Disputes Over Macro Theory and Policy 19 C H A P T E R Disputes Over Macro Theory and Policy

Vertical Aggregate Supply Curve Stable Aggregate Demand CLASSICAL ECONOMICS AND KEYNES Classical Economics Adam Smith - 1776 Laissez-faire The Classical View Vertical Aggregate Supply Curve Stable Aggregate Demand Real Output Depends Upon… Quantity of money possessed by households & businesses Purchasing power of money is determined by the price level Classical View – Tenets of Adam Smith 1 – 4 Vertical supply curve located @ Qf Real Output doesn’t Δ in response to Δ’s in PL as wages and other inputs would be flexible and adapt to PL Δ. Economy operates @ Qf because of Say’s law, “supply creates its own demand”. Response is to “temporary” oversupply, hence wages and other inputs would adjust to Δ in PL HENCE REAL OUTPUT DEPENDS ON - MS underlies AD. A stable MS will control growth. Downward sloping DC is stable and solely responsible for setting PL. Δ in MS will shift the DC but responsive flexible prices and wages will ensure Qf is maintained

Classical Theory AS P1 Price Level AD1 Q1 Real Domestic Output

Classical Theory AS P1 P2 AD1 AD2 Q1 Price Level Real Domestic Output Key here is that a decline in AD reduces PL yet classical school maintains that wages and prices are flexible and will lower to match P2 and consequently maintain Q1 or Qf. AD2 Q1 Real Domestic Output

Keynesian Economics John Maynard Keynes, 1930s The Keynesian View CLASSICAL ECONOMICS AND KEYNES Keynesian Economics John Maynard Keynes, 1930s The Keynesian View Prices and Wages Downwardly Inflexible Active Government Policy Required to Stabilize the Economy Horizontal Aggregate Supply Curve to Full-Employment Unstable Aggregate Demand Core to Keynesian View is that wages and prices are downwardly inflexible not flexible as maintained by the classicalists. PL acts as ASsr and is horizontal. A decline in Qf (real output) has no effect on the PL. When Qf is reached, AS then becomes vertical. AD is unstable from one period to the next even w/o Δ’s in the MS. AD is unstable because of – Ig. Ig component of AD is most likely to fluctuate and the impact is on Qf & employment, whilst the PL remains the same. Active Govt. policy are essential to > AD and move economy back to Qf.

Keynesian View AS P1 Price Level AD1 Q1 Real Domestic Output

Keynesian View AS P1 Price Level AD1 AD2 Q2 Q1 Real Domestic Output

Mainstream View Ca + Ig + Xn + G = GDP Monetarist View M V = P Q = GDP CAUSES OF MACRO INSTABILITY Mainstream View Changes in Investment Ca + Ig + Xn + G = GDP Adverse Aggregate Supply Shocks Monetarist View Equation of Exchange Mainstream View – Most economists espouse this view – “the prevailing view”. Ca + Ig + Xn + G = GDP [AE = real output (GDP)] Any change in one of the spending components shifts the AD Curve. Hence, equilibrium is changed in real output, the price level or both. Ig is key component Instability can also arise form AS: supply restrictions (rations), war, > cost of production, supply shocks = cost-push inflation. Monetarist View – modern form of classical economics (more supply side oriented) MS is the focus of the monetarist theory. Price & wages are flexible and will adapt to PL changes. With no Govt. interference, macroeconomic stability would be substantial. Govt. has caused instability through minimum wage law; pro union legislation and commodity guarantees for some agricultural prices. Govt. is clumsy, mistaken in its interpretation of the business cycle Fundamental equation: MV = PQ (GDP). MS x V (the # of times dollar is spent on g/s per year) PQ = avg. price x quantity of all g/s. Monetarists suggest that V is stable. Factors altering V are predictable and happen gradually. People & firms have a stable pattern for holding money. If V is stable, equation suggests that there is a predictable relationship between MS & GDP Monetarists argue that money policy is the single most important cause of macroeconomic instability; I.e. an > in MS = > in AD. Mainstream view Ig as cause M V = P Q = GDP Stable Velocity

Summary Mainstream View Monetarist View CAUSES OF MACRO INSTABILITY Summary Mainstream View Instability of Investment is the Main Cause of Output Changes Monetary Policy is a Stabilizing Factor Monetarist View With a Stable Velocity, Nominal GDP Depends Upon the Money Supply

Real Business Cycle View Real-Business-Cycle Theory ASLR1 Price Level P1 3Rd Perspective – Business cycles are caused by real factors affecting AS such as decline in productivity, which causes a decline in AS. Real Business Cycle Theory - declines in GDP means less demand for MS. Demand decreases hence, MS <, AD falls but PL is the same because AS also declined. Essentially a new Qf is found. Unemployment is permanent? AD1 Q1 Real Domestic Output

Real Business Cycle View Real-Business-Cycle Theory ASLR2 ASLR1 Price Level P1 AD1 Q2 Q1 Real Domestic Output

Real Business Cycle View Real-Business-Cycle Theory ASLR2 ASLR1 Recession With Stable Price Levels Price Level P1 AD1 AD2 Q2 Q1 Real Domestic Output

Coordination Failures Real Business Cycle View Real-Business-Cycle Theory Coordination Failures ASLR2 ASLR1 Recession With Stable Price Levels Price Level P1 Rather based on the “self-fulfilling” philosophy. If you think it will happen you prepare for it and hence, collectively, it becomes a reality. Keys come form Fed or fiscal policy, Especially Fed policy. AD1 AD2 Q2 Q1 Real Domestic Output

New Classical View Self-Correction? Rational Expectations Theory DOES THE ECONOMY SELF-CORRECT? New Classical View Self-Correction? Rational Expectations Theory Speed of Adjustment Unanticipated Price Changes “Price Level Surprises” Fully Anticipated Price-Level Changes Monetarists and Rational Expectation economists believe that the economy have automatic, internal mechanisms for self-correction. Leads later to = (“Don’t do something, just stand there”.) FIGURE 19.3b demonstrates the process. Main disagreement between new classical economists is over the speed of the adjustment process. Monetarists maintain a gradual change, 2 to 3 years not quick or immediate as the Rational Expectation theory holds. I.e. RET people anticipate some future outcome before they occur, making change very quick, even instantaneous as a result. In RET: Unanticipated Δ’s – “Price Level Surprises” like an > in demand of U.S. goods by foreigners = > in AD = > PL. RET position is that firms MISTAKENLY adjust their production in response to what they PERCEIVE to be a relative price change in their product alone. Hence, any change in GDP is corrected because prices are FLEXIBLE and firms readjust output to its previous level. Do wages > quickly as they are “flexible”? In 19.3a why does economy move from a to b? In RET: Fully anticipated PL Δ’s do not change real output, even for short periods. Firms are able to maintain profit and production levels.

An increase in AD Self- Correction ASLR AS1 P1 AD1 Q1 Price Level a NEW CLASSICAL VIEW OF SELF-CORRECTION An increase in AD ASLR AS1 Self- Correction Price Level P1 a The sequence is for an unanticipated increase in AD AD1 Q1 Real Domestic Output

An increase in AD Self- Correction ASLR AS1 P2 P1 AD2 AD1 Q1 NEW CLASSICAL VIEW OF SELF-CORRECTION An increase in AD ASLR AS1 Self- Correction Price Level P2 b P1 a AD2 The economy moves from a to b. AD1 Q1 Real Domestic Output

An increase in AD Self- Correction AS2 ASLR AS1 P3 P2 P1 AD2 AD1 Q1 NEW CLASSICAL VIEW OF SELF-CORRECTION An increase in AD AS2 ASLR AS1 Self- Correction Price Level P3 c P2 b P1 a AD2 It then self corrects to c. The change isn’t quick or immediate as RET maintains because firms have “mistakenly” adjusted production to what they perceive to be a price change of their product alone” On the other hand, an anticipated > in AD would move the economy directly from a to c. Hence, when there is a price change, output or productivity shouldn’t change. Only the price level changes. AD1 Q1 Real Domestic Output

Mainstream View Downward Wage Inflexibility Efficiency Wage Theory DOES THE ECONOMY SELF-CORRECT? Mainstream View Downward Wage Inflexibility Efficiency Wage Theory Greater Work Effort Lower Supervision Costs Reduced Job Turnover Insider-Outsider Theory and Relationships Downward Wage Inflexibility – Keynes view. Wages and prices are inflexible downward for long periods of time because of: Restrictions placed by minimum wage Efficiency wages – greater productivity is achieved by > wages which lowers overall per unit production costs. Less supervision Less employee turnover Morale effect Insider vs. outsider – insiders keep their jobs even though outsiders might accept lower wages. EMPLOYERS PREFER A STABLE WORK FORCE.

Discretionary Monetary Policy Discretionary Fiscal Policy RULES OR DISCRETION? In Support of Policy Rules Monetary Rule Balanced Budget In Defense of Discretionary Stabilization Policy Discretionary Monetary Policy Discretionary Fiscal Policy Increased Macro Stability Monetary rule would direct the Fed to expand MS each year @ same rate as typical growth of GDP. Figure 19.4 > in MS tied to right shift in ASlr and ensure AD shifts right along with it. The rule would promote steady growth with price stability Few favor amendment requiring balanced budget. Passivity in fiscal policy wont create deficits or surpluses. “Don’t do something, just stand there” philosophy Monetarists and new classical economists believe fiscal policy is ineffective: expansionary policy crowds out private investment. RET economists reject discretionary fiscal policy for same reason and reject monetary policy and believe it doesn’t work because the effects are “fully anticipated by the private sector”. Mainstream defend discretionary stabilization policy arguing that velocity of MS is more variable and unpredictable, in short run Monetary policy can help offset Δ’s in AD. Monetarists believe velocity is basically stable. Mainstreamers oppose balanced budget annually because it would intensify the business cycle by raising taxes, or cutting spending during a recession and the opposite during booms. Mainstreamers support discretionary fiscal policy to combat recession or inflation even if it causes a deficit or surplus budget. Discretionary fiscal and monetary policy have been 34% more stable than prior to 1946 when they weren’t used! A very strong argument for it. If it ain’t broke, don’t fix it. Monetarists and RET would maintain that it is broke and our philosophy would fix it.

Fed Increases The Money Supply Resulting in… RATIONALE FOR A MONETARY RULE Federal Reserve Increases Money Supply at the Long-Run Growth Rate of GDP ASLR1 ASLR2 Fed Increases The Money Supply Resulting in… Price Level P1 P2 AD1 Q1 Q2 Real Domestic Output, GDP

Growth Without Inflation or Deflation RATIONALE FOR A MONETARY RULE Federal Reserve Increases Money Supply at the Long-Run Growth Rate of GDP ASLR1 ASLR2 Growth Without Inflation or Deflation Price Level P1 P2 AD2 AD1 Q1 Q2 Real Domestic Output, GDP

RULES OR DISCRETION? Summary of Alternative Views Chapter Conclusions

KEY TERMS classical view Keynesian view monetarism equation of exchange velocity real-business-cycle theory coordination failures rational expectations theory new classical economics price-level surprises efficiency wage insider-outsider theory monetary rule KEY TERMS Copyright McGraw-Hill/Irwin 2002 BACK END

Supply And Demand Elasticities And Government-Set Prices Chapter 20 Next: Supply And Demand Elasticities And Government-Set Prices Chapter 20