Economics Classical and Keynesian

1. Suppose during 2012 there is a sudden unanticipated burst of inflation. Consider the situations faced by the following individuals—who gains and who loses? a. A homeowner whose wages will keep pace with inflation during the year, but whose monthly mortgage payments will remain fixed. This person has gained. Nominal income is income that you receive in a given time period and it is measured in current dollars. Real income is nominal income adjusted for inflation and is the purchasing power that your money has. Real income dictates the amount of goods and services the nominal income will buy. The homeowner’s nominal income has increased (say 3%), but inflation has increased by the same amount (3%). The 3 percent increase in inflation reduces the 3 percent increase in nominal income, so the nominal income has not increased faster than inflation.

The nominal income has kept pace with inflation. The homeowner’s gain is in regards to his fixed mortgage. Because his mortgage is fixed, it is immune to the inflation increase. If his nominal income in 2011 is $30,000 and his mortgage is $12,000 per year, he has $18,000 remaining to pay all other expenses in 2011. If the homeowner receives a 3 percent raise, his nominal income for 2012 will be $30,900.00. His mortgage payment is fixed and will remain $12,000.00 per year. This leaves $18,900.00 of nominal income. When you reduce this nominal income by 3 percent to adjust for inflation, the homeowner has $18,333.00 of real income to pay for all other expenses in 2012. This is an increase of $333.00 from the year 2011 to 2012. This is not a huge increase, but this homeowner does gain. He can purchase more goods and services in 2012 than he did in 2011. 2011 Budget

2012 Budget

Nominal income for 2011
Nominal income for 2012 with 3% raise from 2011
Mortgage in 2011
Mortgage in 2012
Money remaining for other expenses
Money remaining for all other expenses for the year 2012 before adjusted for inflation $18,900.00

Subtracting 3% from $18,900.00 to adjust for inflation, the real income per year is $18,333. This is the money remaining for all other expenses in 2012: $333 more than in 2011. $18,333.00

b. An apartment landlord who has guaranteed to his tenants that their monthly rent payments will remain the same as it was in 2011. The landlord loses because he receives less real income when inflation increases unexpectedly. The rent from his tenants becomes less than if prices had remained stable. The landlord’s income comes from the rent payments of the people living in the building. If he collects $200,000 in 2011 from rent payments, his nominal income for 2011 is $200,000. If inflation is 3 percent in 2012, his real income decreases. Real income is nominal income adjusted for inflation. Three percent inflation would reduce the nominal income by $6,000. This person’s real income would be $194,000. This is obviously less purchasing power than he had in 2011. Because the landlord’s nominal income stays the same and prices increase, his real income falls and his money has less purchasing power. He can buy fewer goods and services in 2012 than he did in 2011.

The landlord’s nominal income has not risen faster than the rate of inflation and he ends up with a smaller share of total output. Inflation causes a redistribution of income and wealth. The landlord’s income has been redistributed. Inflation has caused $6,000 of the landlords’ money to be redistributed to the tenants. The tenants will continue to purchase at least as many goods and services in 2012 as they did in 2011. The landlord’s real income will fall relative to people whose nominal income increases with inflation. This income redistribution acts like a tax. It takes income or wealth from one group and gives it to another. Those who have gained in this situation are the tenants whose rent will not increase, but the landlord loses. c. A retired individual who earns a pension with a fixed monthly payment from their past employer during 2015: This person has lost. His nominal income remains the same, but his real income decreases because of inflation and his dollars have less purchasing power. He has less money in 2012 to purchase goods and services than he had in 2011 and his standard of living decreases. He is able to purchase fewer goods and services than he could the previous year because his nominal income has remained the same and his real income is less.

His real income has fallen relative to those whose nominal income has increased. His nominal income does not keep pace with inflation and he ends up with a smaller share of total output. 2. Explain the difference between REAL and NOMINAL GDP. Which do you suppose would be the more important measure when looking at long term economic growth as shown in the Aggregate Supply/Demand model? Gross Domestic Product is the dollar value of all the output of goods and services produced in a year in a country. Nominal GDP is that dollar value expressed in current prices. Real GDP is nominal GDP adjusted for price increases (inflation). Nominal GDP is calculated using current prices and real GDP is calculated using constant prices. Real GDP is an inflation-adjusted measure of physical output. Real GDP is the more important measure when looking at long term economic growth. The rate of economic growth measures the annual percentage increase in real GDP. Real GDP is the variable that is used to monitor long-term growth in the economy because it is the most comprehensive measure of economic activity. The Aggregate Supply/Demand model focuses on the behavior of two variables, the economy’s output of goods and services, as measured by real GDP; and the overall price level, as measured by the CPI. The output on the horizontal axis of the model is real GDP, which is the measure of the true value of annual national production.

The amount of GDP output varies every year and so does inflation. Therefore, how we measure real GDP growth must be adjusted to reflect inflation. If the economy of a country in 2000 allowed for output to reach $100 million and in 2001 the economy allowed for output to reach $110 million, it appears that the economy has grown by 10 percent; but this is nominal GDP and has not been adjusted for inflation. When you adjust 2001’s GDP for inflation, say 5%, the real GDP for 2001 is $105 million. The economy has actually grown by 5 percent and $5 million dollars. This is still a large number, but not as large as $10 million. If you use nominal GDP to measure long-term economic growth, you are not getting the true picture of how much output has increased, or if it has actually fallen. If nominal GDP increases by 2 percent, but inflation increases by 3 percent, output has actually declined by 1 percent. If you use nominal GDP, it could look like output has had a huge increase from year to year, but this gives a false measure. Nominal GDP has to be adjusted for changing price levels. Real GDP gives us an accurate reading of GDP because it measures output at constant prices.

The more important measure of economic growth is reflected through real GDP. 3. Classical and Keynesian economists believe in a different role for the government in dealing with recessions. Explain the differences between the two theories and the different roles. Classical and Keynesian economists see the role of the government differently when dealing with a recession. Classical economists believe in the invisible hand and Keynesian economists believe in a helping hand. From the Classical point of view, the economy is inherently stable. They believe there is an automatic mechanism (an invisible hand) that moves the market toward equilibrium and stability. The Classical theory is based on the principle that the market can regulate itself when left alone. When output declines, it is only temporary and the market will self-adjust. Classical economists believe the role of the government during a recession should be to leave the market alone (laissez faire). Government intervention can only bring the economy down and impede the market mechanism from working. In the long run, the good of the economy is best served if the government does not interfere. Classical economists believe that long-run growth is more important and short-run losses are acceptable. The Classical theorists believe that supply creates its own demand (Say’s Law). If a good is produced, it will be purchased. Buyers and sellers just have to find a price acceptable to both.

Classical economists believe that the economy is stimulated when more goods are produced. The concept of flexible prices is very important to the Classical theory. When demand slows, sellers can lower their prices to increase demand and thus restore equilibrium. If demand is too high, sellers can raise their prices to restore equilibrium. Flexible wages are also important to the Classical theory. When someone is unemployed, they can find another job by working for less money. Flexible wages guarantee that anyone who wants to work will work. Keynesian theory states that the economy is inherently unstable and needs a helping hand to find its equilibrium. This helping hand comes in the form of government intervention. Keynesian economists believe that the market is not capable of achieving equilibrium by itself and it is possible that disequilibrium will last for a long time. Keynes believed that small changes in output, prices, or employment were likely to be magnified, not corrected, by the invisible hand. He believed that the depression of the 1930s was not a unique event. He argued that a depression would happen again if we relied on the market mechanism to self-regulate. He saw that macro failure was the rule, not the exception. In the Keynesian economic model, the government has the important role of smoothing out business cycle bumps to ensure economic growth and stability. Keynes believed in helping the economy in the short run, not the long run. When in a recession, the government should not wait to see when or if the market will self-correct.

Keynes believed the government should intervene to save jobs and income. Keynes saw that policy levers are both effective and necessary. Without such intervention the economy would experience repeated macro failures. The Keynesian perspective argues that an economy left alone will not reach its full capacity. Corrective intervention can come in the form of government spending (increased or decreased), tax cuts, or tax increases. Also, Keynesian economists believe that if you demand it, it will be supplied. Keynesian theory maintains that most economies are demand driven and supply is based on demand. Keynesian theory believes in inflexible prices and wages. Prices do increase, but prices are not as flexible when going down. Suppliers must make a profit and will not supply at a loss. It is the same for wages. Wages do decrease, but they are much more inflexible when traveling in that direction. Keynes also saw that the economy does, at times, call for a budget deficit or surplus. During a recession, the government can increase spending and/or lower taxes.

This will cause the budget to run a deficit. Keynes also felt that when the economy is in good shape the debt should be paid. Debt payment can come in the form of spending cuts and/or tax increases. Keynes saw nothing wrong with an unbalanced budget when it was needed to keep the economy healthy and running smoothly. 3. Which do you believe is the relevant one in today’s current economic downturn? Keynesian theory is the relevant theory in today’s economic downturn. The market does need a helping hand. The economy can self-adjust, but the downturns can last for long periods and people suffer during these times. Without government intervention, an economic downturn can continue as it did in the 1930s. The government does have policy levers available that they can use to shift the aggregate demand and/or aggregate supply curves. These measures help restore the economy to its full production possibilities potential.

What do you think?

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