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Essay ECN 001
ECN 002: PRINCIPLES OF ECONOMICS II
NO. 4 (a)
The Keynesian Theory
Keynes’s theory of the determination of equilibrium real GDP, employment, and prices focuses on the relationship between aggregate income and expenditure. Keynes used his income‐expenditure model to argue that the economy’s equilibrium level of output or real GDP may not corresPond to the natural level of real GDP. In the income‐expenditure model, the equilibrium level of real GDP is the level of real GDP that is consistent with the current level of aggregate expenditure. If the current level of aggregate expenditure is not sufficient to purchase all of the real GDP supplied, output will be cut back until the level of real GDP is equal to the level of aggregate expenditure.
Hence, if the current level of aggregate expenditure is not sufficient to purchase the natural level of real GDP, then the equilibrium level of real GDP will lie somewhere below the natural level.
In this situation, the classical theorists believe that prices and wages will fall, reducing producer costs and increasing the supply of real GDP until it is again equal to the natural level of real GDP.
*Sticky prices:* Keynesians, however, believe that prices and wages are not so flexible. They believe that prices and wages are sticky, especially downward. The stickiness of prices and wages in the downward direction prevents the economy’s resources from being fully employed and thereby prevents the economy from returning to the natural level of real GDP. Thus, the Keynesian theory is a rejection of Say’s Law and the notion that the economy is self‐regulating.
*Keynes’s income‐expenditure model*. Recall that real GDP can be decomposed into four component parts: aggregate expenditures on consumption, investment, government, and net exports. The income‐expenditure model considers the relationship between these expenditures and current real national income. Aggregate expenditures on investment, I, government, G, and net exports, NX, are typically regarded as autonomous or independent of current income. The exception is aggregate expenditures on consumption. Keynes argues that aggregate consumption expenditures are determined primarily by current real national income. He suggests that aggregate consumption expenditures can be summarized by the equation
Aggregate Consumption= C + mpc(Y)
where C denotes autonomous consumption expenditure and Y is the level of current real income, which is equivalent to the value of current real GDP. The marginal propensity to consume ( mpc), which multiplies Y, is the fraction of a change in real income that is currently consumed. In most economies, the mpc is quite high, ranging anywhere from .60 to .95. Note that as the level of Y increases, so too does the level of aggregate consumption.
Total aggregate expenditure, AE, can be written as the equation
AE = A + mpc(Y)
where A denotes total autonomous expenditure, or the sum C + I + G + NX. Different levels of autonomous expenditure, A, and real national income, Y, correspond to different levels of aggregate expenditure, AE.
Equilibrium real GDP in the income‐expenditure model is found by setting current real national income, Y, equal to current aggregate expenditure, AE.
In conclusion, Keynes argues that prices will not fall further below P 2 because workers and other resources will resist any reduction in their wages, and this resistance will prevent suppliers from increasing their supplies. Hence, the SAS curve will not shift to the right as in the classical theory and the economy will remain at Y 2, where some of the economy’s workers and resources are unemployed. Because these unemployed workers and resources earn no income, they cannot purchase goods and services. Consequently, the aggregate expenditure curve remains stuck at AE 2, preventing the economy from achieving the natural level of real GDP. Figure therefore illustrates the Keynesians’ rejection of Say’s Law, price level flexibility, and the notion of a self‐regulating economy
Economic growth means an increase in real national income / national output. Economic development means an improvement in the quality of life and living standards, e.g. measures of literacy, life-expectancy and health care. Ceteris paribus, we would expect economic growth to enable more economic development.
As economic growth we consider the increase in real output (real GDP) over time caused by additional resources (production inputs) and higher productivity of these inputs (more efficient production methods). As economic development we consider not only the increase in output but also the structural, technological and institutional changes in production and distribution of product. The latter term is more general.
The main difference is that development includes a number of structural changes (social, institutional, economic and cultural). This is why we may say that less developed economies (relatively low GDP or GNP per capita) “develop” while the developed (or “mature”) economies (relatively high GDP or GNP per capita) that present no significant structural changes “grow”.
Another way of looking at the problem is by saying that development is related to the increase of output while growth does not necessarily mean development. As an example the increase in oil production may lead to the increase of the economy’s product without implying that this growth will lead to the restructuring of the production, of the technology or the distribution of the final product.
Growth is no doubt a necessary term for development without growth development cannot be assumed. As quality of life and other aspects are related to the income level in the economy.
Conclusively, Economic growth is a necessary condition but not sufficient condition for Economic Development.
Reasons for deficit balance of payment
(i) High rate of inflation
(ii) Cyclical fluctuations
(iii) Change in Demand
(iv) Import of Services
(v) Political Instability:
(vi) Political disturbances:
Globalization is the word used to describe the growing interdependence of the world’s economies, cultures, and populations, brought about by cross-border trade in goods and services, technology, and flows of investment, people, and information.
globalization can create new opportunities, new ideas, and open new markets that an entrepreneur may have not had in their home country. As a result, there are a number of positives associated with globalization:
(a) it creates greater opportunities for firms in less industrialized countries to tap into more and larger markets around the world
this can lead to more access to capital flows, technology, human capital, cheaper imports and larger export markets
(b) it allows businesses in less industrialized countries to become part of international production networks and supply chains that are the main conduits of trade
NO 8: Difference Between Economic Growth vs Economic Development
Economic growth is the increase in goods & services produced by an economy or nation, considered for a specific period of time. The rise in the country’s output of goods and services is steady and constant and may be caused by an improvement in the quality of education, improvements in technology, or in any way if there is value addition in goods and services which is produced by every sector of the economy.
It can be measured as a percentage increase in real gross domestic product. Where a gross domestic product (GDP) is adjusted by inflation. GDP is the market value of final goods & services which is produced in an economy or nation.
Economic Development is the process focusing on both qualitative and quantitative growth of the economy. It measures all the aspects which include people in a country become wealthier, healthier, better educated, and have greater access to good quality housing. Economic Development can create more opportunities in the sectors of education, healthcare, employment, and the conservation of the environment. It indicates an increase in the per capita income of every citizen. The standard of living includes various things like safe drinking water, improve sanitation systems, medical facilities, the spread of primary education to improve literacy rate, eradication of poverty, balanced transport networks, increase in employment opportunities, etc. Quality of living standard is the major indicator of economic development. Therefore, an increase in economic development is more necessary for an economy to achieve the status of a Developed Nation.
It can be measured by the Human Development Index, which considers the literacy rates & life expectancy which affect productivity and could lead to Economic Growth.