Chapter 1 keynes and the classic (Scarth)

Macroeconomics 2Abdul Hadi Ilman

Sumbawa University of Technology

What will we learn? Trying to integrate two quite different schools of thought

• New Classical vs Keynesian

• Classical micro-foundation, and excluding market failure

• Keynesian macro policy, and excluding micro-foundation

The development of the “New Neoclassical Synthesis”

• a system that involved the Classical model determining full equilibrium, and a Keynesian

model of temporarily sticky prices determining the approach to that full equilibrium

Short run issues: dynamics, expectations, and micro-foundations

Long run issues: natural unemployment rate, old and new growth theory

What will we learn? The applications the Lucas critique of standard methods for

evaluating policy,

credibility and dynamic consistency issues in policy design,

the sustainability of rising debt levels and an evaluation of Europe's Stability Pact,

the optimal inflation rate,

the implications of alternative monetary policies for pursuing price stability (price-level vs inflation-rate targeting, fixed vs flexible exchange rates),

tax reform (trickle-down controversies and whether second-best initial conditions ease the trade-off between efficiency and equity objectives),

theories of the natural unemployment rate and the possibility of multiple equilibria,

alternative low-income support policies, and globalization (including the alleged threat to the scope for independent macro policy).

Keynes and the ClassicChapter 1

Makroekonomi 2

Abdul Hadi Ilman

Introduction Keynesian view is that adjustment back to equilibrium simply does not take place

without policy assistance.

(i) the economy has multiple equilibria, only one of which involves "full" employment; or

(ii) there is only one equilibrium, and it involves "full" employment, but the economic system is unstable without the assistance of policy, so it cannot reach the "full" employment equilibrium on its own.

Stability vs outright instability

Chapter 1: Specification in the labor market, to clarify the cause of unemployment:

Perfectly flexbile money wages (Classical)

Completely fixed money wages (Keynesian)

Introduction Chapter 2, we assume that nominal rigidities are only temporary, and we consider a dynamic analysis that

has Classical properties in full equilibrium, but Keynesian features in the transitional periods on the way to full equilibrium

In Chapter 3, we enrich this dynamic analysis by exploring alternative ways of bringing expectations into the analysis. we will have identified two important considerations that make macroeconomic convergence more problematic: firms' reactions to sticky prices and sales constraints, and expectations.

In Chapter 4, we rectify one major limitation of the analysis to that point — that formal micro-foundations have been missing. The intertemporal optimization that is needed to overcome this limitation is explained in Chapter 4.

in Chapter 5, we examine the New Classical approach to business cycle analysis — the modern, more micro-based version of the market-clearing approach to macroeconomics, in which no appeal to sticky prices is involved.

Finally, in Chapters 6 and 7, we examine what has been called the "New" Neoclassical Synthesis — a business-cycle analysis that blends the microeconomic rigour of the New Classicals with the empirical applicability that has always been the focus of the Keynesian tradition and the original Neoclassical Synthesis.

Criteria for Model Selection Broad criteria for macro models

• First, models must be subjected to empirical tests, to see whether the predictions are consistent with actual experience.

• Second, should be evaluated as to their consistency with optimizing underpinnings. Microeconomics base

Frustrating debate in 1970s and 1980s between these two schools of thought

In 1990s, there were constructive dialogs to combine the best features of the competing approaches so that now the subject is empirically applicable, has solid micro-foundations, and it allows for market failure

Classical Economics Economists:

Adam Smith( Scottish philosopher)

Alfred Marshall(British economist)

Arthur Cecil Pigou (British economist)

David Ricardo (British economist)

JS.Mill

Malthus

CENTRAL PRINCIPLE

The economy is best organised as a self-regulating system of markets.

Known also as: laissez faire, liberal, supply side

Classical Economics Wages and prices are fully

flexible in order to clear markets rapidly.

Economy operates at full employment most of the time. Classical aggregate curve is vertical

Minimal govt intervention reflecting distrust of government and belief in its inefficiency.

Unemployment in the economy is either Voluntary or due to some External Interference.

Keynesian Economics Advocates:

• Francis Ysidro Edge Worth

• Jean-Baptist Say

• Paul Samuelson

• John Maynard Keynes

CENTRAL PRINCIPLE

The economy often operates at less than full employment; market system does not self adjust.

Known also as: interventionist, demand side

Key Differences IN THE CLASSICAL WORLD

• Free market economies are always stable

• Tending towards full employment & full production equilibrium

• Free fluctuating pricies in the three macro markets (Goods, money, labor)

IN THE KEYNESIAN WORLD

• Free market economies are unstable

• Equilibrium but no reason for full employment/full production

Classical Model Assumptions:

Endogenous variables:

• Y, N, r, P, and W

Classical Dichotomy: the key real variables (output and employment) are determined solely on the basis of aggregate supply relationships (the factor market relations and the production function), while the demand considerations (the IS and LM curves) determine the other variables (r and P) residually

Classical View on Unemployment

The labor &the other resources are always fully employed.

General unemployment is assumed to be impossible.

If there is any unemployment, it is assumed to be temporary/ abnormal.

In the long run the economy will have full employment/natural rate of

unemployment if wages & prices are flexible

Classical’s Reason for Full Employment

Say’s law: Supply creates its own demand.

Abstinence theory of interest: Interest rate influences people’s saving.

Classical theorists held that wages & prices would change proportionally

Graphically the pure classical theorists would have a vertical AS curve. That shows

the same GDP associated with full employment, at each level in the economy.

Classical’s Reason for Unemployment

Intervention by the

government/private

monopoly.

Wrong calculation by

entrepreneurs & inaccurate

decisions

Artificial resistance

• Classical unemployment occurs when real

wages are kept above the market clearing

wage rate, leading to a surplus of labor

supplied

• Classical unemployment sometimes known

as real wage unemployment. Because it

refers to real wages being too high.

Keynesian Economics

Markets clear only slowly, if at al

In a depression or recession, much employment is involuntary.

Economy operates less often than full employment, since market don’t clear

Govt intervention may be desirable to stabilize the business cycle. (Fiscal and monetary policies)

Demand becomes much bigger driving force

Supply will adjust to demand

According to Keynes; Demand creates its own supply”

Keynesian policy Implications Under the classical system, government had no role in management of

the economy- “Laissez faire” do nothing.

Under Keynes, Government must step into to correct instability of the economy.• If the economy faces recessionary gap, govt must increase demand by spending

more; lowering taxes;lowering interest;

• If the economy faces an inflationary gap, govt must reduce demand by spending less; raise taxes; increase interest rate;

Keynesian’s view on Unemployment Keynesian theory holds that unemployment is the normal state of the economy &

significant government intervention is required if employment/output targets are to be reached

• Central Keynesian conclusion:• AD determines real GDP• In short run, AD can be adjusted to achieve target GDP & unemployment levels

with prices not changing (fixed, flat price)

Conclusion Unemployment can exist only in the presence of some stickiness in money wage.

Should we advocate increased wage flexibility so as to avoid at least some unemployment?

• Micro view: private agents must have adopted the institution of temporarily rigid wages (contracts) for a reason and that reason must be understood before one can be confident that increasing wage flexibility is "good."

• Macro view: the microeconomic costs of increased flexibility would not be large and, therefore, directly proceed with a macroeconomic analysis -of whether the built-in stability of the overall economy is enhanced by wage flexibility

Tugas Buktikan bahwa slope AD negative