Extension Chapter 6 The development of macroeconomic debates Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Learning Objectives Review the classical and Keynesian views of the economy and then present them within a simplified aggregate demand–aggregate supply framework. Examine the monetarist position, and its emphasis on the money supply through a development of the equation of exchange. Briefly describe rational expectations theory (RET) and its implications for policy makers. Review supply-side economics and its implications. Discuss the insights that these alternative views have provided for us on the operation of the macroeconomy. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Classical Employment Theory Underspending in a capitalist economy was highly unlikely, and prices and wages adjust very rapidly to ensure full employment at all times. Two basic assumptions of the classical theory are: underspending is most unlikely to occur prices and wages adjust to ensure that a decline in spending would not result in a fall in real output, employment and real incomes. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Say’s Law The foundation of the classical theory is Say’s law: The very act of producing goods generates an amount of income exactly equal to the value of the goods produced. Production of output automatically generates the incomes required to purchase this output, i.e. supply creates its own demand. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Problems with Say’s Law Saving: a complicating factor If households saved a given portion of their income, supply would not create its own demand. Saving would cause a deficiency of consumption, resulting in unsold goods, unemployment and falling income. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Problems with Say’s Law (cont.) Saving, investment and the interest rate The money market will ensure that the interest rate (the price of money) would adjust to bring about equilibrium between saving and investment. The interest rate will ensure that the leakage from the income-expenditure stream will reappear as investment dollars. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Classical View of the Money Market S (saving) S I S’ r2 Increase in saving in Investment Rate of interest (%) Rate of interest (%) r1 r I I q q’ Dollars saved and invested Dollars saved/invested Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Classical Employment Theory Price–Wage flexibility The assumption that all prices, including wages and interest rates, are flexible and will rapidly adjust to remove disequilibria. Classical theory and laissez faire The price system ensured that price–wage flexibility and fluctuations in the interest rate were capable of maintaining full employment. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Keynesian Economics The Great Depression of the 1930s Keynes and Keynesian Economics Keynes (1936), General Theory of Employment, Interest and Money The capitalist economy is inherently unstable and likely to achieve equilibrium with considerable unemployment or severe inflation, and the possibility of persistent unemployment. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Keynesian Economics (cont.) Unlinking of savings and investment plans Savers and investors are different groups Saving and investment decisions are made by different groups of individuals. Firms also save in the form undistributed profits. Savers and investors are differently motivated Savings decisions are motivated by diverse considerations. Motivations for business investment are complex. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Keynesian Economics (cont.) Money balances and banks Savings and investment plans can be at odds and result in fluctuations in total output, income, employment and the price level. Discrediting price–wage flexibility The existence of price–wage flexibility prices and wages are inflexible downwards it is doubtful that price–wage declines would alleviate widespread unemployment. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

AD–AS in the Classical Theory Vertical aggregate supply curve exclusively determines level of real domestic output Stable down-sloping aggregate demand exclusively determines price level. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Classical View of the Macroeconomy Qf AS P1 AD1 AD2 P2 Price Level Real Gross Domestic Output Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Keynesian View of AD–AS Horizontal aggregate supply curve SR prices and wages are downwardly inflexible Unstable aggregate demand especially investment demand management and stabilisation policies by the government are required. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Keynesian View of the Macroeconomy AS AD1 AD2 P1 Qu Price Level Qf Real Gross Domestic Output Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Monetarism Monetarism is built on classical foundations assumes price and wage flexibility. Markets are competitive with a high degree of macroeconomic stability. Monetarists argue that government policies interfere with competition and promote downwards price-wage inflexibility. minimum wages, pro-union legislation, rural price supports, pro-business monopoly legislation, etc. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Monetarism (cont.) Economy is essentially stable competitive markets cause adjustments to product and resource price and not output and employment. Government creates rigidities and weaknesses in the market. Government intervention must be avoided inefficient, harmful to incentives, and policy mistakes that destabilise the economy. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Keynesian Aggregate Expenditure Equation C + I + G + NX = GDP Aggregate spending by buyers equals total value of goods and services bought. Money plays a secondary role. Involves a lengthy transmission mechanism. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Monetarist Equation of Exchange MV = PQ where M is the supply of money V is the velocity of money P is the price level Q is the physical volume of goods and services produced MV refers to actual spending! (Whereas C + I + G + NX refers to planned expenditure.) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Monetarist Equation of Exchange (cont.) Simple and direct transmission mechanism: change in money supply causes a change in GDP. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Velocity of Money (V) Defined as the number of times per year the average dollar is spent on final goods and services. Monetarists: V is stable or on a steady long-term trend Why? Money is the primary medium of exchange. Store-of-money function is inconsequential. Over time transactions demand increases steadily. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Velocity (cont.) Keynesians: V is unstable Why? Money is held for transactions and as assets. No dependable relationship between M and V. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

The Money Supply and the Level of GDP 1968–69 to 2004–05 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

The Velocity of Money and Interest Rate 1968–69 to 2004–05 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Fiscal Policy Debate The monetarists believe that: Fiscal policy is weak due to crowding-out effects. Funding deficits by selling securities crowds out private investment. There is a relatively inelastic demand-for-money curve. There is a relatively elastic investment demand curve. They should argue for the use of monetary rules. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Fiscal Policy Debate (cont.) Keynesians believe that: The crowding-out of investment is insubstantial. There is a relatively elastic demand-for-money curve. There is a relatively inelastic investment demand curve. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Monetary Mismanagement According to Monetarists, the two sources of monetary mismanagement are: irregular time lags wrong target: interest rates vs money supply. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Monetary Rule According to Monetarists, monetary authorities should stabilise the rate of growth of the money supply, not the interest rate. Keynesians argue against this V is variable both secularly and cyclically a money rule could contribute to fluctuations. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

AD–AS Analysis: Keynesians vs Monetarists Monetarists believe that the AS curve is relatively steep. Any change in AD through monetary policy will have little impact on equilibrium real GDP, but will result in large increases in the price level. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Monetarist AD–AS Perspective GDP2 P2 P1 GDP1 Price Level Real Gross Domestic Output Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

AD–AS Analysis: Keynesians vs Monetarists Keynesians believe that the AS curve is relatively flat. Thus, changes in AD through fiscal or monetary policy will have a larger impact on equilibrium real GDP but only a small impact on the price level. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Keynesian AD–AS Perspective GDP2 P2 Price Level P1 GDP1 Real Gross Domestic Output Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Rational Expectations Theory (RET) Also known as new-classical economics. Businesses, consumers and workers understand the workings of the economy and use this knowledge to assess the anticipated effects of current economic policies upon the future of the economy in order to further their own self-interest. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Rational Expectations Theory (cont.) Basic Concepts: expectations about the future assumes all markets are purely competitive Prices and wages are highly flexible Markets instantly adjust to new changes AS curve is vertical. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

RET and Policy Frustration Aggregated responses of the public will make discretionary stabilisation policies ineffective. Increases in AD will result in an offsetting increase in the price level, leaving output and employment unchanged. Compared to traditional classical theory: RET does not result in temporary lapses from full-employment level of output. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

RET and the AD–AS Model AS P2 P1 AD2 AD1 Q1 Price Level b a Real Domestic Output Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Rational Expectations Theory Further consequences: Pro-cyclical policy: businesses may come to expect tax relief whenever a recession occurs and postpone investment purchases. Evaluation Behaviour Knowledge and understanding about the workings of the economy may be overstated by RET. Sticky prices Markets are not purely competitive. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Rational Expectations Theory (cont.) Policy and stability Empirical evidence that economic policy does affect GDP and employment. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Supply-Side Economics Economic disturbance can be generated from the supply side. Change in aggregate supply is an active force in determining the levels of inflation and unemployment. Stagflation of the 1970s and 1980s contributed to the growth in public sector due to the growing tax wedge between production costs and product prices. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Supply-Side Economics (cont.) Tax-transfer disincentive incentives to work transfer disincentives incentives to save and invest. Resource misallocation Resources of large numbers of lawyers and accountants discovering ways to avoid taxes, could be more effectively used elsewhere. Overregulation Government involvement in the economy has adverse effects on productivity and costs. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

End of all chapters Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal