Boriana Handjiyska

Fundamental for understanding the forces driving the American economy are the classical and Keynesian economic models. They constitute a solid base for further economic research and analysis of economic events.

The goal of classical economics is to explain what determines prices of goods, services and resources, and what forces regulate the market. There are two important assumptions that underlie the classical views. One is that no one in the market has control over the prices of goods, services and resources, meaning that there is a perfect competition. The second assumption is that people are rational, which means that producers will strive for profit maximization and consumers will aim at maximizing their satisfaction from the goods and services, that is, people act according to their self-interest.

The classical theory is a supply-side theory. It is based on the Say’s law that "supply creates its own demand". By producing a certain good or service the producer earns income which is spent on other goods and services. Even if some income is saved this does not mean that spending is reduced because increase in saving will reduce interest rates and thus will stimulate borrowing for investment purposes.

According to the classical theory the function of money is a medium of exchange, which for convenience is preferred to barter. The quantity theory of money states that prices are a function of the money supply p=f(M).

The formal classical model is based on two propositions: the individual’s production function and the principle of profit maximization. Classical theory assumes that the quantity and quality of capital and natural resources as well as the level of technology are fixed. It follows that the output of the individual firm depends on the quantity of labor employed. There is a trend that when employment is increased the marginal physical product of additional units of labor decline. This is the principle of diminishing returns. In order the firm to maximize its profits it needs to operate at a point where the income from an additional unit of output is equal to the cost of that output. This is the profit maximization principle.

Another assumption that the classical theory makes is that people do not suffer from 'money illusion' meaning that people realize that a particular unit of money changes in value. In the classical model money is considered neutral.

The labor market theory is based on all of the above-stated assumptions and propositions. It consists of two parts: the demand for and the supply of labor determine employment; and the employment level using the production function determines output. The demand/supply curve of labor operates as any other demand/supply curve and thus sets the level of employment in respect to wages. The level of employment, on the other hand, determines the level of income since income is dependent on the number of people working.

There are four important equations where w is money wage, p is price level, N is the level of employment, K is the stock capital and T is technology:

Nd=f(w/p) demand of labor is a function of the real wage

Ns=g(w/p) supply of labor is a function of the real wage

Nd=Ns equilibrium

Y=f(N,K,T) the production function

In the last equation output is a function of employment, capital and technology. Since in the short-run capital and technology are fixed, then output is a function of employment. From the first two formulas one can see that demand is a function of the real wage W=w/p, which equals the marginal product of labor. The marginal product of labor is important because it determines the decisions of the business firms concerning how much labor to hire. Firms hire labor until the marginal product of the last unit of labor hired equals the real wage W. The law of diminishing returns and the fact that prices at which additional units of production can be sold decline, determine the relationship that if business firms use more labor the real wage w/p must necessarily decline. In the US economy right now there is the same relationship: because of tight labor markets (not enough demand for labor), the wages rose by 0.5% from August and there is fears that they will continue to rise further.

On the graph one can see that equilibrium level occurs where demand for and supply of labor meet. According to the classical model all unemployment that occurs at equilibrium level must be voluntary, because it is driven by resistance to accept lower wage. At equilibrium level the economy is at full employment. The classical theory holds that the economy is always at full employment, otherwise the mechanisms of the labor market would adjust it until it reaches equilibrium at full employment.

This must be so also because the real wage is bargained between employers and employees as one can see from the graph: demand and supply set the real wage, it is not employers by themselves who decide what the price of labor will be. (The very first assumption of classical theory stated above is that no one in the market has control over the prices of goods, services and resources, in this case labor).

The theory of the price level in the classical model is very much linked to the quantity theory of money. It asserts that the monetary value of output (Yp) is equal to the quantity of money in circulation times its average rate of turnover (Mv), where v is the income velocity of money v = Y/M.

Mv =Yp price level theory

p = f(M) the quantity theory

The classical aggregate supply and demand model rests on the relationships developed so far and can be expressed by six equations and four graphs. It is essential that all wages and prices are flexible. In such case the market regulates itself entirely through the mechanisms of supply and demand and it is always at full employment.

Y=f(N) output is a function of employment

Nd=f(w/p) demand for labor is a function of the real wage

Ns=g(w/p) supply of labor is a function of the real wage

W=(w/p) real wage is the ratio of money wage over price

Mv=Yp

Y=Mv/p

The classical model is supply oriented (e.g. Say's law 'supply creates its own demand'). In contrast the Keynesian model is a demand-side model. The essential proposition of the Keynesian model is that the level of output and employment in the economy is the amount of total expenditures, which are determined by income. Production is done because of expected demand. According to the Keynesian theory aggregate demand is the crucial factor that sets the level of income and employment. A major difference between the classical and Keynesian models is that while the classical linked output and employment through the price level, the Keynesian model links them to the expected income from the sale of that output, where expected proceeds is an ex ante term. Thus, employment is a function of income N=f(Y).

Aggregate demand, on the other hand, is a curve showing how much consumers, firms and government are willing to spend at each level of real income. Like the supply curve, the demand curve also is an ex-ante occurrence. The relationship is represented in the equation DD=C+I+G+M-X, where C is consumption spending, I is investment spending, G is government spending, M is imports and X is exports.

In the Keynesian model consumption is defined by the equation C=a+bY where a is the level of consumption which would happen if income was zero, and b is the coefficient of income that is spent (not saved and not invested). 'b' is the marginal propensity to consume.

The income equilibrium level occurs where the demand equation DD=C+I+G+M-X meets the supply curve. A crucial difference from the classical model is that the equilibrium level determined by the demand and supply curves is not necessarily one of full employment. This is where government intervention comes in: e.g. by increasing government spending the DD curve will shift upwards to the right and thus it will shift the equilibrium level at a higher level of output. Since employment is a function of output N=f(Y), employment will rise. If it is known what the full employment level is, the government can approach it by increasing government spending or by fiscal policies that stimulate consumption. It is important to note that equilibrium can exist at a level other than full employment. If there is a lack of aggregate demand with respect to full employment level there will be a deflationary gap in the economy. If aggregate demand is in excess there will be an inflationary gap. This is what is happening in US economy right now. There seems to be over-consumption and over-investment. Combined with tight labor markets, this creates fears of inflation.

To summarize the major differences between the classical and Keynesian schools of economics:

classical - market self-regulates itself to equilibrium at full employment

Keynesian – it can be in equilibrium at a level other than full employment

Classical – supply side

Keynesian – demand-side

Classical - total market self-regulation

Keynesian – need for government intervention

Classical – employment and income are linked by the price level

Keynesian – they are linked by expenditure (see graphs on pp. 3 and 6)

Both the classical and the Keynesian models have proved to be right in most aspects of their theory with few exceptions. A very useful feature is that they are compatible with each other. Joined together they create the IS-LM model, which is a complete model that determines the equilibrium level between the goods and services sphere and the monetary sphere, each of which is also in equilibrium.

US economy right now is ‘trapped in a bubble’. Low interest rates, fast economic growth, low unemployment rate and low inflation (CPI) – too perfect to be real and sustainable. A problem occurs: this high productivity growth has been reached by a huge credit expansion. Fiat money is not backed up by specie (gold) and as such is very easily inflatable. A sudden unexpected burst of inflation would inevitably lead to a recession or even a depression the extent of which are determined by fiscal and monetary policies. What policies should the government enact?

As we have seen so far the classical model proposes that the market will regulate itself. But history (the Great Depression in particular) has shown that it doesn’t happen always this way. The Keynesian model proposes fiscal policies. At the current level of spending it might be practical to raise taxes and cut spending so that inflation is avoided. But actually it is not so practical. With the current budget surplus the tendencies are exactly the opposite: cut taxes or increase spending. The dilemma is between those two choices as an article from Business Week proposes: "Do we use most of the projected federal budget surplus for a tax cut or to …shore up Social Security and Medicare?" On the other hand Bill Bradley, currently candidate for president, proposes a health plan, which will provide "health care to almost all Americans, including coverage for children". Good idea, but is it inflation safe? According to the classical model increase in government spending will necessarily lead to an increase in price level. The solution to the danger of inflation does not seem to be found either in the passivity of the classics or in the fiscal policies of the Keynesian model. The key to the problem is found in the Federal Reserve and is called ‘interest rates’. Let’s first look at some theory.

The classical model asserts that investment is a function of the interest rates I = f (i) and saving is a function of the interest rates S = g (i). When the entrepreneur chooses to finance investment with credit, as interest rates fall it becomes cheaper for the entrepreneurs to borrow money. The price of money is part of the cost of production, which increases the profits of the entrepreneur. This stimulates investment. When retaining earnings are used for investment, low interest rates again encourage investment because the opportunity cost of not saving is lower - the returns from saved money are lower. At lower interest rates the same amount of money saved might earn less money than if it were invested. Same relationship is true when interest rates are high - investment will be discouraged. Therefore interest rates should be raised.

However, according to the classical model the equilibrium level should be obtained naturally. The classical theory of interest is governed by the rules of supply and demand schedules, the graph of which consists of two curves - supply and demand of savings, where demand of savings is investment. Equilibrium is reached naturally with no need for government intervention. For example if interest rates are higher than the equilibrium level there is more demand for savings than there is supply of it. This will make interest rates fall until equilibrium for the demand and supply of savings is reached. Respectively if interest rates are lower than the equilibrium level, the demand for savings will be higher than the supply, which should raise the interest rates. As maintained by the classical model market forces entirely regulate the economy and there is no need for government policies.

However, the current situation of the US economy disproves the classical theory, because the demand for savings in the economy is significantly higher than the supply for savings, but nevertheless interest rates stay unchanged. Here comes the role of the Federal Reserve. In order to reduce the credit expansion it is the task of the Fed to raise the interest rates. It has done this twice so far this year and on the 5^th October it was considering a third hike but it is unlikely to happen because of reported low inflation rate. However, the views on whether the inflation is low or not are contradictory. The Fed’s opinion says: "For now the thread of another hike… appears to have receded, given tame August inflation reports on consumer and producer prices, cooler September readings on payrolls gains and wage growth, and wait-and-see tone of the Fed’s statements following its August 24^th rate increase". This is the optimistic view. The opinion of Congressman Paul is slightly different and accuses the first point of view of pretentiousness. "Current government propaganda promotes the false notion that inflation is no longer a problem…The dangerous financial bubble is a result of the Fed’s deliberate policy of inflation. The Fed’s argument that there is no inflation, according to the government-concocted CPI figures is to justify a continuing policy of monetary inflation because they are terrified of the consequence of deflation." Who is right – the federal Reserve or the Congressman? One is for sure: if there is a danger of inflation it should not be belittled. Inflation in US right now is dangerous not only for the American consumer but also for the world consumer as a whole. US dollar has become an international currency and banks all around the world hold portion of their reserves in US$. If the dollar becomes inflated this will lead to a huge recession not only in US but in the world in general. And as the Asian crisis managed to spread out and influence the economies on the rest of the continents a new crisis in America would have an impact on all countries. The solution to the problem seems to be simple: a hike in interest rates will cool demand for savings. With a savings rate of 0% and household debt of 81% of personal income this tactic can never be wrong. This approach is neither classical nor Keynesian. It is monetarist and it proposes a monetary policy.

Monetary policy: interest rate should be raised. This will reduce investment and stimulate some saving. Over-investment has proven to be a problem. Having the Asian crisis as a precedent, it is better to be on the safe side. Higher interest rates also will reduce the danger of inflation.

Fiscal policy: there should not be a tax-cut. Americans are confident consumers. Stimulating more consumption would most likely lead to a higher inflation rate as the classical model proposes: an increase in demand level leads to an increase in the price level.

To maintain high level of growth: part of the budget surplus should be spent on investment in education. The major part of output/income comes from and goes to qualified workers; other part of the budget surplus should go for investment in health care (as Bill Bradley suggests). Health care will balance income inequality gap by supplying the poor with health treatment that they otherwise cannot afford. Health care subsidies is a way towards a more equal and healthy society but not less efficient.