Principles of Economics
2nd edition
by Fred M Gottheil
PowerPoint Slides prepared by Ken Long
©1999 South-Western College Publishing
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Chapter 28
Can Government
Really Stabilize the
Economy?
3/22/2016
©1999 South-Western College Publishing
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This chapter discusses
principles associated with
The
Rational
Expectations
School
The
Keynesian
School
on
The
The
Neo-Keynesian
Supply-Side
School
School
on
on
The
Classical
School
on
Phillips
Automatic
Curve
Stabilizers
Analysis
on
Employment
&
Inflation
Employment
&
Inflation
Employment
Employment
and
Inflation
Inflation
Employmentand
& Inflation
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What are the basic Schools
of Economic Thought?
• Classical • Supply-side
• Keynesian • neo-Keynesian
• Monetarism
• Rational Expectations
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What is
Classical Economics?
Because the economy is
always tending toward a
full employment
equilibrium, there is no
need for government
intervention
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What are the two
propositions of
Classical Economics?
1. All markets are
basically competitive
2. All prices are flexible
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How do the Classical
Economists explain
unemployment?
Unemployment is a
temporary situation caused
by wage rates climbing
above equilibrium
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What about the
long-run?
Wage rates will adjust,
bringing about full
employment in the
long-run
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Real Wage and Employment
S
W1
W2
D1
Q2 Q1
9
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According to Classical
Economists, why might
unemployment be persistent?
People interfere with the
competitive process
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How do people
interfere with the
competitive process?
• Unions
• Minimum wage laws
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According to Classical
Economists, what should
the government do during
periods of unemployment?
NOTHING
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How do the Classical
Economists explain
inflation?
Money supply
increases
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Money
Velocity
Prices
MV
P=
Q
GDP
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Who controls the level
of money and therefore
the price level?
The Federal Reserve
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How much should the
Fed increase the
money supply?
Approximately equal to the
long-run full employment
rate of growth, about 3%
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What is
Keynesian Economics?
Government intervention
when the economy is in
a less than full
employment equilibrium
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According to the
Keynesians, why do we
have unemployment?
Unemployment is the
result of insufficient
aggregate demand
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What is the solution to
Unemployment?
Use government’s fiscal
policies to increase
aggregate demand
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Where does the money
come from to increase
aggregate demand?
The government practices
deficit spending
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What is a Recessionary
Gap?
The difference in real GDP
between a less than full
employment equilibrium
and the real GDP at the full
employment equilibrium
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Aggregate Expenditure
Recessionary Gap
C+I+G
C+I+G
less than full employment
full employment
Real GDP
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What is the New Deal?
President Roosevelt’s
policies of the 1930’s
to increase aggregate
demand by stimulative
fiscal policies
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What is the Employment
Act of 1946?
Congress officially declares
that it is the continuing
policy and responsibility
of the federal government
to take an active role in
the economy
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How do the Keynesians
view inflation?
They are not worried
about inflation
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What is the Economics
of Fine-Tuning?
The government becoming more
proficient at fiscal policy,
managing deficit and surplus
budgets to create full employment
equilibrium with no inflation
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For what were the
Keynesians ill prepared?
The stagflation of the
1970’s, when we had high
rates of both
unemployment and
inflation
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How do the views of
Keynesians differ from those
of neo-Keynesians?
The neo-Keynesians
emphasized the possibility
that an economy can be in
equilibrium at less than full
employment with inflation
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What is the
Phillips Curve?
A graph showing the
inverse relationship
between the economy’s
rate of unemployment
and the rate of inflation
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Rate of Inflation
The Phillips Curve
Rate of Unemployment
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According to the neoKeynesians, what is the
relationship between
inflation and
unemployment?
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The neo-Keynesians believe that
a fall in the unemployment rate
causes the rate of inflation to
increase, and a rise in the rate
of inflation causes the rate of
unemployment to decrease
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What is
the significance of the HumphreyHawkins Act of 1978?
It modified the Full
Employment Act of 1946,
altering its role to now
promote a livable point on the
Phillips curve
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What caused an increase
in costs in the 1970’s?
• OPEC increased the world
price of oil
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How do the neoKeynesians explain the
1970’s Phillips Curve
Instead of one Phillips
curve, there was a set
of Phillips curves
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Rate of Inflation
The 1970’s Phillips Curve
Rate of Unemployment
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What is the Rational
Expectations School?
Government’s policy of
managing aggregate demand
is undermined because of
people’s anticipation of
consequences
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What is an example of
the negative effect of
anticipation?
When workers anticipate an
increase in aggregate
demand, they will bargain
for higher wages to protect
them from inflation
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What does the long-run
Phillips curve look like?
It is effectively vertical
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What policy implications
are associated with the
rational expectations
school?
Government cannot
increase employment in
either the short or long
run.
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What is the Laffer Curve?
Increasing tax rates from
zero increases tax revenues
up to a point - beyond that
point increases will shrink
the economic pie because
of disincentives
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The Laffer Curve
Tax Revenue
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What is the point to the
Laffer Curve?
An increase in taxes might
lead to lower tax revenues
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What is Crowding Out?
A fall in private
investment spending
caused by an increase in
government spending
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How can government
borrowing cause
Crowding Out?
Interest rates can be
driven up, leaving less
money available for
private investment
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What are
Automatic Stabilizers?
Structures in the economy
that tend to add to
aggregate demand when
the economy is in a
recession, and subtract
during inflation
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What are some examples
of Automatic Stabilizers?
Unemployment benefits
The progressive income tax
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http://www.whitehouse.gov
http://stats.bls.gov/eag.table.html
http://www.bog.frb.fed.us/releases/
h15/data/m/prime.txt
http://thomas.loc.gov
http://www.bls.gov
http://www.westegg.com/inflation
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• What are the basic Schools of
Economic Thought?
• What is Classical Economics?
• What is Keynesian Economics?
• According to the Keynesians, why do
we have unemployment?
• What is the Employment Act of 1946?
• What is neo-Keynesian Economics?
• What is the Phillips Curve?
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• What is Demand-side Inflation?
• What is Supply-side Inflation?
• What is the Rational Expectations
School?
• What is Supply-side Economics?
• What is the Laffer Curve?
• What is Crowding Out?
• Upon what do economists agree?
• What are some examples of
Automatic Stabilizers?
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END
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