Keynes and the Classical

Economists:
The Early Debate on Policy
Activism

THE CLASSICAL MODEL

Says Law
The classical economists based their predictions
about full employment on a principle known as
Says Law, the creation of French economist J. B.
Say (17761832). According to Says Law,
Supply creates its own demand. In other words,
in the process of producing output, businesses
also create enough income to ensure that all the
output will be sold. Because this theory occupies
such an important place in classical economics.

THE CLASSICAL MODEL

Flexible Wages and Prices
The classical economists believed that all
pricesincluding wage rates (the price of
labor) and other input priceswere highly
flexible. They believed that Says Law and
the flexibility of interest rates would ensure
that spending would be adequate to maintain
full employment.

THE CLASSICAL MODEL

Full Employment
As a consequence of their faith in Says Law and the
flexibility of wages and prices, the classical
economists viewed full employment as the normal
situation. They held this belief in spite of recurring
periods of observed unemployment. By the mid
1800s, economists recognized that capitalist
economies tend to expand over time but not at a
steady rate. Instead, output and employment
fluctuate up and down, growing rapidly in some
periods and more slowly, or even declining, in
others.

THE CLASSICAL MODEL

Laissez-Faire
The classical theorists belief in the economys
ability to maintain full employment through its own
internal mechanisms caused them to favor a policy
of laissez-faire, or government by nonintervention.
Society was advised to rely on the market
mechanism to take care of the economy and to limit
the role of government to the areas where it could
make a positive contributionmaintaining law and
order and providing for the national defense, for
example.

THE KEYNESIAN CRITICISM

The role of demand side
Keynesian
economics
places
central
importance on demand, believing that on
the macroeconomic level, the amount
supplied is primarily determined by
effective demand or aggregate demand.
For example, without sufficient demand
for the products of labor, the availability
of jobs will be low; without enough jobs,
working people will receive inadequate
income, implying insufficient demand for
products. Thus, an aggregate demand
failure involves a vicious circle.

THE KEYNESIAN CRITICISM

Wage/Price rigidity
Keynes argued that the classical assumption of highly
flexible wages and prices was not consistent with the real
world. Ac-cording to Keynes, a variety of forces prevent
prices and wages from adjusting quickly, particularly in a
downward direction. First, markets are less competitive
than the classical theory assumed. Keynes saw that many
product markets were monopolistic or oligopolistic. When
sellers in these markets noted that demand was declining,
they often chose to reduce output rather than lower prices.
And in labor markets, particularly those dominated by
strong labor unions, workers tended to resist wage cuts. As a
consequence, wages and prices did not adjust quickly; they
tended to be rigid or sticky.

THE KEYNESIAN CRITICISM

Employment with unemployment
Keynes and the classical economists agreed that the
economy would always tend toward equilibrium,
but they disagreed about whether the level of
output at which the economy stabilized would
permit full employment. In the classical model the
economy tends to stabilize at a full-employment
equilibrium. In the Keynesian model the economy
tends toward equilibrium but not necessarily at full
employment. When the economy is in equilibrium
at less than full employment, an unemployment
equilibrium exists.

THE KEYNESIAN CRITICISM

Government intervention
Because Keynes did not believe that a market economy
could be relied on to automatically preserve full
employment and avoid inflation, he argued that the
central government must manage the level of aggregate
demand to achieve those objectives. How could this be
accomplished? One approach was through fiscal policy,
the manipulation of government spending and taxation
in order to guide the economys performance. Another
approach would be to use monetary policy: policy
intended to alter the supply of money in order to
influence the level of economic activity.

THE KEYNESIAN
Consumption function
ECONOMICS
Consumption function
Consumption function shows the relationship
between the level of consumption expenditure
and the level of income.
C = f (Y)
C = a
C = 100

+ bY
+ 0.75Y

Where a is autonomous and bY is income

induced consumption.

THE
KEYNESIAN Consumption function
ECONOMICS
Autonomous consumption expenditure
Autonomous
consumption
expenditure
occurs when income levels are zero. Such
consumption does not vary with changes in
income. If income levels are actually zero,
this consumption is financed by borrowing or
using up savings.
Induced consumption
Induced consumption describes consumption
expenditure by households on goods and
services
which
varies
with
income.

Marginal Propensity to Consume

The marginal propensity to consume
(MPC) is the extra amount that people
consume when they receive an extra unit
of income.
MPC

= C / Y

MPC is the slope (first derivative) of

consumption function.
Induced consumption can be described
by formula: Induced consumption =

Y=C+S

MPC= C/ Y
MPS= S/ Y

Complete the table

APC = C/Y
APS = S/Y

The Consumption Function

45 line: At any point on the 45line consumption exactly
.
equals income and the households
have zero saving. MPC is the
slope of the consumption function, which measures the change
in consumption per unit change in income.
C

Savings
Consumption
function C = f(Y)

Consumption

45
0

Y1

Determinants of Consumption
Current disposable income: it is the central factor
determining a nation's consumption.
Permanent income: it is the level of income that households
would receive when temporary influences are removed.
Wealth: it is the net value of tangible and financial items
owned by a nation or person at a point of time.
Other (interest rate, inflation, expectations).

Savin
g
Saving is that part of income that is not consumed. Saving equals income minus consumption:
S=YC
Income is the sum of consumption and savings: Y = C + S
then

and

C S
1
Y Y

C S

1
Y Y

Marginal propensity to save

It is defined as the fraction of an extra unit of income that goes
to extra saving.
MPC + MPS = 1 because the part of each unit of income
that is not consumed is necessarily saved.

Saving function
Like consumption, saving is also the
function of income: S = f(Y)
If autonomous consumption exists
then autonomous saving exists as well
and saving function is:
S = f (Y)
S = -a
+ cY
S = -a
+ MPS.Y

The saving function is the mirror image of the

consumption function. It shows the relationship
between the level of saving and income.
.

C,
S
C = f(Y)

S = f(Y)

CA
0
-CA

45
Y

Investment
Investment pays two roles in

macroeconomics:
It can have a major impact
on AD (real output and
employment)
It leads to capital
accumulation (it increases
the nation's potential
output and promotes

Determinants of Investment
Revenues: an investment

should bring the firm

additional revenue.
Costs: interest rate influences
the costs of the investment.
Consumer demand: the bigger
the increase in consumer
demand, the more investment
will be needed.
Expectation: business

Consumption and
Investment
Functions
The spending curve shows
the level of desired
expenditure by consumers
(CA + MPC.Y) and businesses
(I) corresponding to each
level of output.

Consumption and
Investment
Functions
C, I
C + I = CA + MPC . Y + I
C = CA + MPC . Y

I
I

Consumption and
Investment
Functions
The spending curve shows
the level of desired
expenditure by consumers
(CA + MPC.Y) and
businesses (I)
corresponding to each level
of output.

Consumption and
Investment
Determine Output
If the level of output is e. g. Y1 at

this level of output the C+I

spending line is above 45line, so
planned spending is greater than
planned output.
This means that consumers would
be buying more goods than the
businesses were producing. Thus
spending disequilibrium leads to a

Equilibrium National
Income
C, I
C + I = CA + MPC . Y + I
E

4
5

Y1

Consumption and
investment
determine
output
YE

Y2

Saving and
Investment
Determine Output
Equilibrium occurs when

desired saving of households

equals the desired investment
of businesses.
When desired saving and
desired investment are not
equal, output will tent to
adjust up or down.

Saving and
Investment
Determine Output
S, I

S = f (Y)
E

0
Y1
-

YE

Y2

Investment
Multiplier
The Keynesian investment multiplier

model shows that an increase in

investment will increase output by a
multiplied amount by an amount
greater than itself.
The multiplier is the number by
which the change in investment
must be multiplied in order to
determine the resulting change in
total output.

Investment
Multiplier
The size of the multiplier k
depends upon how large the MPC
is.

Y
Y
1
1
1
k

I Y C 1 C 1 MPC MPS
Y