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 Theory AS P1 Price Level AD1 Q1 Real Domestic Output

Classical Theory AS P1 Price Level P2 AD1 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

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 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 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 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

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 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 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 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

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

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