22. Classical economics and the Keynesian revolution: the major areas of disagreement

The general ideas

Classical	Keynesian
1. There is long run equilibrium.	1. There might be a persistent disequilibrium in the modern market economy.
2. Short run disequilibrium is abolished by market mechanism.	2. This disequilibrium can't be eliminated with the existent market mechanism.
3. There are no such long-run problems in the economy, as recession, unemployment, recession.	3. There are such problems as there is a long-run unemployment. No inflation in this period (1936)
4. Government should not interfere in market mechanism. Markets are people running themselves	4. Government should interfere in the economy in order to correct disequilibrium.

Areas of disagreement

Areas	Classical	Keynesian
1 – Prices and Wages	Prices and wages are relatively flexible. Markets tend to clear quickly.	Prices and wages are relatively inflexible. Impossible for prices and wages to fall down. Government price policies, final anti-monopoly laws. Because monopolies try to keep prices at high level. Wages don't tend to fall and as a result markets can't automatically restore equilibrium.
2 - Macroeconomic Equilibrium	W=J (Withdrawals = inJections) W=S+T+M; J=I+G+X So, Saving=Investment iMport=eXport Taxes=Government because government must balance its budget.	W <> J So: S <> I, M <> X, T <> G
3 - Elasticity of AS curve and stability of AD	AS curve is inelastic, it is vertical. AS = Ypotential Supply creates its own demand.	AS supply curve is elastic AS depends on AD.
4 – Inflation (velocity of money circulation	MS – money supply V-velocity P-price index Y-value of national output MsV=PY V is stable and depends on D for money. Y is stable too.	1)Increase in MS does not necessary lead to inflation. V is instable. Y depends directly on MS. 2)Inflation may be caused by sufficient increase in AD.

23. Consumption, saving and withdrawals functions in the Keynesian analysis. Injections and their determinants.

Important assumptions in the Keynisian analysis

1. Absence of inflation-amount of money corresponds to the change in AD and av int rate is fixed.

2. absence of bus fluctuations(Inj=W)

3. Injections-exodiness var(doesn’t depend on Y in the short run).W and Cd-endogenouss(depend on Y)

The consumption of domestically produced goods and services( C_d) – the direct flow of money payments from households to firms.

Consumption function:

The main determinant of national consumption is national income. This relationship may be illustrated with the consumption function C=f(Y) and 45* line diagram.

Description of diagram:

1. Y influnces directly on C

2. At low level of income befor point of intersection (A) consumption function lies above 45 degre line. It means that nation spends more than it earns-dissaving.

3. At point A cons=nat income, that is nation spend all its income corresponded to A. A is called break-even point.

4. After p. A cons is less than nat income (other part goes on saving)

The slope of con function depends on marginal propencity to consume (mpc-a proportion of arise in Y that goes on consumption mpc=∆C/∆Y, apc-is the proportion of total national income that goes on consumption apc=C/Y)

Withdrawals(W)(or leakages) – income of households or firms that are not passed on round the inner flow. Withdrawals equal net savings(S) plus net taxes(T) plus import expenditure(M): W=S+T+M

1.Savings

mps-proportion in the incr of Y saved=∆S/∆Y

aps-proportion of Y saved=S/Y

Non-income determ:

1. 1.wealth and distribution of income

2. 2.level of taxes

3. 3interest rate

4. 4.expectations of future prices

5. 5.personal motivation to save.

2.Taxes

Types:

1. 1.Lump-sum –no changes in T when Y rises

2. 2.Proportional-T rise proportional as Y rises

3. 3.Progressive-T rise more intensivle than Y

4. 4.Regressive-T rise less int than Y

• Mpt-proportion of rise in Y payed in tax=∆T/∆Y

• Apt-proportion of Y payed in T=T/Y

Non-income detetm:

• 1.tax rates

• 2.size of underground economy

3.Imports

1. M of luxury goods 2. M of basic g&s

mpm-proportion of rise in Y that goes abroad=∆M/∆Y

apm-proportion of Y that goes abroad=M/Y

Non-income determin:

• 1.relative prices-if domestic prices are higher than imported than people prefer to buy imported

• 2.relative quality-if quality of imported is better than domestic M rises

• 3.Relative interest rates-if foreign int rayes rise relative to domestic,more money will flow abroad, M rises

• 4.exchange rate-if people expect exchange rate is about to depriciate,there will be an outflow of capital, M rises

• 5.preferences

• 6.total consumption

Injections(J) – expenditure on the production of domestic firms coming from outside the inner flow of the circular flow of income. Injections equal investment(I)plus government expenditure(G) plus expenditure on exports(X). J=I+G+X

Injections

1.Investment

1. a)real interest rate-the higher the interest rate the more expensive is borrowing and the less I

2. b)capacity and stocks-the more capacity the less I

3. c)expected rate of net profit-I depends on firms expectations about future marker conditions.

2.Gov expenditure-the higher level of Y, the higher amount of Trevenue,the more it can afford to spend in the long run.

3Exports-the same determinants as import.