Principles of Economics by Fred M Gottheil

1. Principles of Economicsby Fred M Gottheil PowerPoint Slides prepared by Ken Long ©1999 South-Western College Publishing

2. Chapter 28 • Can Government Really Stabilize the Economy? 6/10/2014 ©1999 South-Western College Publishing

3. What are the basic Schools of Economic Thought? • Supply-side • neo-Keynesian • Classical • Keynesian • Monetarism • Rational Expectations ©1999 South-Western College Publishing

4. Classical theory • Saw the economy as self-correcting • Felt that a lack of aggregate demand was unlikely • If aggregate demand fell, adjustments in prices, wages, and interest rates would occur to return the economy to full employment

5. What is the main conclusion of Classical Economics? • Because the economy is always tending toward a full employment equilibrium, there is no need for government intervention

6. What are the two propositions ofClassical Economics? • 1. All markets are basically competitive • 2. All prices are flexible

7. Another important element of classical theory…. • Say’s Law, Supply creates its own demand • Supplying output creates the income needed to demand the output • Thus seen as unlikely for the economy to suffer a “glut” of unsold goods

8. What about savings in classical theory? • Leads to the classical theory of savings and investment, belief that all savings will get invested in the economy

9. Classical theory of savings and investment • Savings--higher interest rates encourage more savings • Investment, lower interest rates encourage business investment

10. Classical model of savings and investment Interest Rates Supply of savings i1 Investment demand S = I Savings and Investment 10

11. Classical model of savings and investment Interest Rates Supply of savings, S1 S2 i1 Investment demand i2 Q1 Q2 Savings and Investment Note that S=I at Q1 and Q2 11

12. How do the Classical Economists explain unemployment? • Unemployment is a temporary situation caused by wage rates that are above the equilibrium level ©1999 South-Western College Publishing

13. What about thelong-run? • Wage rates will adjust, bringing about full employment in the long-run ©1999 South-Western College Publishing

14. Real Wage and Employment S1 W1 W2 D1 D2 Q2 Q1 14 ©1999 South-Western College Publishing

15. According to the Classical Economists, why might unemployment be persistent? • People interfere with the competitive process ©1999 South-Western College Publishing

16. How do people interfere with the competitive process? • Unions • Minimum wage laws ©1999 South-Western College Publishing

17. According to the Classical Economists, what should the government do during periods of unemployment? • NOTHING ©1999 South-Western College Publishing

18. How do the Classical Economists explain inflation? ©1999 South-Western College Publishing

19. Money Velocity Prices MV Q P = GDP 19 ©1999 South-Western College Publishing

20. Who controls the level of money and therefore the price level? • The Federal Reserve ©1999 South-Western College Publishing

21. How much should the Fed increase the money supply? • Approximately equal to the long-run full employment rate of growth, about 3% ©1999 South-Western College Publishing

22. What isKeynesian Economics? • Government intervention when the economy is in a less than full employment equilibrium ©1999 South-Western College Publishing

23. According to the Keynesians, why do we have unemployment? • Unemployment is the result of insufficient aggregate demand ©1999 South-Western College Publishing

24. What is the solution to Unemployment? • Use government’s fiscal policies to increase aggregate demand ©1999 South-Western College Publishing

25. Where does the money come from to increase aggregate demand? • The government practices deficit spending ©1999 South-Western College Publishing

26. What is a Contractionary Gap? • The difference in real GDP between a less than full employment equilibrium and the real GDP at the full employment equilibrium ©1999 South-Western College Publishing

27. Contractionary Gap C+I+G+(X-M)’ C+I+G+(X-M) Planned Spending less than full employment full employment Real GDP ©1999 South-Western College Publishing

28. What is the Employment Act of 1946? • Congress officially declares that it is the continuing policy and responsibility of the federal government to take an active role in the economy ©1999 South-Western College Publishing

29. How do the Keynesians view inflation? • They are not worried about inflation ©1999 South-Western College Publishing

30. Highly simplified AS curve in Keynesian theory • The backward L supply curve, no concern about inflation until full employment achieved

31. “Naive” AS Curve AS P Full Employment AD5 AD4 AD3 GDP AD2 AD1 31 Qf

32. For what were the Keynesians ill prepared ? • The stagflation of the 1970’s, when we had high rates of both unemployment and inflation ©1999 South-Western College Publishing

33. Modified AS Curve AS P Full Employment AD6 AD5 AD4 AD3 GDP AD2 AD1 33

34. What isneo-Keynesian Economics? • The neo-Keynesians emphasized the possibility that an economy can be in equilibrium at less than full employment with inflation ©1999 South-Western College Publishing

35. What discovery supported the view of less than full employment equilibrium and inflation? • The Phillips Curve ©1999 South-Western College Publishing

36. What is thePhillips Curve? • A graph showing the inverse relationship between the economy’s rate of unemployment and the rate of inflation ©1999 South-Western College Publishing

37. The Phillips Curve Rate of Inflation Rate of Unemployment 37 ©1999 South-Western College Publishing

38. Explaining the Phillips Curve -Rightward Shift in AD- Price level and output rise Employment increases Unemployment decreases Price level and unemployment move in opposite directions.

39. Explaining the Phillips Curve -Leftward Shift in AD- Price level and output fall Employment decreases Unemployment increases Price level and unemployment move in opposite directions.

40. The Phillips Curve: U.S. Experience Inflation Unemployment

42. What happened to the Phillips curve in the 1970’s? • It appeared to shift outward, due to the supply side inflation and stagflation of the 70’s

43. Explaining the outward shifts in the Phillips Curve • Supply shocks of the 1970’s, leftward shifts in AS lead to higher inflation and unemployment both • Thus a worsened trade-off between inflation and unemployment

44. What isSupply-side Inflation? • Prices rise because of an increase in costs ©1999 South-Western College Publishing

45. How did we break the back of Stagflation? • In 1980, the Fed decreased the money supply and held it down until prices came down ©1999 South-Western College Publishing

46. What was the result of this Fed action in 1980? • A very severe recession ©1999 South-Western College Publishing

47. What was the long-run gain from this policy? • The back of inflation was broken making it possible to concentrate on stimulating employment ©1999 South-Western College Publishing

48. How do the neo-Keynesians explain the 1970’s Phillips Curve • Instead of one Phillips curve, there was a set of Phillips curves ©1999 South-Western College Publishing

49. The 1970’s Phillips Curve Rate of Inflation Rate of Unemployment 49 ©1999 South-Western College Publishing

50. Another view of the Phillips curve is…Natural Rate Theory • Recall the natural rate of unemployment, the sum of frictional and structural