Transcript Classical & Keynesian Economics Samir K Mahajan EX-ANTE AND EX-POST Ex-ante means planned or intended or expected.

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 supply of goods and services the economy planned to be produced by all production units in
the economy as a whole 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.
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
o
o
o
Private consumption Expenditure ( C)
Private investment Expenditure (I)
Government Expenditure (G)
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. Employment of labour is an
important macro-economic variable. The term ‘employment’ has been synonymously treated with employment to 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 their
reservation about wage( 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. In an economy with involuntary unemployment there is a surplus of labour at the current real
wage.
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 economists argued that in the long-run the economy would automatically tend to move towards fullemployment (absence of involuntary unemployment) and unemployment would be voluntary.
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. They concluded that under perfect competition in a free capitalist
laissez-faire economy, forces (invisible hand) operate in the economic system which tend to maintain fullemployment in the long run without inflation.
CLASSICAL ECONOMICS: SAY’S LAW OF MARKET
Say’s law of market lies at the centre of the classical notion of full employment. J B say, a French economist of the 19th
century introduced the theory of market which states that “supply creates it demand”.
Any productive process has generally two effects due to employment of factors of production such as: i. a certain output of
goods and services results which is supplied to the market and ii. an income stream is generated on account of payments
made by firms to the owners of factors of production and these factors incomes are spent on the goods produced and
supplied. Thus according to Say’s law, all income is spent by the community, though there is a ‘leakage’ of saving in circular
flow of income expenditure. Yet it argues that such saving is not a real leakage, but a sort of channelization in spending.
That is, saving is another form of spending because to save means to intend to spend on producers goods i.e. investment.
What ever is saved is automatically invested in productive activities. Thus, according to Say’s law, every additional output
creates an additional income which creates an equal amount of extra expenditure.
Thus, increase in output = Increase in income = Increase in spending.
According to say, as every additional supply creates an additional demand, aggregate supply equals aggregate demand and
there can be know general over production and general unemployment.
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. Change in money has no impact on the real economy’s prices of equilibrium at full-employment
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 who avowed a strong belief in the
operation of market forces resulting automatic adjustment at full-employment level. 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 shortterm 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 and pointed out
that there is no automatic self-adjustment in the economy.
o
Keynes also attacked the classical theory in regard to saving and investment. He objected to the classical idea of saving
investment-equilibrium through flexible rate of interest. To him saving-investment equality is brought about by
changes in income rather than changes in interest rate.
CONSUMPTION FUNCTION OR PROPENSITY TO CONSUME
Consumption function or propensity to consume
studies the relationship between consumption
expenditure and disposable income.
The concept of consumption function is based on
Keynesian psychological law of consumption which
states that as income of the community increases, its
consumption expenditure will also increase but less
than proportionately, because a part of the income is
also saved.
The consumption function may be written as in the
following equation:
C= f( Y )
C= Ca + Cm Y
Where Ca = autonomous consumption
Cm = mpc (marginal propensity to consume)
Y = disposable income = income after deduction of tax
SAVING FUNCTION OR PROPENSITY TO SAVE
Keynes views saving as that part of income which is not
spent on current consumption. Saving is the excess of
disposable income over consumption. Thus saving
function or propensity to save explains the relationship
between saving and income.
Saving function can be expresses as :
S=Y– C
= Yd – Ca – Cm Y
= – Ca + Y – Cm Y
= – Ca + ( 1 – Cm) Y
Where, – C a = dissaving (negative saving) at zero level of
income
( 1 – Cm) = marginal propensity to save
TECHNICAL ATTRIBUTES OF CONSUMPTION
FUNCTION
o Average Propensity to Consume : Average Propensity
to Consume (apc) is the ratio of total consumption
expenditure to total disposable income.
i.e. 𝒂𝒑𝒄 =
𝒕𝒐𝒕𝒂𝒍 𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 (𝑪)
𝒕𝒐𝒕𝒂𝒍 𝒅𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝒊𝒏𝒄𝒐𝒎𝒆 (Y)
o Marginal
Propensity to Consume : Marginal
Propensity to Consume (mpc) is the ratio of change
in total consumption expenditure to change total
disposable income.
i.e. m𝒑𝒄 =
𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒐𝒕𝒂𝒍 𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 (∆𝑪)
𝒄𝒉𝒂𝒏𝒈𝒆 𝒕𝒐𝒕𝒂𝒍 𝒅𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝒊𝒏𝒄𝒐𝒎𝒆 (∆Y)
TECHNICAL ATTRIBUTES OF SAVING FUNCTION
o Average Propensity to save : Average Propensity to save
(aps) is the ratio of total saving to total disposable
income.
i.e. 𝒂𝒑𝒔 =
𝒕𝒐𝒕𝒂𝒍 𝒔𝒂𝒗𝒊𝒏𝒈 (𝑺)
𝒕𝒐𝒕𝒂𝒍 𝒅𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝒊𝒏𝒄𝒐𝒎𝒆 (Y)
o Marginal Propensity to save : Marginal Propensity to
saving (mps) is the ratio of change in total saving to
change total disposable income.
i.e. m𝒑𝒔 =
𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒐𝒕𝒂𝒍 𝒔𝒂𝒗𝒊𝒏𝒈( ∆𝑺)
𝒄𝒉𝒂𝒏𝒈𝒆 𝒕𝒐𝒕𝒂𝒍 𝒅𝒊𝒔𝒑𝒐𝒔𝒂𝒃𝒍𝒆 𝒊𝒏𝒄𝒐𝒎𝒆 (∆Y)
o Relationship Between apc and aps :
We have , We have, Y= C + S
𝒐𝒓,
or,
Y C +S
C
S
=
= + = 𝒂𝒑𝒄 + 𝒂𝒑𝒔
Y
Y
Y
Y
𝒂𝒑𝒄 + 𝒂𝒑𝒔 = 𝟏
o Relationship Between mpc and mps:
We have, Y = C + S
Differentiating with respect to Y, we get,
dY d(C + S)
dC
𝒅S
=
=
+
= 𝒎𝒑𝒄 + 𝒎𝒑𝒔
dY
dY
dY
𝒅Y
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.
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. Keynes believed that fluctuations in me.e.c . is
fundamental cause of business cycles and income fluctuations in capitalist country.
INVESTMENT MULTIPLIER
The theory of investment multiplier establishes a precise relationship between initial increase increment of investment and the
resulting increase in income and employment aggregate employment, income, given the marginal propensity to consume in short run.
He views that investment multiplier is a direct function of mpc and vice-versa. On that basis, Keynes sets general formula for
investment multiplier (K) as follows:
K=
𝟏
𝒅𝑪
𝟏− 𝒅𝒀
=
𝟏
𝟏−𝒎𝒑𝒄
=
𝟏
𝒎𝒑𝒔
Hence higher the value of mpc, higher is the value of multiplier and vice versa. Or lower the value of mps, higher the multiplier effect.
Theoretically, when mpc=0, K=1 and when mpc =1, K = ∞ . How both these cases are rare phenomena. In normal cases, mpc can not be
zero or one.
Given the multiplier effect (K), we can measure the resulting change in level of income (dY) by causes by an planned change in
investment (dI) as follows:
dY = K. dI
Or, 𝐊 =
𝒅𝒀
𝒅𝑰
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 macroeconomic 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)
Using equations (ii) and (iii) in equation (i), we get
Consumption + Investment = Consumption + Saving
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.
Figure-1
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 fullemployment equilibrium. Usually, it can be at any point of less than full-employment level. According to Keynes, Fullemployment is a rare phenomenon.
Effect of Increase in Effective Demand on Income :
Keynes’ theory suggest that level of employment and income can be raised through an uplift of effective demand by
increasing aggregate demand. Since consumption expenditure tends to remain stable in the short period, level of
aggregate demand can be raised by increasing investment expenditure.
If Investment is increased by additional
autonomous investment ∆I , we have,
Aggregate Demand = C + I + ∆I. With an
increase in investment expenditure, total
expenditure (aggregate demand ) would
increase and total income would increase by
the multiplier effect. This is shown in Figure2.
In Figure-2, point e represents the original
aggregate demand (C+I) level determining
OY level of income. With ∆I , the new level of
aggregate demand shifts to C + I + ∆I and
intersect with unity line at e/ which is the new
equilibrium point at which the corresponding
OY/. The lower portion of Figure-2 represents
the Keynesian cross of Saving =Investment.
With ∆I, the new investment curve is (I + ∆I)
which intersect with the saving function at e/
which shows OY/ level of income.
It may be noticed that increase in income
(∆Y=YY/ ) is in excesses of increase in
investment (∆I ). This is due to multiplier
effect.
determination of income contd.
Figure-2.
Ref: D M Mithani and Internet