Archive for the 'Keynesian Economics' Category

Apr 08 2011

The battle of ideas: Hayek versus Keynes on Aggregate Supply

Introduction: The two models below represent two very different views of a nation’s aggregate supply curve. The theories behind the two models represent the ideas about the macroeconomy of two economists, John Maynard Keynes and Friedrich von Hayek.

Instructions: The videos introducing Keynes’ and Hayek’s theories can be found here: “Commanding Heights: the Battle for Ideas”. We will watch them in class, but if you need to review them you may watch them again from home. Once you’ve watched the videos and read chapter 17 from your Course Companion, answer the questions that follow each of the two models below.
Figure 1: the Classical AD/AS model

  1. Why does Hayek’s “classical” aggregate supply curve always lead to an equilibrium level of national output equal to the full-employment level of

    real GDP?

  2. The vertical AS curve above is sometimes referred to as the “flexible-wage and flexible-price” model of the macroeconomy. Why must wages and prices be perfectly flexible for this model to be an accurate representation of a nation’s economy.
  3. Hayek was an advocate for free markets, he felt that government intervention in a nation’s economy would only interfere and disrupt the efficient allocation of resources. How does the model above reflect his belief that governments cannot improve a nation’s level of output beyond what the free market is able to achieve?
  4. Do you believe that the classical model of aggregate supply is representative of the real world? Why or why not? What evidence is there from recent history that the model is or is not accurate?

Figure 2: The Keynesian AD/AS model

  1. Based on the model above, which level of aggregate demand corresponds with the macroeconomic goals of “full-employment and stable


  2. Changes in which factors could cause aggregate demand to shift from AD2 to AD3? If AD falls to AD3, what happens to the price level in the economy? What happens to the level of output of goods and services? What happens to employment and unemployment?
  3. Sometimes the Keynesian AS model is known as the “sticky-wage and sticky-price model”. How does the model reflect the idea that wages are downwardly inflexible, in other words, will not fall even if demand for goods and services fall? For what reasons might wages in an economy be downwardly inflexible (in other words, not fall even as total demand in the economy falls)?
  4. How realistic is the Keynsian model of aggregate supply in the real world?
    1. Can you point to any evidence from the last few years that it might be correct (in other words, that a fall in AD will lead to decrease in national output?) Find data on the GDP’s of two Western European countries from 2008 and 2009 to support your findings.
    2. Can you point to any evidence from the last few years that the model might be flawed (in other words, that a fall in AD actually does lead to a fall in the price level)? Find data on inflation in the same two Western European countries to examine whether or not wages and prices are completely inflexible downwards as the model suggests.


Figure 3: Our IB Economics AD/AS model

The diagram above represents a compromise between the classical AD/AS model and the Keynesian AD/AS model. This graph is the one we will use throughout the IB and AP Economics course when illustrating a nation’s macroeconomy. Answer the questions that follow about the diagram.
  1. How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?
  2. Why are there two aggregate supply curves? What is the difference between the two?
  3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the “fixed-wage period” and the long-run the “flexible-wage period”. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?
  4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?
  5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?

260 responses so far

Jan 28 2010

The best Econ rap… EVER!! – A new resource for Econ teachers and students, from Russ Roberts and John Papola

The long awaited rap video from George Mason University’s Russ Roberts featuring the theories of John Maynard Keynes and F. A. Hayek has been released at last!

We’ve heard some decent Econ raps before (remember “Demand, Supply” by Rhythm, Rhyme, Results?) But this song covers all bases in the predominant macroeconomic schools of thought. Keynes and Hayek are brought back to life and their theories pitted against one another in an all out liquor fueled debate on the streets of New York City.

The video was just released this week. It is packed full of theory from the Classical, supply-side school of macroeconomics (represented by Hayek) and the demand-side school (represented, of course, by Keynes). The video includes cameos from Fed chairman Ben Bernanke and Treasury Secretary Tim Geithner, whose role as bartenders filling Keynes glass reflects their role in the real economy at keeping the money supply and government spending at high levels, fueling economic booms and the eventual busts that result.

Stay tuned to this blog for more feedback on the video, including some graphical analysis and discussion questions for Macro teachers to use in class!

2 responses so far

Dec 28 2009

Keynesian/Classical debate enters the realm of hip hop

Keynes vs. Hayek: Late Economists Hip-Hop Legacy | PBS NewsHour | Dec. 16, 2009 | PBS.

A major theme of both the AP and IB Economics courses is the long-running debate between the Keynesian, demand-side theories of macroeconomic policy and those of the Classical, supply-side school. Today’s “Great Recession” has revived this debate, which itself dates back to the Great Depression of the 1930’s, when an Englishman and an Austrian could be found at the ideological centers of two different philosophies of the role government should play in the macroeconomy.

John Maynard Keynes and Friedrich Hayek were close friends whose views on government’s role differed greatly. Hayek was a classical, laissez faire libertarian who believed that any intervention by government in a nation’s economy disrupted the efficient functioning of the free market and threatened to stifle private enterprise. Keynes, the father, of course, of modern Keynesian economics, believed that free markets left unchecked were vulnerable to the volotile animal spirits of investors and speculators whose often irrational behaviors could create externalities such as unemployment and credit crunches, thereby harming society as a whole.

Paul Solman of PBS (who I recently met at an Economics teachers conference in Washington DC) interviews a modern Keynesian, Robert Skidelsky (Keynes’ biographer) and a neo-classical economist, Russ Roberts (who I also recently met in Richmond, VA).

6 responses so far

Sep 29 2009

How big is the government spending multiplier in America? Well, it depends on which economist you ask…

Economics focus: Much ado about multipliers | The Economist

What is the goal of fiscal stimulus during a recession? Is it simply to increase nation’s total income by a certain amount determined by how much a government increases its own spending by? If this were the case, then an $800 billion stimulus package, like the one begun this year in the US, would lead to a total increase in national income of, well, exactly $800 billion.

While such an outcome is possible, it is not the desired outcome of the Obama administration and the economists who have supported the use of expansionary fiscal policy during economic downturns (i.e. the Keynesian school of economists). Keynesians expect that an initial increase in government spending (or a decrease in taxes) will result in households and firms increasing their own consumption and investment, meaning successive increases in spending. The initial change in spending ultimately gets multiplied through further rounds of spending. The total change in national income resulting from an initial change in government spending or taxes depends on the size of the fiscal multiplier. Now, this is where things get tricky! From the Economist:

The size of the multiplier is bound to vary according to economic conditions. For an economy operating at full capacity, the fiscal multiplier should be zero. Since there are no spare resources, any increase in government demand would just replace spending elsewhere. But in a recession, when workers and factories lie idle, a fiscal boost can increase overall demand. And if the initial stimulus triggers a cascade of expenditure among consumers and businesses, the multiplier can be well above one.

The above scenario, where an economy is operating below full-employment and government spending puts the nation’s idle resources to work, creates new income and further increases private spending, is precisely what the Obama team and its economists hope will happen in the US economy soon. A multiplier of above one means the $800 billion will ultimately increase America’s national income by something greater than $800 billion!

The multiplier is also likely to vary according to the type of fiscal action. Government spending on building a bridge may have a bigger multiplier than a tax cut if consumers save a portion of their tax windfall. A tax cut targeted at poorer people may have a bigger impact on spending than one for the affluent, since poorer folk tend to spend a higher share of their income.

Crucially, the overall size of the fiscal multiplier also depends on how people react to higher government borrowing. If the government’s actions bolster confidence and revive animal spirits, the multiplier could rise as demand goes up and private investment is “crowded in”. But if interest rates climb in response to government borrowing then some private investment that would otherwise have occurred could get “crowded out”. And if consumers expect higher future taxes in order to finance new government borrowing, they could spend less today. All that would reduce the fiscal multiplier, potentially to below zero.

Herein lies the controversy about the effectiveness of deficit-financed fiscal stimulus. Several posts on this blog have focused on the neo-classical, supply-side economists’ fears that expansionary fiscal policy financed by government borrowing will drive up interest rates to private borrowers, thereby “crowding-out” private investment, off-setting any expansion in output achieved through government spending. In the Keynesian model, however, it is precisely because interest rates have bottomed out at the “zero bound” (according to Paul Krugman) that government borrowing and spending will not lead to crowding-out, rather could actually increase investors’ willingness to spend (their “animal spirits”) on new capital, actually “crowding-in” private investment.

Alas, the debate continues. The ironic thing is that even years from now, after all of Obama’s stimulus money has been spent, and the US economy is either fully recovered or it is not, we still won’t know how large the fiscal multiplier was, since tomorrow’s economists will find it nearly impossible to isolate the variable of the $800 billion of government spending and determine just how much of America’s growth in income can be attributed to government spending, and how much resulted from automatic stabilizers built-in to help the economy recover on its own during recessions.

Discussion Questions:

  1. Why do tax cuts for the rich tend to have a smaller multiplier effect than tax cuts for lower income households?
  2. How can government borrowing drive up interest rates, and why is this a concern to policy makers deciding on the size of a fiscal stimulus package?
  3. What are the animal spirits the article mentions? Where have you heard this expression before?
  4. Do you think borrowing trillions of dollars and spending it to put people back to work and try to dig the US economy out of recession is wise, or should the US government be practicing better fiscal responsibility?

11 responses so far

Mar 03 2009

Recession’s effects on small vs. large companies: some evidence in support of the Classical view of self-correction

Why Are Large Companies Losing More Jobs Than Small Ones? – TIME

This is a fascinating, short article from TIME. Before reading it, see if you can answer the multiple choice question below:

Q: Why do small companies lay off proportionately fewer workers during a recession than large companies?

A) Because small firms are less likely to be in the industries hardest hit by a recession (such as manufacturing)?
B) Because small firms are less focused on maintaining profits to satisfy greedy shareholders?
C) Because small companies are able to hang on to employees and even hire new ones during a recession because of all the talent being laid off by big firms.

Still thinking? Well, it’s likely that all three are true to some extent. But it’s the third one that seems most intriguing as a student of economics. Here’s what the article says:

…small companies hire disproportionately more early on in an economic recovery because it’s easy for these firms to find good workers while unemployment is still high—and easy for workers to come across small companies since there are so many of them. Once the economy is chugging along at full-steam and the labor market is tight, larger companies regain the advantage, since they’re likely able to offer more money—and poach from smaller outfits.

Seems pretty straight forward, right? Sure, but the fact that small firms are likely to hire when unemployment is high supports one side in a long-running economic debate over the economy’s ability to “self-correct” in times of recession.

As any student of Macroeconomics learns early on, there are two dominant theories of macroeconomics, both which are represented in the aggregate demand/aggregate supply diagram that we learn and use in AP and IB Economics.

The two models below represent the two opposing views of macroeconomics. First we see the Keynesian model, which shows that when overall demand in an economy falls, unemployment increases drastically and output tanks, plunging the economy into a deep recession. This is primarily because of the “inflexible” nature of wages, meaning that even when unemployment rises, workers are unwilling to accept lower wages and firms therefore are unwilling to hire more workers.

According to Keynesians, the only way to get the economy out of the recession is by increasing overall demand through heavy doses of government spending (case in point, the $775 billion stimulus in the US).

Next is the Classical AD/AS model with a vertical long-run aggregate supply curve. The implication of the vertical AS curve is that regardless of the level of overall demand in the economy, output will always return to the full-employment level, and thus unemployment will always return to its natural level. The major assumption underlying the Classical model is that wages are in fact flexible in times of recession. As unemployment rises, workers will accept lower wages since they’d rather be making less than making nothing at all. As wages fall firms will begin hiring more workers, increasing overall output and decreasing unemployment until full-employment output is restored.

The implication of the model on the right is that government is NOT needed to get the economy out of a recession, because it will self-correct due to the new hiring and production by firms in response to falling wages in the labor market.

The reason this article stood out to me was that it seems to offer some evidence in support of the flexible-wage, Classical model of macroeconomic self-correction. There has been surprisingly little talk among news anchors, pundits and politicians about the likelihood of the US or ANY economy suffering in the global slowdown “self-correcting” as the Classical model would suggest it should. But the fact that small businesses are less likely to lay off workers in a recession and more likely to begin hiring them due to the large number of workers being laid of by big companies offers at least an inkling of evidence in support of the Classical model of flexible wages and macroeconomic self-correction.

Discussion Questions:

  1. Why is laying off workers the first thing big companies do when faced with falling demand for their products? Why don’t they shut down factories instead?
  2. What pressures does a publicly traded company (one that sells stocks to investors) face in times of recession that a small, privately owned business does not?
  3. When the global recession is finally over, do you think more people or fewer people will be working for small companies (less than 50 people) than before the recession? What would you rather work for, a small firm or a large one? Why?

262 responses so far

« Prev - Next »