The Self Regulating Economy Del Mar College, John Daly ©2002 South-Western Publishing, A Division of Thomson Learning.

The Self Regulating Economy

Del Mar College, John Daly

©2002 South-Western Publishing, A Division of Thomson Learning

Classical Economists’ Views

• Say’s Law: Supply creates its own demand.• Implied in Say’s Law: there cannot be either a

general overproduction of goods or a general underproduction of goods.

• Even in a money economy, where individuals sometimes spend less than their full incomes, Say’s Law still holds. This argument was partly based on the assumption of interest rate flexibility.

Classical Economists’ Views

• For Say’s Law to hold in a money economy, funds saved must give rise to an equal amount of funds invested.

• In a money economy, according to classical economists, interest rates will adjust to equate saving and investment.

• Any fall in consumption (and consequent rise in saving) will be matched by an equal rise in investment.

Real GDP and Natural Real GDP: Three

PossibilitiesA. Real GDP is less than the

Natural Real GDP

B. Real GDP is Greater than Natural Real GDP

C. Real GDP is Equal to Natural Real GDP

What happens if the Economy is in a Recessionary Gap?

• The unemployment rate is higher than the natural unemployment rate.

• This implies that unemployment is relatively high and that as old wage contracts expire, business firms will negotiate contracts that pay workers lower wage rates.

What Happens if the Economy is in a Recessionary Gap?

What Happens to the Economy in an Inflationary Gap?

• The unemployment rate is lower than the natural unemployment rate.

What Happens to the Economy in an Inflationary Gap?

Self-Regulating Economy: A Recap

• Flexible wages (and other resource prices) play a critical role in the story of the self-regulating economy.

• Macroeconomists want to know if the economy has a natural resting place.

Can the Unemployment Rate be Less than the Natural Employment Rate?

• Given these two PPFs, the Institutional PPF has institutional constraints: anything that prevents economic agents from producing the maximum Real GDP physically possible.

• An economy can never operate beyond its physical PPF, but it is possible for it to operate beyond it’s institutional PPF.

• The economy is operating at it’s lowest unemployment rate at the institutional PPF.

Changes in the Economy:Short-Run & Long-Run

• If the economy is self regulating, an increase in aggregate demand can raise the price level and Real GDP in the short run, but in the long run the only effect of an increase in aggregate demand is an increase in price level.

Changes in the Economy:Short-Run & Long-Run

• If the economy is self-regulating, a decrease in aggregate demand can lower the price level and Real GDP in the short run, but in the long run the only effect of a decrease in aggregate demand is a lower price level.

Q & A

• If the economy is self-regulating, what happens in a recessionary gap?

• If the economy is self-regulating, what happens in an inflationary gap?

• Give an example to illustrate how the economy can operate below the natural unemployment rate.

• If the economy is self-regulating, how do changes in aggregate demand affect the economy in the long run?