ECN 1200

Macroeconomics
Lecture 5

Lecturer: Mr. Allicock

Purpose
The purpose of this presentation is to give an
introduction to Classical and Keynesian
Macroeconomic Analysis.

.
 Learning Objectives
At the completion of this presentation you should be able to
have an understanding of:

• Analysis of Aggregate Supply and Aggregate Demand

with respect Classical and Keynesian Schools of thought

• Analysis of output and employment under both the

Classical and Keynesian Theories.

• Marginal Propensity to Consume, Save with some

calaculations.
 Background
Classical Economic Theory
• Began with Adam Smith in 1776 and continued until the
1930’s.
• It assumes full employment is the norm in the market
economy and therefore a laissez-faire (let it be) policy is
best by government.
• Rational thinking to maximize own self interest of both
consumers (utility) and firms (profits).
• This allows for an equilibrium price and quantity
combination to occur given both consumers and
producers willingness and ability to buy and sell.
• Natural market forces through the invisible hand allow
the market to correct itself.
 Classical School Assumptions
Classical Economic Theory
• Flexible wages and Prices- that’s is, increase with
inflation and decrease with deflation.
• Aggregate demand is comprised of consumer
spending, investment spending and net exports and
aggregate supply is fixed (vertical) at the economy’s
level of full employment level of real GDP output.
• Changes in aggregate demand causes changes in the
aggregate price level and real GDP produced within
the economy remains the same because the economy
always produces its potential real GDP output.
 Assumptions
Classical Economic Theory
• As aggregate demand increases and the aggregate
price level rises this cause inflation within the
economy, consumer purchasing power decreases,
workers ask for higher wages to compensate for
inflation. The result is an increase in consumption
after wages rise which increases aggregate demand
even further and the economy experiences additional
inflation. This results in demand pull inflation
growing out of control and consumers, firms and
foreigners slow their consumption. This the classical
assumes the market will correct itself.
 Assumptions
Classical Economic Theory
• As consumption slows, aggregate demand begins to decrease
causing a deflation in prices across the economy. As the
economy slows, wages fall with prices levels as firms decrease
their demand for workers now that consumption is declining.
• Further declines in aggregate demand causes consumers
purchasing power to increase and consumers begin to buy more
goods and services because there are now more affordable.
This cycle continues and correct the economic contraction. The
classical theory believe that periods of recession and excessive
inflation are temporary and the macro economy will self
correct it self through changes in aggregate demand and there
is no need for government intervention because the invisible
hand works through flexible wages and prices.
Classical AD/AS Curve
 Background
Keynesian Economic Theory
• Began with John Maynard Keynes in the 1930’s- The
father of modern mix economics.
• Keynesian theory is an addendum to classical theory.
It assumed laissez-faire capitalism is subject to
recurring recessions.
• Need government intervention to stabilize the
economy since there are times natural market forces
completely break down and cannot correct market
failures.
 Keynesian School Assumptions
• The Keynesian school of thought an addendum of the
classical school, assumes that even though the macro
economy corrects itself through the invisible hand, that
is not always true since the invisible hands breaks down
and the economy fails to correct itself due to market
failures. The only way to return the economy to
equilibrium is through government intervention.
• Keynesian school believes that there are three ranges of
aggregate supply within the macro economy.
1. Classical range
2. Intermediate range
3. Keynesian range
Keynesian Range of AS
 Keynesian School Assumptions
Classical range
Prices and wages are flexible and the market corrects itself
according to the classical theory as previously discussed.
That’s is when the aggregate demand changes prices and
wages change without any change in real GDP.

Intermediate range
Prices and wages loose its flexibility and when aggregate
demand changes, both price and real GDP output changes.
Additionally, when the economy moves into the intermediate
range it is experiencing a recessionary gap since it is
producing less than the macro economy full employment
level of Real GDP as discussed in the classical range (vertical
AS).
 Keynesian School Assumptions
Keynesian range
In this range wages and prices are sticky and this represents
the core of Keynesian theory. Sticky wages implies that
workers wages remain the same regardless of the changes in
aggregate demand.
Keynesian theory posits that when aggregate demand enters
the Keynesian range of aggregate supply, prices are so low
that they remain sticky and will not decrease any further.
Aggregate demand changes will cause changes in real GDP
output but prices will remain fixed and will not change since
firms are not willing to sell for lower prices because they
have to earn revenues or they will be forced out of business.
Similarly, wages are sticky because workers are not willing to
work for a reduced wage because they need income to spend.
 Keynesian School Assumptions
Keynesian range cont’d
Because prices are sticky, consumption declines further
and aggregate demand declines further which leads to
further economic contractions or a wider recessionary
gap and worsening macro-economic conditions. This
causes the unemployment rate to increase and income
and consumption levels decline, aggregate demand will
continue to fall because prices and wages are sticky
hence, the invisible hand breaks down and the economy
cannot correct itself. This spiral continues until the
economy collapses or government intervenes to
stimulate aggregate demand and reverse the adverse
economic conditions.
Keynesian AS Curve
 Building the Aggregate Expenditure
Model

Two of the most critical questions in Macroeconomics are:

• What determines the level of GDP, given a nation’s
production capacity?
• What causes real GDP to rise in one period and to fall in
another?
 Assumptions of the AE Model
Aggregate Expenditure refers to the economy’s total
spending and the aggregate expenditure model has its origin
in the writings of John Maynard Keynes.

Keynesian economics uses consumption function in order

to understand factors that alter consumer spending.
The basic premise of the model is that the amount of goods
and services produced and the level of employment depends
directly on the level of aggregate expenditure.
 Assumptions of the AE Model
Businesses will produce only the level of output that they
think they can profitably sell. They will idle their workers
and machinery when there are no market for their goods and
service.
When aggregate expenditures fall, total output and
employment decreases. Conversely, when expenditures rise,
total output and employment increases.

A major assumption under this model is that increases in

output and employment does not raise the price level, hence
the price level is constant.
AE= AD=Y= C+I+G+(X-M)
 The Consumption Function
The consumption and savings functions
The Consumption Function - The relationship between the level of
income in an economy and the amount households plan to spend on
consumption, other things constant.
(C = a + bYD)
Where C= total consumption spending
a= autonomous consumption spending (required spending
without disposable income, food and shelter)
b= Marginal propensity to consume (change in consumption
brought about by a change in disposable income)
Yd= Disposable income.
 The Consumption Function
Households look at their level of disposable income and
decide how much to spend. So spending depends on
disposable income.
Y-T=Yd
YD- C= S
C+S = YD
 The Consumption Function
Marginal Propensity to Consume (MPC)
The marginal propensity to consume gives the change in
consumption, which results from a change in income. The
MPC is therefore the slope of the consumption function. It
tell you by how much consumption would change if income
changes.
C = a + bYD).
b = MPC
MPC = (Change in Consumption/Change in Income)
Yd=100, C=60, MPC= 0.6
 The Consumption Function
Average Propensity to Consume
The fraction, or percentage of total income that is consume
is called the average propensity to consume
APC = (Total Consumption/Total Income)
 The Consumption Function
• Increases in disposable income, will increase
consumption which in turn increases aggregate demand.
• The desire to save less will also increase consumption.
• MPC is not the same for all consumers, consumers with
lower disposable incomes spend a larger proportion of
their incomes on consumption than those who earn more
income.
 The Consumption Function
Non-income (Autonomous) Determinants of
Consumption
The amount of disposal income is the basic determinant of
the amounts household will consume and save. But certain
determinants other than income might cause households to
consume more or less at each possible level of disposable
income and thereby change the location of the consumption
and saving schedules. Those other determinants are wealth,
expectation, indebtedness and taxation.
Along the consumption function, consumption spending
depends on the level of disposable income, other things
constant.
The Consumption Function
 The Savings Function
Marginal Propensity to Save
The marginal propensity to save is a change in consumer savings as a
result of a change in disposable income.

MPS = (Change in Saving/Change in Income)

 
Average Propensity to Save
The fraction of total income that is saved is the average propensity to
save
APS = (Total Savings/Total Income)
 
NB: MPS + MPC = 1 so 1-MPC= MPS and 1-MPS= MPC
The Savings Function
The Consumption and Savings
Function
 The Investment Function
The Demand for Investment (I)
Firms buy capital goods now with the expectation of a
future return.
 
Expected Rate of Return: This is the annual dollar earnings
expected from the investment divided by the purchase price.
 
Investment Demand for the Economy
The economy’s investment demand curve shows the inverse
relationship between the quantity of investment demanded
and the market rate of interest, other things equal.
The Investment Function
 The Investment Function
The simplest investment function assumes that planned
investment or autonomous investment is independent of
level of income.
 
The Autonomous Investment Function (Non income
Determinants of Investment) 
• The Market Interest Rate
•  Business Expectations
 The Government Purchases
Function
The Government Purchase Function: The relationship
between government purchases and the level of income in
the economy, other things constant. Government’s
purchases are considered autonomous that do not depend
directly on the level of income in the economy, because
spending decisions are made by government officials.
 The Net Exports Function
The Net Export Function – The relationship between net
exports and the level of income in the economy, other
things constant.
Net Exports
Net Exports = Exports – Imports
When incomes rise, persons spend more, and some of the
increased spending goes to imported goods.
The amount of Guyana’s exports depends on the incomes of
foreigners, not Guyana’s income. Hence, it is considered
to be autonomous.
So, net exports tend to decline as income increases.
 The Net Exports Function
Non income Determinants of Net Exports
 
Factors held constant along the net export function include
the following:
Guyana’s price level
Price levels in other countries
Interest rates here and abroad
Foreign income levels
The Exchange rate between the dollar and foreign
currencies
END