Macroeconomic Theory: From Classical Foundations to Keynesian Models and Investment Demand

The Classical School (1800s):
- The journey of economic philosophy began with Adam Smith in the late 1700s and continued through the 1800s.
- Prominent later classical thinkers included Jean Baptiste Say and David Ricardo, whose works largely mirrored the original philosophy of Smith.
- Neoclassical School (Late 1800s): This period marked an evolution toward a more analytical and secular approach to economics. It focused less on the "right way" of doing things (philosophy) and more on tools like supply and demand.
- The Power of the Market: Neoclassical tools centered on the Law of Demand and the Law of Supply.
- Say’s Law: Developed by Jean Baptiste Say, this principle posits that as long as there is a supply, there will be a demand for it. It shifts focus away from societal welfare (whether a good is beneficial or detrimental) to the mechanics of market exchange.

International Trade Applications: David Ricardo applied neoclassical philosophy to global markets, arguing that trade benefits all participants even if one country has an absolute efficiency advantage in all production.
Marginal Cost Definition: Defined as the cost of producing one additional unit of a good.
Law of Comparative Advantage:
- If a country can produce a good at a lower marginal cost than its trading partner, it possesses a comparative advantage in that good.
- A country should specialize in the production of goods where it holds a comparative advantage and trade for goods where it has a comparative disadvantage.
- This ensures the most efficient use of global resources even when one entity is broadly more productive.

The Roaring Twenties: The second decade of the twentieth century (post-World War I) was characterized by massive economic expansion.
The Great Depression (1930s): Following the natural peak of the business cycle, the economy entered a prolonged recession known as the Great Depression.
John Maynard Keynes:
- A British economist educated at Cambridge University in London.
- Strongly influenced by classical giants but became skeptical of their core assumptions, specifically the Quantity Theory of Money.
- Equation of Exchange: Keynes accepted that expenditures must equal income ( $M \times V = P \times Q$ ) but challenged the assumption of a constant velocity of money ( $V$ ). He believed velocity fluctuates.
- Persistence of Unemployment: Contrary to classical views that unemployment is temporary, Keynes argued it is persistent. Workers do not immediately accept any job; they wait for opportunities that match their skills and pay comparable to previous earnings.

Definition of "Sticky": In Keynesian philosophy, wages and prices are described as sticky, meaning they are inflexible downwards during a recession.
Wages: Unemployed workers generally refuse to accept drastically lower wages, and employers during a recession do not expect workers to make outrageous wage demands.
Prices: Businesses suffering from low profits during a recession are unlikely to inflate prices to generate revenue, as this would be irrational. Instead, prices remain inflexible rather than dropping to clear the market.
Policy Implications: Because wages and prices do not adjust downward quickly, unemployment becomes the primary policy problem. Inflation is not a major concern during Keynesian recessionary periods.
Time Horizons: The Keynesian school focuses on the economy in the very short run, whereas the Classical school analyzes the economy in the long run.

Categorization of Investment: Business spending (Gross Private Domestic Investment) is not purely autonomous; it is undertaken for specific profit-generating purposes. Categories include:
- Plant and equipment.
- New construction.
- Research and Development (R&D).
- New inventories.
- The Arts (new technology, music, etc.).
Profit Expectation: Expenditures are only incurred if the expected rate of return from capital is greater than the cost of the investment.

Timing Mismatch: There is often a delay between an initial investment and the revenue generated from sales. Therefore, businesses must account for the time value of money.
Future Value (FV) Formula:
- $FV = P \times (1 + r)^t$
- Where $P$ is the principal, $r$ is the interest rate, and $t$ is time.
- Example: $1000$ deposited at $6\%$ interest for one year results in $1060$ ( $1000 + 60$ ).
Present Value (PV) Formula:
- $PV = \frac{FV}{(1 + r)^t}$
- When solving for $PV$ , $r$ is often called the discount rate.
- Example: To have $1060$ in one year at $6\%$ interest, one must deposit $1000$ today ( $\frac{1060}{1.06} = 1000$ ).
Tools for Calculation: For periods ( $t$ ) greater than one year, manual calculation of $r$ (the interest rate) is tedious. Use of a financial calculator is required.
- Recommendation: The Texas Instruments TI BA II Plus (available as a mobile app or physical device) is essential for business and corporate finance students.

Ranking Projects: Businesses rank potential expenditures by their Internal Rate of Return (IRR) (also known as the Marginal Efficiency of Investment or Marginal Efficiency of Capital).
Example Project Ranking:
1. New Machine: $10\%$ return on $1,000$ expenditure.
2. New Merchandise Line: $8.33\%$ return on $3,000$ expenditure ( $4,000$ cumulative).
3. R&D New Product: $7.14\%$ return on $7,000$ expenditure ( $11,000$ cumulative).
4. New Computer System: $2.5\%$ return on $5,000$ expenditure ( $16,000$ cumulative).
Decision Rule: A business will only undertake an investment if the expected rate of return exceeds the cost of capital (the interest rate charged by the bank).
- At a $6\%$ interest rate: The machine, merchandise, and R&D are feasible. The computer system (2.5\%<6\%) is not.
- At an $8\%$ interest rate: The R&D ( $7.14\%$ ) becomes unfeasible.
Investment Demand Curve: There is an inverse relationship between the interest rate and the total quantity of investment. This is a negative-sloping curve.

The Price of Money: The interest rate is defined as the price of money, determined by the supply and demand for money.
Money Supply Fluctuations:
- Money Supply Rises: The supply curve shifts right, causing the "price" (interest rate) to fall. This leads to more investment spending and an increase in GDP (expansion).
- Money Supply Falls: The supply curve shifts left, causing the interest rate to rise. This discourages investment spending and leads to a decrease in GDP (contraction).
Consumer Impact: Lower interest rates also encourage household spending on large items like cars and houses.
Textbook References:
- Classical/Keynesian Comparison: Page 624 (Chapter 31).
- Time Value of Money: Pages 374-375 (Chapter 18), Table 18.2.
- Investment Demand Curve: Page 626 (Chapter 31), Figure 31.1.
- Money Supply and Interest Rates: Page 734 (Chapter 35), Table 35.3.
Upcoming Topics: The Aggregate Demand/Aggregate Supply (AD/AS) Model (Chapter 32), which incorporates price changes and fiscal policy.