12.02.2018 Views

merged

Create successful ePaper yourself

Turn your PDF publications into a flip-book with our unique Google optimized e-Paper software.

Chapter 8 Keynesian Economic Theory<br />

The basic economic problem is scarcity. Human wants are unlimited. Resources are limited. The<br />

basic goal in dealing with the problem of scarcity is to produce as much consumer satisfaction as<br />

possible with the limited resources available. Producing the ideal quantity of total output will<br />

contribute toward reaching this basic goal. According to classical economic theory, a market<br />

economy is self-regulating and will automatically adjust to the ideal quantity of total output, called<br />

Natural Real GDP.<br />

Classical economic theory was the predominant theory in industrialized nations from the time of<br />

Adam Smith until the Great Depression of the 1930s. During the Great Depression, market<br />

economies were not automatically adjusting to Natural Real GDP.<br />

In 1936, economist John Maynard Keynes (Cnes) published “The General Theory of<br />

Employment, Interest, and Money”. This book established Keynesian theory as a major<br />

alternative to classical theory. For a review of this book, see the appendix at the end of the<br />

chapter.<br />

Keynesian Theory and Say’s Law<br />

According to classical theory (Say’s Law), “supply creates its own demand”. The act of production<br />

leads to equivalent income to the resource owners. And if the resource owners choose to save a<br />

part of their income, this consumer savings will not reduce demand. Any consumer savings will<br />

be exactly offset by business investment. This will be true, according to classical theory, since the<br />

quantity of both savings and investment is determined by the interest rate.<br />

Keynesian theory rejects Say’s Law. Keynesian theory holds that factors other than the interest<br />

rate would affect savings and investment. Expectations of future returns would affect business<br />

investment. If investors become pessimistic about future rates of return, they may not invest more<br />

in response to lower interest rates.<br />

So an increase in savings may not be offset by an equal increase in investment. If savings is<br />

greater than investment, supply will be greater than demand. Thus, excessive savings could lead<br />

to inadequate Total Expenditures.<br />

Keynesian Theory and Closing a Recessionary Gap<br />

Classical theory argues that wages and prices are flexible and cause the economy to be selfregulating.<br />

A recessionary gap would automatically be closed. During a recessionary gap, there<br />

would be a surplus of labor. The surplus of labor would cause wage rates to fall. The decrease in<br />

wage rates would cause a decrease in the overall costs of production. The decrease in the overall<br />

costs of production would shift the SRAS curve to the right until Natural Real GDP is reached.<br />

The price level would be lower.<br />

But Keynesian theory argues that wages and prices are not flexible downward. Factors such as<br />

the minimum wage law, long-term labor contracts, labor union bargaining power, and general<br />

employee resistance to wage cuts may make wage rates inflexible downward. If wage rates do<br />

not fall during a recessionary gap, the overall costs of production do not decrease. If the overall<br />

costs of production do not decrease, the SRAS curve does not shift to the right. If the SRAS<br />

curve does not shift to the right, there is no automatic adjustment to Natural Real GDP. Thus, the<br />

economy can get stuck in a recessionary gap for an extended period of time.<br />

How can the economy get out of a recessionary gap? If the SRAS curve does not shift right, then<br />

the AD curve must shift right to move the economy back to Natural Real GDP. According to<br />

Keynesian theory, the solution to a recessionary gap would be an increase in Total Expenditures<br />

to shift the AD curve right. This is illustrated on the graph in Example 1 on the next page:<br />

FOR REVIEW ONLY - NOT FOR DISTRIBUTION<br />

8 - 1 Keynesian Economic Theory

Hooray! Your file is uploaded and ready to be published.

Saved successfully!

Ooh no, something went wrong!