Section 6: Modules 35 & 36

Module 35: History of Views Money & Price Level Classicals believe prices are flexible, making Agg S vertical, even in short run An increase in MS leads to proportional rise in Agg PL w/ no effect on Agg Output As a result, increases in MS lead to inflation only

John Maynard Keynes Great Depression changed thinking Made economists believe in short run importance 2 thoughts on Depression 1)just a bump that would fix itself 2)bigger problem that needed fixing Keynes compared economy to a car Just needed a tune up; not an overhaul

Keynes Continued 1)emphasized short run effects on Agg Demand on Agg Output; not long run Price Level 2)created idea of short run Ag Supply & shifts in Ag Demand affect Ag Output, Prices, & Unemp “In the long run, we are all dead”

More Keynes Prior to Keynes, economists believed if MS was constant, all would be ok Keynes said business confidence was key Due to ‘animal spirits,’ business cycles appear Classicals said declines in business confidence would have no effect on PL or Ag Output

Fighting Recessions Keynes’s work legitimized fiscal & monetary policies Not all agree however Think Liquidity Trap Milton Friedman believed that business cycles are attributed to fluctuations in MS Depression was avoidable if MS hadn’t contracted Monetary Policy better b/c fiscal policy has to decide 1)who gets tax cuts or 2)who gets govt spending Shift to monetary policy is insulated from political process (when r decrease, it decreases for all)

Monetarism Belief that GDP will grow if MS grows steadily Central bank (Fed) should target a constant growth rate (3%) & maintain no matter what Friedman believed short run importance but also believe policy makers make economy worse He argued time lags are problematic w/ policies Said crowding out occurs when MS is constant & expansionary fiscal policy is used

Probs w/ Keynes Believed that the rightward shift of AD is smaller than multiplier indicated & w/ constant money supply, there was no point to fiscal policy All that occurred was that interest rates increased which reduced investment by businesses & households Friedman argued for ‘autopilot’ by Fed Monetary policy rule = formula for its actions & leaves little discretion

Quantity Theory of Money Emphasizes positive relationship between PL & the MS Relies on velocity of money; the ratio of nominal GDP to MS Velocity is # of times $1 turns over per yr between buyers & sellers Ex: you tip a pizza driver, he buys lunch, etc Equation is M x V = P x Y Where M is MS; V is velocity; P is Ag Price Level; Y is rGDP Belief is velocity is stable in short run & changed slowly in LR Claim is steady growth in MS means steady growth in GDP

Money Velocity Equation How does a 5% increase in the MS affect the price level? V is usually constant b/c consumers don’t often change spending habits in long run Y is not impacted by price level or MS in the long run P will increase by 5% to offset the increase of 5% in MS

Class Problem 1) If the money supply is 20, the velocity is 5, and the price level is 10, calculate the output. 2) If the money supply and velocity are constant and the output increases, what must be true of the price level? 3) If the velocity and output are constant, what must be true of the price level if the money supply increases?

Political Business Cycle Using macroeconomic policy to serve political ends Evidence shows correlation between state of economy & election w/in months of election Temptation is to pump up economy before election Economy should be insulated from politics

Supply Side Economics Belief that cuts in taxes would spur growth Some even believe that it would increase taxes due to increase in GDP Supply-Siders believe that tax cuts would increase potential output, but this is not proved yet *Increases incentives to work & invest

Inflation & Natural Rate of Unemployment Recall NAIRU (low unemp = high inflation) & (high unem = low inflation) Inflation is embedded in expectations To avoid accelerating inflation, unemployment must be high enough that actual inflation = expected inflation This is the natural rate hypothesis Govt cannot keep unempl below natural rate it is asked to keep unempl steady Once inflation becomes embedded, rising prices will happen even if unempl increases Ex: 1970s Macroeconomic policy should stabilize economy instead of seeking a low unemployment rate

New Classical Economists Returned to idea of Ag Demand affecting only Ag Price Level; not Ag Output Based on 2 concepts: 1)Rational Expectations-indiv & firms make decisions optimally People make decisions based on future expectations 2)Real Business Cycle Theory-slowdowns in productivity shift Ag Supply left; recovery occurs & shifts Ag Supply to right

Differing Viewpoints Classicals Keynesians Monetarists Primary Concern Economy will fix itself in long run Agg Demand can impact Agg Output MS is important; deals w/ velocity of $ Fiscal Policy Laissez-Faire Essential during booms/busts Not Needed Monetary Policy Important to keep economy moving Should target growth rate & use MS to achieve target View of Agg Supply Vertical b/c any shift will immediately change PL Upward sloping & can shift in short run Upward sloping

Mod 36 Macro Consensus Points just about everyone now agrees on: 1)Monetary policy should play the main role in stabilization policy 2)The central bank should be independent, insulated from political pressures, in order to avoid a political business cycle 3)Discretionary fiscal policy should be used sparingly, both because of policy lags and because of the risks of a political business cycle

Consensus Modern consensus is Monetary & Fiscal policy work only in short run Discretionary fiscal policy is considered unadvisable except in special times

Do you understand this???