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Watch Classical Economics.


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With your knowledge of the AS and AD curves, and the position of equilibrium relative to Full Employment, we will now turn our attention to correcting for inflationary or recessionary times. While there are different economic theories about the best way to correct an economy this lesson will focus on only two, Classical Economics and Keynesian Economics.

The Father of Economics, Adam Smith.Classical economics is a theory introduced by the "Father of Economics," Adam Smith. His idea states that if you leave the economy alone any sort of problem will correct itself.

The basics of Classical economics:

  • Aggregate supply determines output, which basically means if a business makes an item than the income will be created for people to buy the product. In other words, Supply creates its own demand.
  • There is no role for government in an economy, because the economy will self-regulate itself.
  • Prices and wage are flexible.
  • The Economy will achieve full employment in the long run.

The principles of Classical economics are represented in the graph below when the economy is in a recession. We start with the economy in a recession, which is identified by PL1 and Q1 in the graph below. According to a classical economist, with the unemployment in the economy, eventually wages and prices of resources will decrease. When the costs of inputs decrease the AS curve will shift to the right and achieve equilibrium again at a lower price level (PLf) and a higher output (Yf).

The graph depicts an economy in recession. Price is on the y-axis and GDP is on the x-axis. Remember that the price and quantity prior to the recession are identified as PL1 and Q1. With the recession, the aggregate supply line shifts to the right, changing the intersection of the aggregate supply line and aggregate demand. Since the aggregate demand line slopes downward, a shift to the right of the aggregate supply line means that the equilibrium point moves down and to the right. As the price of input materials decreases, the output of products will increase, until equilibrium is reached. At the new equilibrium point, price levels are lower and the production quantity or output is higher. The change in product, or shift on the x-axis, is the recessionary gap.

The principles of Classical economics can also be illustrated when the economy is booming or doing well. The graph below represents the ideas of a classical economist in a boom time. A booming economy and high inflation is represented by PL1 and Q1 in the graph below. According to a classical economist, with low unemployment and a higher price level, eventually the cost of wages and resources will increase. With the cost of inputs increasing the AS curve will shift to the left and achieve a new equilibrium at a higher price level (PLF) and a lower output (Yf).

The graph depicts an economy experiencing inflation Price is on the y-axis and GDP is on the x-axis. Remember that the price and quantity prior to the boom are identified as PL1 and Q1. With the boom, the aggregate supply line shifts to the left, changing the intersection of the aggregate supply line and aggregate demand. Since the aggregate demand line slopes downward, a shift to the left of the aggregate supply line means that the equilibrium point moves up and to the left. As the price of input materials increases, the output of products will decrease, until equilibrium is reached. At the new equilibrium point, price levels are higher and the production quantity or output is lower. The change in product, or shift on the x-axis, is the inflationary gap.

These two examples show the basic beliefs of a classical economist. If you leave the economy alone, any problems will correct themselves.

Watch Keynesian Economics.

 

Transcript

The ideas of classical economics lasted until the Great Depression of the 1930s. It was at this time that Keynesian Economics (pronounced "CANES-ee-un") was introduced to President Franklin Roosevelt by John Maynard Keynes. The persistence and the depth of depression could not be explained by classical economists. Keynes (pronounced "Canes") offered a new approach to looking at the economy. He believed the economy would not achieve full employment in the long run, as espoused by classical economists, unless the government stepped in and affected aggregate demand.

The basics of Keynesian Economic thoughts:

  • Aggregate demand determines output, which basically means if people don't have the money to buy items businesses won't produce anything. In other words, demand creates supply.
  • There is a management role for the government in the economy. The government needs to increase spending and decrease taxes in a recession and decrease spending and increase taxes when there is inflation.
  • Prices and wages are sticky, and don't adjust so quickly.
  • The famous quote attributed to Keynes about waiting for the economy to fix itself, is "In the long run we are all dead."

You can see the idea of Keynes in the graph below. Start with the economy in a recession, which is identified by PL1 and Q1 in the graph below. According to Keynes, with unemployment in the economy, the government needs to increase aggregate demand by lowering taxes and increasing spending. By lowering taxes consumers have more disposable income which means their consumption will increase. Since the components of Aggregate demand include C and G, increasing both will shift AD to the right. A new equilibrium will be achieved with a higher price level (PLf) a greater output (Yf).

The graph depicts an economy in recession. Price is on the y-axis and GDP is on the x-axis. Remember that the price and quantity prior to the recession are identified as PL1 and Q1. With the recession, the government should increase aggregate demand. This will shift the line to the right, changing the intersection of the aggregate supply line and aggregate demand. Since the aggregate demand line slopes downward, a shift to the right of the aggregate demand line means that the equilibrium point moves up and to the right. As the price of input materials increases, the output of products will increase, until equilibrium is reached. At the new equilibrium point, price levels are higher and the production quantity or output is higher. Note the difference here from classical economics, where the supply line shifts, not the demand line.

You can see the idea of Keynes in the graph below. Start with the economy experiencing high inflation, identified by PL1 and Q1 in the graph below. According to Keynes, with inflation the biggest problem in the economy, the government needs to decrease aggregate demand by increasing taxes and decreasing spending. By increasing taxes consumers have less disposable income which means their consumption will decrease. Since the components of Aggregate demand include C and G, decreasing both C and G will shift AD to the left. A new equilibrium will be achieved with a lower price level(PLf) a smaller output (Yf).

A graph.

Watch the two videos below to learn more about Keynesian Economics, fiscal policy and monetary policy.

Watch Monetary Policy.

 

Transcript

The other entity tasked with trying to help the economy recover from a recession or control inflation is the Federal Reserve.

Read A Closer Look at Open Market Operations for a review of monetary policy.

The money supply can be manipulated to help correct the economy. The graph below shows this correction. We will start with the economy in a recession, which is identified by PL1 and Q1 in the graph below. The Federal Reserve, faced with a stagnant economy, or an economy that is not growing, and high unemployment, would use an expansionary money policy would help to correct the situation. By increasing the money supply and decreasing the interest rates businesses and consumers would borrow more money. By increasing the money supply and decreasing the interest rates businesses and consumers would pay to borrow more money. By increasing consumption and investment Aggregate Demand would shift to the right. The economy would achieve a new equilibrium at a higher price level (PLf)and a higher output (Yf).

The graph depicts an economy in recession. Price is on the y-axis and GDP is on the x-axis. Remember that the price and quantity at the beginning of the recession are identified as PL1 and Q1. With the recession, the government increases money supply, which pushes an increase in aggregate demand. This will shift the line to the right, changing the intersection of the aggregate supply line and aggregate demand. Since the aggregate demand line slopes downward, a shift to the right of the aggregate demand line means that the equilibrium point moves up and to the right. As the price of input materials increases, the output of products will increase, until equilibrium is reached. At the new equilibrium point, price levels are higher and the production quantity or output is higher. Note that the graph itself is identical to the similar situation in Keynesian economics, in which the shift in demand (not supply) drives the new equilibrium point.

Keeping in mind the tools of the Federal Reserve you can see how manipulating the money supply will help correct the economy. This is shown in the graph below. We start with the economy experiencing high inflation, which is identified by PL1 and Q1 in the graph below. The Federal Reserve, faced with high inflation, would use a contractionary monetary policy to take money out of the economy to correct the situation. By decreasing the money supply and increasing interest rates it would cost businesses and consumers more to borrow money. By decreasing consumption and investment Aggregate Demand would shift to the left. The economy would achieve a new equilibrium at a lower price level (PLf) and a lower output (Yf).

The graph depicts an economy experiencing inflation. Price is on the y-axis and GDP is on the x-axis. Remember that the price and quantity prior to the boom are identified as PL1 and Q1. With the boom, the federal reserve decreases the moeny supply and increases interest rates. This will push the aggregate demand line to the left, changing the intersection of the aggregate supply line and aggregate demand. Since the aggregate demand line slopes downward, a shift to the left of the aggregate demand line means that the equilibrium point moves down and to the left. As the price of input materials decreases, the output of products will decrease, until equilibrium is reached. At the new equilibrium point, price levels are lower and the production quantity or output is lower. Note that the graph itself is identical to the similar situation in Keynesian economics, in which the shift in demand (not supply) drives the new equilibrium point..

One problem in the economy that confounds both classical and Keynesian economists is called stagflation. Stagflation is caused by shifting the AS curve to the left. In this situation you will see an increase in the price level and an increase in unemployment. This situation is the worst because not only are people out of a job, but everything costs more. The problem for Keynesian economists was evident during the 1970s with the oil crisis. With the cost of oil increasing rapidly the cost of everything increased, the economy slowed and people were put out of work. Looking at the graph shows that any attempt to increase AD by the government would have made inflation even worse. The classical solution by allowing the economy to correct itself was met with much criticism from the people who were suffering. In the case of the 1970s the Federal Reserve eventually implemented a contractionary monetary policy to eradicate the high inflation from the economy. The 1970s were followed by periods of high economic growth during the 1980s and 1990s.

Watch Stagflation to gain a perspective on stagflation.

If you need an explanation of all the graphs used in the lesson, watch the compilation below.

 

Transcript

Now that you have a basic understanding of the problems for an economy and how monetary and fiscal policy are used to either stimulate or slow down the economy, read Monetary and Fiscal Policy to see a more detailed summary.

With your understanding of fiscal and monetary policy watch Keynes vs. Hayek to hear a recent discussion on the disagreements over Classical and Keynesian economics. Keep in mind that Friedrich Hayek is a classical economist. The word austerity is the term describing the cutback in government spending going on in some European countries that are trying to get debt and government spending under control.

 

 

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