Classical & Keynesian Economics PDF

Classical & Keynesian Economics Samir K Mahajan  EX-ANTE AND EX-POST Ex-ante means planned or intended or expected. For example, ex-ante investment means investment panned to be made during the year. Ex-post means actual or realized. For example, e...

Classical & Keynesian Economics Samir K Mahajan  EX-ANTE AND EX-POST Ex-ante means planned or intended or expected. For example, ex-ante investment means investment panned to be made during the year. Ex-post means actual or realized. For example, ex-post investment means actual. All variables in the theory of income determination are ex-ante variables.  AGGREGATE SUPPLY Aggregate supply is the total volume goods and services the economy planned to be produced by all production units in the economy during a given period of time. The value of this output equals the cost planned to be incurred on producing this output. The cost includes factor payments such as wages, rents, interests, profits etc which in turn forms factor income. Factor incomes are either consumed or saved. Thus, Aggregate Supply may be summarised as: AGGREGATE (or TOTAL) SUPPLY= TOTAL PRODUCT = TOTAL (FACTOR) INCOME= CONSUMPTION EXPENDITURE + SAVING  AGGREGATE DEMAND Aggregate demand is the total demand for final goods and services that the economy as a whole plan to buy at a given level of income time during a given period of time. Aggregate demand equals total (planned) expenditure for final goods and services (consumption and investment goods). The component of Aggregate Demand in an open economy are o Private Consumption Expenditure ( C) o Private Investment Expenditure (I) o Government Expenditure (G) o Net Export i.e Export (X)– Import (M) Thus, Aggregate Demand= Aggregate Expenditure= C + I + G + (X – M)  SOME NOTIONS ABOUT EMPLOYMENT AND UNEMPLOYMENT o Employment : Employment of a factor refers to its use in the process of production. However, the term ‘employment’ has been synonymously treated with employment of labour or workers. Worker is said to be employed when he is engaged in act of production. o Unemployment: Unemployment (or joblessness) occurs when people are without work and actively seeking work. o Voluntary Unemployment: Voluntary unemployment exists when people have chosen not to work because the wage at which they want to work is higher than the prevailing wage. o Involuntary unemployment: Involuntary unemployment occurs when a person is willing to work at the prevailing wage yet is unemployed. o Full employment: Full employment in a very simple sense may mean that the total available supply of labour is completely absorbed in gainful employment. Full-employment may mean absence of involuntary unemployment.  Classical Economics: Assumption of Full-Employment The entire economic premise of the classical economists was based on the assumption of full-employment of labour and other economic resources. Classical economists argued that in the long-run under perfect competition a free capitalist laissez-faire economy would automatically tend to move towards full-employment (absence of involuntary unemployment) and unemployment would be voluntary.  CLASSICAL ECONOMICS: IMPLICATION OF SAY’S LAW o There is automatic adjustment (built-in stability) when supply creates its own demand. Hence there is no need of government intervention in the functioning of a in a free-enterprise capitalist economy. o Since supply creates its own demand there is no possibility of any general overproduction or deficiency in aggregate demand. Aggregate supply always equal aggregate demand. o When there is no general over-production, there is no general unemployment and free economy automatically attains equilibrium at full-employment level in the long-run. o Supply creates its demand in real terms. Money is just a veil. Behind the flow of money there is real flow of goods and services. o Saving-investment equality is brought about by the flexibility of interest-rate. o Wage-flexibility in a competitive labour market tends to bring about full-employment of workers.  KEYNES’ CRITICISM AGAINST CLASSICAL THEORY Keynesian economics is the outcome of J.M Keynes’ disagreement with the classicists. Keynes in his masterpiece ‘The General Theory of Employment, Interest and Money’ laid a frontal attack on the doctrine of classical economics. o Keynes considered the fundamental classical assumptions of full-employment equilibrium condition as rare and unrealistic and phenomenon. According to him, there is possibility of equilibrium at less than full- employment (underemployment) as a normal phenomenon. o Keynes opposed the classical insistence on long-term equilibrium; instead he attached greater importance to short-term equilibrium. According to him, in the long run we are all dead. o Classical economics rests on Say’s law of market which blindly assures that supply always creates its own demand and affirmed impossibility of general over production and disequilibrium in the economy. Keynes totally disagreed with this and stress the possibility of supply exceeding demand, causing disequilibrium in the economy.  CONSUMPTION FUNCTION OR PROPENSITY TO CONSUME Consumption function or propensity to consume studies the relationship between consumption expenditure and disposable income. The consumption function may be written as in the following equation: C= f( Y ) C= Ca + Cm Yd Where Ca = autonomous consumption Cm = mpc (marginal propensity to consume) Yd = disposable income = income after deduction of tax  SAVING FUNCTION OR PROPENSITY TO SAVE Keynes views that saving is the excess of disposable income over consumption. Thus saving function or propensity to save explains the relationship between saving and disposable income. Saving function can be expresses as : S = Yd – C = Yd – Ca – Cm Yd = – Ca + Yd– Cm Yd = – Ca + ( 1 – Cm) Yd Where, – C a = dissaving (negative saving) at zero level of income ( 1 – Cm) = marginal propensity to save  TECHNICAL ATTRIBUTES OF CONSUMPTION FUNCTION TECHNICAL ATTRIBUTES OF SAVING FUNCTION o Average Propensity to Consume : Average Propensity o Average Propensity to save : Average Propensity to save to Consume (apc) is the ratio of total consumption (aps) is the ratio of total saving to total disposable expenditure to total disposable income. income. 𝒕𝒐𝒕𝒂𝒍 𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 (𝑪) i.e. 𝒂𝒑𝒄 = 𝒕𝒐𝒕𝒂𝒍 𝒔𝒂𝒗𝒊𝒏𝒈 (𝑺) 𝒕𝒐𝒕𝒂𝒍 𝒅𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝒊𝒏𝒄𝒐𝒎𝒆 (Yd ) i.e. 𝒂𝒑𝒔 = 𝒕𝒐𝒕𝒂𝒍 𝒅𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝒊𝒏𝒄𝒐𝒎𝒆 (Yd ) o Marginal Propensity to save : Marginal Propensity to o Marginal Propensity to Consume : Marginal saving (mps) is the ratio of change in total saving to Propensity to Consume (mpc) is the ratio of change change total disposable income. in total consumption expenditure to change total disposable income. 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒐𝒕𝒂𝒍 𝒔𝒂𝒗𝒊𝒏𝒈( ∆𝑺) o i.e. m𝒑𝒔 = 𝒄𝒉𝒂𝒏𝒈𝒆 𝒕𝒐𝒕𝒂𝒍 𝒅𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝒊𝒏𝒄𝒐𝒎𝒆 (∆Yd ) 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒐𝒕𝒂𝒍 𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 (∆𝑪) i.e. m𝒑𝒄 = 𝒄𝒉𝒂𝒏𝒈𝒆 𝒕𝒐𝒕𝒂𝒍 𝒅𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝒊𝒏𝒄𝒐𝒎𝒆 (∆Yd ) o Relationship Between apc and aps : We have , We have, Yd = C + S Yd C +S C S 𝒐𝒓, = = + = 𝒂𝒑𝒄 + 𝒂𝒑𝒔 Yd Yd Yd Yd or, 𝒂𝒑𝒄 + 𝒂𝒑𝒔 = 𝟏 o Relationship Between mpc and mps: We have, Yd = C + S Differentiating with respect to Y, we get, dYd d(C + S) dC 𝒅S = = + = 𝒎𝒑𝒄 + 𝒎𝒑𝒔 dYd dYd dYd 𝒅Yd or, m𝒑𝒄 + 𝒎𝒑𝒔 = 𝟏  INVESTMENT FUNCTION Keyes treated investment as real or physical investment such as spending on fixed assets or fixed capital goods (like machines, equipments), inventories etc which is used for further production. From the view point of economy, investment may be treated as autonomous investment and induced investment. Autonomous Investment : Autonomous investment is independent of change in income, rate of interest, or rate of profit. Volume of autonomous investment is fixed at different level of income, and is affected by invention or discovery of new goods, change in size of population, change in consumer’s demand, research and development. Government investment expenditure are mostly autonomous in nature.  investment function contd. Induced investment: Induced investment are made with a view to earn profit and are influenced by level of income, and volume of profit. Keynes highlighted that induced to invest (I) depends on two determinants such as marginal efficiency of capital (e) and rate of interest (i). i.e. , I = f (m.e.c. , i) Marginal efficiency of capital (m.e.c) is the expected rate of return on capital goods , and is extremely volatile as it is affected by market optimism and pessimism in capitalist countries. Keyes views that in short-run interest rate is relatively a stable factor and does not change violently. Given the rate of interest, m.e.c. is the most significant factor in determining inducement to invest. Private entrepreneur would be induced to invest , if there is positive gap between m.e.c. and rate of interest which in turn affect the volume of income and employment in an economy.  KEYNESIAN THEORY OF EMPLOYMENT: THE PRINCIPLE OF EFFECTIVE DEMAND The principles of effective demand lies at the heart of Keynes's General Theory of Employment. Keynes used the term ‘effective demand’ to denote actual total demand for goods and services ( both consumption and investment expenditure) by people in a community. The level of effective demand determines the level of employment which in turn determines the level of output and income in the economy. ❑ Factors Determining Effective Demand: Effective demand refers to the level of demand which corresponds to equality between aggregate supply function (ADF) and aggregate demand function (ASF). Aggregate supply refers to the minimum revenue (sale proceeds) that the entrepreneurs in the economy as a whole must get from the sale of output at different level of employment. Aggregate demand represents the maximum revenues expected by the entrepreneur in the economy as a whole from the sale of output at different level of employment.  principle of effective demand contd. According to Keynes, Aggregate supply is an increasing function of level of employment (N). Aggregate supply curve will be perfectly inelastic (vertical straight line) at a point where economy attains full employment. In figure figure, at full-employment (Nf) , the AS curve becomes a vertical straight line. Thus, ASF = f(N) With an increase in the level of employment (N), aggregate demand tend to rise and vice versa. Thus, ADF = f(N) ❑ The Point of Effective Demand – Equilibrium level of Employment : The interaction between ASF and ADF determines the level of effective demand, employment and income. So long as ADF >ASF, the entrepreneur would be induced to provide increasing employment, and this would continue till both ASF and ADF are equalised. The economy reaches equilibrium level of employment or point of effective demand when ADF =ASF.  principle of effective demand contd. In figure, the point of effective demand and equilibrium of the economy is attained at point E where ASF intersects with ADF. The point of effective demand (E) determines the actual or equilibrium level of employment (Ne ) and output. According to Keynes, the equilibrium between ADF and ASF does not imply that the economy is necessarily having full employment at this point rather it can and often does take place at less than full employment. To him full employment equilibrium is a rare phenomenon. Of the two determinants of level of effective demand, Keynes assumes that ASF is given in short run. Thus, he speaks little about ASF. Since ASF is given, the essence of Keynes's theory of employment is found in his analysis of ADF. Given aggregate supply, effective demand can be raised by increasing aggregate demand.  DETERMINATION OF INCOME: ANALYSIS OF KEYNESIAN CROSS AND EFFECT OF INCREASE IN EFFECTIVE DEMAND The equilibrium level of output, income and expenditure is determined at the point where aggregate demand (AD) is equal to aggregate supply(AS). At equilibrium, Aggregate Demand =Aggregate Supply ………………………….. (i) Keynes assumes that level of aggregate supply is given in short period. Hence the level of aggregate demand determines the level effective demand and level of aggregate income. Let us assume simple two sector macro- economic model in which all savings are made by household, and there is no government spending and taxation. Thus such that aggregate demand is composed of two elements such as : consumption expenditure of households (C ) and the investment decision of the firms (I). i.e. Aggregate Demand (AD) = Consumption + Investment ……………………………….. (ii) Further, since for every possible level of output, an equivalent amount of money income is generated. Further, income is either spent or saved. Thus, Aggregate Output = Aggregate Supply =Aggregate Income = Consumption + Saving ……….. (iii)  determination of income contd. Using equations (ii) and (iii) in equation (i), we get Consumption + Investment = Consumption + Saving Figure-1 Or, Saving=Investment ---------------------- (iv ) This is explained Figure-1. In upper portion of Fig-1, 45 degree line is the unity line which represents equality between total spending and total income (Income= Expenditure). Line C represents the consumption function. At OY level of income, total income would be more than total consumption expenditure and there would be a saving gap amounting to ae. This saving gap must be filled with adequate expenditure. When business community incurs investment expenditure (I) , we get Aggregate Demand = C+I line which is parallel to the C line. (C + I) line passes through the unity line at point ‘e’ at which the corresponding level of income is OY Thus total expenditure or aggregate demand is OB which is equal to total income OY.  determination of income contd. Further, aggregate income (= aggregate output ) is in equilibrium where saving is exactly equal with investment. This is shown in lower portion of Figure-1 in which at point ‘e’ saving line intersect with investment line. Since saving (ae) amounts to a leakage in income spending, to maintain the flow of expenditure , an equivalent amount of investment is essential to match that leakage. It follows that saving-investment equality is fundamental condition of the equilibrium level of income which is called Keynesian cross. Thus, at equilibrium level of income , two conditions of equilibrium may be inferred Aggregate Demand = Aggregate Supply Saving =Investment Keynes views that the equilibrium level of income or effective demand, the economy is not necessarily full- employment equilibrium. Usually, it can be at any point of less than full-employment level. According to Keynes, Full- employment is a rare phenomenon. Ref: D M Mithani and Internet