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Keynesian Economics: Shaping Short-Run Macroeconomic Policy

Explore the emergence of the Keynesian short-run model during the Great Depression, challenging traditional long-run economic views. Understand how government intervention in aggregate demand can stabilize the economy. Learn about the Keynesian model's emphasis on immediate action and its impact on policy decisions.

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Keynesian Economics: Shaping Short-Run Macroeconomic Policy

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  1. Chapter 11 Homework • Number 1, 4, 8, and 14

  2. Chapter 12 The Role of Aggregate Demand in the Short Run

  3. Emergence of the Keynesian Short-Run Model • Classical economists thought that an economy will self-adjust to any problems. • Economy will always be at or near full employment. • Called the Long Run Economic Model • The Great Depression set the stage for a new short-run economic model.

  4. The Great Depression’s Challenge to the Long-Run Model • Most severe economic trauma in U.S. history. • From 1929 to 1933, the unemployment rate increased from about 3% to almost 25%. • By 1933, real GDP had fallen by almost 27%. • Marriage and birth rates fell. • Participation in radical political movements increased. • Fear was fostered by not knowing what was happening or how to fix it.

  5. The Great Depression’s Challenge to the Long-Run Model (cont’d) • Following the long-run economic model, the belief was that the economy would eventually cure itself. • However, during the1930s it didn’t seem to be working • The nation’s short-run suffering required immediate action.

  6. The Keynesian Short-Run Model Emerges • John Maynard Keynes was a professor of economics at Cambridge University in England.

  7. The Keynesian Short-Run Model Emerges (cont’d) • Keynes’ book, The General Theory of Employment, Interest and Money, was published in 1936. • Arguably the most important economics book of the 20th century • It challenged the accepted long-run macroeconomic model.

  8. The Keynesian Challenge to the Long-Run Model • The Keynesian model is a short-run model of the behavior of the macroeconomy that: • Emphasizes the role of aggregate demand and government action in the macroeconomy • Questions the validity of the long-run model as an effective guide for macroeconomic policy

  9. The Keynesian Challenge to the Long-Run Model (cont’d) • Compared to the Classical long-run model, the Keynesian model: • Is concerned with the short run • “In the long run, we’re all dead.” • Focuses on aggregate demand • Can be shaped by policy • Suggests that the economy could remain below full employment for prolonged periods • Because markets don’t adjust quickly • Promotes government stabilization policy

  10. The Keynesian Model and Economic Policy • In 1933, President Roosevelt proposed—and Congress passed—a wide variety of economic legislation designed to stabilize the economy and put people back to work. • Roosevelt was unwilling for the economy to “fix itself”.

  11. Characteristics of the Short-Run Model • Major belief is that full employment is the exception rather than the rule. • Advocates an aggressive approach to economic policy that attacks and cures short-run problems quickly and effectively.

  12. Characteristics of the Short-Run Model (cont’d) • Three pillars of the model • Each is a contradiction of a characteristic of the long-run model. • Challenges: • Say’s Law • The loanable funds market • Flexible prices and wages

  13. Challenge to Say’s Law • Say’s Law = “supply creates its own demand.” • Keynes taught that demand creates its own supply. • Aggregate demand motivates firms • Produce a good only if there is a demand for it. • If something is wrong with the economy, it’s due to a problem with aggregate demand.

  14. Challenge to the Loanable Funds Market • Long-run model interest rate adjusted so that the quantity supplied of funds equals the quantity demanded of funds. • Saving was channeled into investment spending. • Short-run model no mechanism converts saving to investment spending. • Factors other than the interest rate can also influence saving and investment: • Disposable income has a major impact on saving. • Expected return on investment affects the decision to invest.

  15. Challenge to Price and Wage Flexibility • Long-run model  freely adjusting prices and wages. • Based on an economy comprised of small, competitive firms, workers negotiating their own wages, and minimal government. • Short-run model  prices and wages are “sticky downward.” • Based on an economy characterized by: • Large firms with some control over the prices they charge • Workers represented by strong unions with the power to negotiate wages and other benefits

  16. Price Inflexibility • Long-run model  AD decline leads to lower prices as the short-run aggregate supply curve shifts to the right. • Firms are not required to reduce output or employment. • Short-run model little pressure for firms to cut prices. • AD declines  firms cut output and employment. • Unless and until prices adjust, the economy will remain below full employment.

  17. Wage Inflexibility • long-run model  decline AD workers accept lower nominal wages to keep their jobs. • short-run model  workers resist accepting lower wages. • Wage stickiness doesn’t allow the economy to self-adjust to a decline in aggregate demand. • Employers will ultimately have to lay off some workers.

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