. This relationship is called IS. If we define consumption (C) as C = C(Y-T) where T corresponds to taxes, the equilibrium would be given by: Y = C(Y-T) + I + G + NX

31. We consider that investment is not constant, and we see that it depends mainly on two factors: the level of sales and interest rates. If the sales of a firm increase, it will need to invest in new production plants to raise production; it is a positive relation. With regard to interest rates, the higher they are, the more expensive investments are, so that the relationship between interest rates and investment is negative. Now, in addition to what we have in the IS-LM model, since we have net exports, we have also to take into account the exchange rates, which directly affect net export Let’s say e is the domestic price of foreign currency or, in other words, how many units of our own currency have to be given up to receive 1 unit of the foreign currency. The new relationship is expressed as follows (where i is the interest rate). Y = C (Y- T) + I (Y, i) + G + NX(e)

32. If we keep in mind the equivalence between production and demand, which determines the equilibrium in the market for goods, and observe the effect of interest rates, we obtain the IS curve. This curve represents the value of equilibrium for any interest rate. An increasing interest rate will cause a reduction in production through its effect on investment. Therefore, the curve has a negative slope. The adjacent graph shows this relationship.

33. As stated before, we also need to analyse changes in exchange rates (here,  e ). If e decreases, then we’ll be able to buy more foreign currency with less of our own currency. On the other hand, foreigners we’ll need to pay more of their currency to buy our own. Therefore, when e decreases, also called an appreciation under flexible exchange rates or a revaluation under fixed exchange rates, domestic residents have more purchasing power, thus being able to buy the same amount of goods using less domestic currency.

34. LM curve: the market for money The LM curve represents the relationship between liquidity and money. In an open economy, the interest rate is determined by the equilibrium of supply and demand for money: M/P=L( i,Y ) considering M the amount of money offered, Y real income and i real interest rate, being L the demand for money, which is function of i and Y. Also, the exchange rate must be analysed since it affects money demand (investors may decide buy or sell bonds in a country depending on the exchange rate).

35. The equilibrium of the money market implies that, given the amount of money, the interest rate is an increasing function of the output level. When output increases, the demand for money raises, but, as we have said, the money supply is given. Therefore, the interest rate should rise until the opposite effects acting on the demand for money are cancelled, people will demand more money because of higher income and less due to rising interest rates. The slope of the curve is positive, contrary to what happened in the IS curve. This is because the slope reflects the positive relationship between output and interest rates.

36. BP curve: the balance of payments The BP curve shows at which points the balance of payments is at equilibrium. In other words, it shows combinations of production and interest rates that guarantee that the balance of payments is viably financed, which means that the volume of net exports that affect total production must be consistent with the volume of net capital outflows. It will usually slope up since the higher the production, the higher the imports, which will disturb the equilibrium of the balance of payments, unless interest rates rise (which would cause capital inflows to maintain the equilibrium). However, depending in how great the mobility of capital is, it will have a greater or smaller slope: the higher the mobility, the flatter the curve.

37. Once the BP curve is derived, there is an important thing to know about how to use it. Any point above the BP curve will mean a balance of payments surplus. Any points below the BP curve will mean a balance of payments deficit. This is important since depending where we are, different things may affect the interest rates.

38. The IS-LM-BP model In the model we distinguish between perfect and imperfect capital mobility, but also between fixed and flexible exchange rates. For each of these cases, we’ll see what happens when both an expansionary monetary and fiscal policy are applied to the economy. We’ll first review Mundell’s model, which deals with perfect mobility. Then, we’ll analyse Fleming’s imperfect mobility model.

39. Perfect capital mobility (Fixed exchange rate) An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E0 to E1. However, since we are below the BP curve, we know the economy has a balance of payments deficit. Since exchange rates are fixed, government intervention is required: the government will purchase domestic currency and sell foreign currency, which will drop the money supply and therefore shift the LM’ curve to its original position (which makes the equilibrium go to E2). Monetary policy has therefore no effect under these circumstances.

40. An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium form point E  to point E 1 . Since the economy has now a balance of payments surplus, and because the exchange rate is fixed, government will intervene in the exact opposite way: they’ll purchase foreign currency and sell domestic currency. This will increase the money supply, shifting the LM curve to the right. The final equilibrium is reached at point E 2  where, at the same interest rate, production has increased greatly: fiscal policy works perfectly under these circumstances.

41. Perfect capital mobility (Flexible exchange rate) An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E0 to E1. However, since now exchange rates are flexible, we have a different situation: the balance of payments deficit will depreciate the domestic currency. This will increase net exports (since foreigners can now buy more of our products with the same amount of money), which will shift the IS curve to the right (to IS’). The final equilibrium is reached at point E2 where, at the same interest rate, production has increased greatly, monetary policy works perfectly under these circumstances.

42. An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E  to point E 1 . The economy will therefore have a balance of payments surplus, which in this case of flexible exchange rate will appreciate the domestic currency. This will decrease net exports, since we are able to import more goods and services with less money, while foreigners will import less of our products because of our appreciated domestic currency. This drop in net exports will shift the IS’ curve back to its original position. Since now the final equilibrium E 2  corresponds to the initial equilibrium, we know fiscal policy is no good in this case.

43. It is easy to see why Mundell devised what is known as the impossible trinity. In a few words, no economy can have the following three: perfect capital mobility, fixed exchange rates and an independent and efficient monetary policy. Under the perfect capital mobility assumption, and in order to have an efficient monetary policy, exchange rates must be flexible. Or have fixed exchange rates but assume that monetary policy won’t be efficient.

44. Imperfect capital mobility (Fixed exchange rate) Here we have the exact same situation as before: an expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E  to E 1 . However, since we are below the BP curve, we know the economy has a balance of payments deficit. Since exchange rates are fixed, the government will purchase domestic currency and sell foreign currency, which will drop the money supply and therefore shift the LM’ curve to its original position (which makes the equilibrium go to E 2 ). Monetary policy has again no effect, no matter how great or small capital mobility is.

45. An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E0 to point E1. Now, depending on capital mobility, we’ll either have a balance of payments surplus (high capital mobility, BP+ curve) or a balance of payments deficit (small capital mobility, BP- curve). Since exchange rates are fixed, government will need to intervene: its acquisitions and disposals of both domestic and foreign currency will shift the LM curve to either LM’ or to LM* (you can review what happens above: a balance of payments surplus is the same scenario as in a fiscal policy with perfect capital mobility and fixed exchange rates, while the balance of payments deficit corresponds to the monetary policy scenario). Under these circumstances, fiscal policy is completely efficient. It’s actually the more efficient the higher capital mobility is.

46. Imperfect capital mobility ( Flexible exchange rate) An expansionary monetary policy will shift the LM curve to LM’, which makes the equilibrium go from point E  to E 1 . However, since now exchange rates are flexible, the balance of payments deficit will depreciate the domestic currency. This will increase net exports, shifting the IS curve to IS’. Also, since domestic assets are less expensive, the BP curve will shift to the right (to either BP’+ or BP’-). Therefore, with high capital mobility, final equilibrium will be at point E 2 . Monetary policy works well under these assumptions. It’s actually the more efficient the higher capital mobility is.

47. An expansionary fiscal policy will shift the IS curve to IS’, moving the equilibrium from point E  to point E 1 . Now, depending on capital mobility, we’ll either have a balance of payments surplus (high capital mobility, BP+ curve) or a balance of payments deficit (small capital mobility, BP- curve). In the case of a balance of payments surplus, and considering flexible exchange rates, there will be an appreciation of the domestic currency. This will decrease net exports, which will shift the IS’ curve to the left. Also, since domestic assets are more expensive, the BP+ curve will shift to the left.

48. The final equilibrium will therefore be at point E2. If there is a balance of payments deficit (the case for the BP- curve), the result will be the same one as in the monetary policy case (being E2* the final equilibrium). In this scenario, fiscal policy will be more efficient the smaller capital mobility is. The Mundell-Fleming model is a very useful tool when dealing with the analysis of open economies. A great deal of textbooks and papers argue for or against each of these models. However, there’s no denying the world is moving towards liberalizing international trade and capital movements (mostly through WTO’s agreements), which would make us lean towards Mundell’s view. To sum up, under perfect capital mobility, monetary policy will only work with flexible exchange rates, while fiscal policy will only work with fixed exchange rates.

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