Classical  | Keynes | -Prices are flexible -price level would adjust whenever aggregate demand shifted, so government interventions could have no effect on aggregate output. Critics to Keynesianism – Comparing spending to tax multipliers doesn’t take into account the growth incentives of low taxes. – Aggregation obscures that some spending is less useful than other spending. (e.g., Frederic Bastiat’s broken window fallacy) – pay the repairer so he will spend more in other things  | -Prices are rigid and downward, making the aggregate supply flat -believed classical economics held in the long run, but in the short run the price level wouldn’t adjust. -The Keynesian cross equates aggregate demand (aggregate expenditure) with aggregate output (aggregate income). – Increases in consumption, investment, government spending, net exports, and autonomous consumption are positively related to an increase in output. – An increase in taxes is negatively related to an increase in output. – Changes in spending were dominated by investment spending, unstable due to “animal spirits.” – This leads Keynesians to believe that increases in government spending are more effective than tax cuts. (tax cut multiplier is less than 1)…Use expansionary fiscal policy to reactivate the economy: increase gov spending and cut taxes,If gov borrows a lot of money that increases the interest rates and it’s difficult for the private sector to borrow too – crowdingout, economy needs to be under capacity for this multiplier effect: because of the ripple effect the initial increase in gov sending may be higher worth of actual spending in the economy Fiscal policy Gov can intervene by changing gov or taxes
Recessionary gap: increase gov spending, cut taxes (increase disposable income) – spending creates jobs by increasing consumer spending that will boost the economy (expansionary)IS/LM MODEL The ISLM model, which stands for “investment-savings” (IS) and “liquidity preference-money supply” (LM) is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the loanable funds market (LM) or money market| IS | LM
| -Based on goods market (Keynesian consumption curve) and shows the combinations of interest rates affecting GDP -Slopes down because as interest rates are lower people tend borrow more and spend more, increasing the GDP -Relationship of interest rates affecting GDP when the good markets is in equilibrium, meaning all income people receive is spent (no savings) -Shift by any change in the goods market (fiscal changes – or monetary if it issues bonds) – Higher interest rates, less borrow, less spending, less GDP – Affected by exchange rates | -Shows the relationship of interest rates and national income from the money market -Shows relationship between interest rates and national income when money market is equilibrated (all money printed is demanded by the country) – Shift by any change in the money market (monetary) – Increases because the more national income there is, also the more money there is. Higher interest rates must be due from the increase income – Affected by exchange rates  Liquidity trap: LM is completely flat so monetary policy doesn’t work at all (most likely because the money demand is flat as well) that’s why Keynes wants fiscal policyFloating vs. Fixed EXRATE-floating rates:allows monetary policy to be used to pursue other goals (stable growth, low inflation)fixed rates:avoids uncertainty and volatility, making international transactions easier, disciplines monetary policy to prevent excessive money growth & hyperinflationCritique of Keynesianism Keynes recommended that governments run deficits (fiscal stimulus) during recessions and surpluses (fiscal dampener) during booms. Politicians heard economists say “sometimes run deficits” and forgot the “sometimes” part.Mundell-Fleming The Mundell-Fleming model – an open economy (an economy with international trade) by adding a balance of payments line (BoP=0).
Balance of payments equilibrium. In a floating exchange rate the supply of currency will always equal the demand for currency, and the balance of payments is zero-If two countries trade a lot, one country’s policies can affect the other country. -With secondary IS curve movements, there is an opposite effect on the other country.- This is why the U.S. government strongly encourages other countries to use a fiscal stimulus and strongly discourages other countries from using a monetary stimulus.Impossible trinity Free capital flows: absence of capital controls, no restrictions in converting money into a foreign currency and you make your currency readily available for such transactions.Fixed exchange rates -Countries with both: need a huge Forex reserve for the currency to be fully backed, interest rates may be very similar to the ones from the country of the forex reservesIndependent monetary policy-IMP, FER: because money is not flowing in and out freely they can control the monetary policy and maintain the fixed exchange rates IMP, FCF: the monetary policy of changing exchange rates has an impact on the fixed exchange rates, because the freedom of capital flows