Viewpoints of Classical and Keynesian Economists - Essay Example

Running Head: [short [institute of affiliation] Explain the different viewpoints ical and Keynesian economists. How did the economy that existed at the time these theories were developed influence these theories? Which theory seems to be more appropriate for the economy today? In a closed economy, goods or the outputs can be at market equilibrium, in which case the quantity of the goods produced equal the quantity of the goods demanded. While the output of the economy can be at market equilibrium, the high level of unemployment can be traced back, not from the demand-supply equilibrium in the wage market as classical economists argue, but because of lower aggregate demands which, as Keynes argues, leads to lower demands in labor in turn. In a closed economy where there is no foreign trade, the level of outputs that are produced will be at market equilibrium as the demand levels will further be met by the supply levels. However, during recessions, when unemployment rate rises, the demand will still be met by the supply, although the demand level will be lower. This is why in the goods market prices and quantity will settle at the equilibrium but high unemployment can still be present in the economy. This has been termed as the “Keynesian unemployment”. As what has been described earlier, in determining output to meet the demands, there are two views—the Keynesian and the classical view. The classical view argues that prices and wages are flexible, in such a way that excesses in either demand or supply will quickly be absorbed by the economy and resume full employment of resources after economic shocks—or abrupt changes in the aggregate demand and supply curves. The Keynesian view on the other hand argues, as apparent in its sticky theory of prices and wages which says that these two factors are sticky in the short run because of contractual rigidities such as agreements made with different interest groups such as the labor unions. In the latter situation, the one proposed by Keynes, higher levels of aggregate demands are needed for output to respond positively because aggregate supply curve is relatively flat especially when output levels are low. In this situation, the economy can have long periods of unemployment because prices and wages are slow to adjust to shocks, and reaching full employment of resources is slow to reach. When classical economists argue that unemployment results from the interaction of the labor demand and supply curves, and lowering the wages will spread the labor supply which can curb unemployment in the process, Keynes argue that such is not applicable when unemployment is due to business cycle downturns, when because of lower demands of products in the economy, demand for labor is also low. The lower demand for goods results into lower demands for labor. Labor is a necessary input and resource in order to produce goods. But with employers facing a lower demand for their products, they would not be motivated to further employ some labor which costs would not be covered by sufficient demands and turn into sales. Cutting down on labor would result into layoffs, which further results into the rise in unemployment. The sticky theory of wages as earlier discussed argues that due to inflexibility of wages, labor markets are slow to adjust to labor shortages and surpluses, which does not address unemployment in what the classical view suggests. Keynesian model of macroeconomics seem to be more appropriate these days, although there have been criticisms about it, which pertains to the Keynes’ fiscal policy weakness model in stabilizing the economy. Although this is not perfect, the Keynesian view of stabilizing the economy has been useful in order to spur growth as medicine to cyclical business downturns. By putting the government to regulate the economy through fiscal and monetary policies, the effects on the downturns can be remedied. Why do Keynesian economists believe that market forces do not automatically adjust for unemployment and inflation? What is their solution for the stabilization of economic fluctuations? Why do they believe changes in government spending impact the economy differently than changes in income taxes? Economists sometimes distinguish types of unemployment into voluntary and involuntary. Voluntary unemployment is seen to be efficient outcome of competitive markets, that is, when qualified people choose not to work because of the going wage rate. On the other hand, involuntary unemployment is the result of business cycle downturns, when given the going rate in the market is insignificant, and unemployment arises because of lower demand for labor due to lower demand in goods in the market. When Keynes traced the cause of this kind of unemployment and found out that this is not just a result of the labor market forces that interact, but due to business cycle downturns, or recessions, he proposed that government can actively curb down this unemployment rates by employing some policy: the monetary and fiscal policy. In order to counter the impacts of business downturns, through fiscal policy, governments can boost its spending in order to boost aggregate demand, which in turn increases output. As aggregate demand in a closed economy is a function consist of consumption, investment and government spending, by increasing government spending by the creation of more collective goods, or other forms of government spending will help increase in aggregate demand. Keynes argues that government can affect the allocation of resources through policies that concerns its spending and taxation. This is the fiscal policy that Keynes prescribes. When the government collects money from people in the form of taxes, resources thus flows into the government coffers. This increase in aggregate demand will determine a matching increase in output to meet it is supposed to maintain the demand levels for labor, which can curb down unemployment or sustain it in its current rate in order not to make it rise any higher. The government can in turn decide to channel these resources into certain projects that will require spending and funding. It can channel the resources to those industries that have high unemployment levels. This spending will further increase demands for businesses in such industry, and this increase demand in the goods of the industry will in turn increase demand for labor. Equally as powerful as the fiscal policy in determining the allocation of resources, thus actively affects important variables in the economy such as unemployment is monetary policy. Monetary policy affects sectors in the economy that are interest-sensitive, such that interest rates and credit conditions have significant effect in encouraging aggregate demand overall. By either raising or curbing the interest rates, the government can affect the aggregate demand—which in its composition comprises consumption and investments, which are greatly affected by these interest rates. By curbing down interest rates, government is in a way encouraging more investments to be created in the economy. By encouraging people to unleash their money and put into businesses, demand for labor will once again increase with the increase of businesses. This demand for labor will in turn provide employment for people; increase their purchasing power which will result in increase in consumption. And this increase in consumption will in turn contribute to the increase the aggregate demand, which will further increase the demand for labor which causes unemployment rates to fall. In the case of fiscal policy which includes taxes and government spending, Keynesian economists argue that because of a certain multiplier’s effect to the economy which is a factor of the propensity to consume and to save, there are differences in the effect. On one hand, for government spending, the multiplier is equivalent to 1/(1-b), where b is the marginal propensity to consume; marginal propensity to consume, according to Samuelson and Nordhaus in their book Economics (769), is “the extra amount that people consume when they receive an extra dollar of disposable income).” As in the assumption that government spending will either directly increase the people’s purchasing power by making income flow into households, or indirectly by making income flow into businesses, which in turn creates jobs and pass on the income to the employees—this increase in government spending will increase the GDP by that certain multiplier. 1 is the numerator, because for every dollar that consumers receive, it is assumed that they also have the propensity to save. On the other hand, changes in taxes has a different effect in the economy because it utilizes a different multiplier—that is, b/(1-b) where b is the marginal propensity to consume. Marginal propensity to consume is the numerator in the multiplier, because an increase or decrease in taxes only affects consumption (with the assumption that taxes do not affect savings). Therefore, instead of 1 being the numerator, the numerator b produces a different multiplier—also known as the tax multiplier. This differences in the multiplier create a difference on effects in terms of stabilizing the economy, as part of fiscal policies. What is the difference between contractionary and expansionary fiscal policy? Which do you think is more appropriate today? What impact of this do you think this policy decision would have on your organization? Contractionary fiscal policy is usually applied in order to slow down the the economy. Contractionary fiscal policy, one the form of increase in taxes, which is aimed to increase the government revenues, will have an effect on aggregate demand, and output in the economy. When taxes are increased, an effect on the consumption follows. Because taxes decrease the disposable income of the people, the purchasing power of the people also decreases. The other form of contractionary fiscal policy is a decrease in government spending. This has an overall effect in the aggregate demand, such that investment is also affected. The decrease in government spending may come in the form of fewer jobs generated by the government, thus, less consumption, and fewer projects from the government which will require investments in businesses. Either by decreasing the government spending or increasing taxes—the aggregate demand falls and has a definite effect on the output. Expansionary fiscal policy on the other hand aims to do the opposite—to help boost income in the economy. By either lowering the taxes or increasing the government spending, this set of fiscal policy aims to contribute to the aggregate demand in the economy. By lowering the taxes will increase the consumers’ purchasing income; by increasing government spending means more income will flow into the households in the form of wage or flow into the businesses in the form of projects and commissions from the government—in either case, aggregate demand increases. Because of its contribution to aggregate demand, these expansionary fiscal policies are aimed to help the economy expand. The economy is in a downturn; therefore expansionary fiscal policy would be needed. This policy, as we can now see comes in the form of government subsidies in order to help the ailing industries. Expansionary policy will impact my organization, in that it can increase my organization’s sales due to government spending—projects that are commissioned by the government, which will require oil and gas as inputs. This expansionary policy, because there is an increase in aggregate demand will help businesses, including the businesses in our industry alike. This is a problem solving exercise comparing the impact of a change in government spending versus a change in income taxes. Suppose; C = 500 + 0.80(Y – 400) I = 400 G = 400 (X – M) = -100 Solve for income or GDP. Then determine the impact on income of an increase in government spending equal to 100. Then, using the original data, compute the impact of a decrease in taxes equal to 100. Why do you think that the results are different? Scenario 1: Y=500+0.80(Y-400) +400+400-100 Y=880+0.80Y 0.20Y=880 Y=4400 Scenario 2: Government spending is increased by 100 Y=500+0.80(Y-400) +400+500-100 Y=980+0.80Y 0.20Y=980 Y=4900 Scenario 3: Taxes are decreased by 100 Y=500+0.80(Y-300) +400+400-100 Y=960+0.80Y 0.20Y=960 Y=4800 The difference in the figures lies in the effect of the multiplier in the model. When one of the elements in the income function is increased, the whole economy is not increased by that amount, but by the amount multiplied with a multiplier. The multiplier for consumption, investment, government spending and net exports is equivalent to 1/(1-b), where b is the marginal propensity to consume. Because the marginal propensity to consumer is 0.80, the marginal propensity to save is 1-0.8 or 0.2. By dividing 1 by 0.2, we get 5 which is the multiplier for the whole model of the economy. For every increase or decrease in the factors in the income function, it is multiplied by 5. Hence, the increase in government spending in scenario 2 caused a total increase in the economy of 500, from 4400 to 4900. The multiplier for taxes, however, is different. The multiplier for taxes is equivalent to b/(1-b), where 0.8/(1-.08) is equivalent to 4. Taxes, as we know have an effect on the consumption function, as it either decreases or increases disposable income. Therefore, by decreasing the taxes by 100, the effect is not multiplied by the same multiplier as 5, but multiplied only by 4, which results an increase in the total GDP of 400. Hence, from 4400, the GDP increases to 4800. Reference List Appleyard, Field, & Cobb., (2006), International Economics (5th ed.). McGraw-Hill Irwin Barro, R. J., (1997). Macroeconomics. 5th ed. Cambridge, Massachusetts: MIT Press. Phelps, E., (1994). Structural Slumps: The Modern Equilibrium Theory of Unemployment, Interests, and Assets. Cambridge, Massachusetts: Harvard University Press,. Samuelson, P. A. & Nordhaus, W. D., (2004), Economics (International Ed.). McGraw-Hill Irwin. Read More