19 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 38 Keynesian Economics In a broad sense, Keynesian economics is the foundation of modern macroeconomics. In a narrower sense, Keynesian refers to economists who advocate active government intervention in the economy.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 38 Keynesian Economics Two major schools decidedly against government intervention have developed: monetarism and new classical economics.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 38 Monetarism The main message of monetarists is that money matters. Monetarism, however, is usually considered to go beyond the notion that money matters.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 38 Monetarism The monetarist analysis of the economy places emphasis on the velocity of money, or the number of times a dollar bill changes hands, on average, during a year; the ratio of nominal GDP to the stock of money (M): or since then,

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 38 The Quantity Theory of Money The quantity theory of money is a theory based on the identity M x V = P x Y and the assumption that the velocity of money (V) is constant (or virtually constant). Then, the theory can be written as the following equality:

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 38 The Quantity Theory of Money If there is equilibrium in the money market, then the quantity of money supplied is equal to the quantity of money demanded. When M is taken to be the quantity of money demanded, this equality would make the quantity of money demanded dependent on nominal GDP, but not the interest rate.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 38 The Quantity Theory of Money The demand for money may depend not only on nominal income, but also on the interest rate. Whether velocity is constant or not may depend partly on how we measure the money supply.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 38 The Velocity of Money, 1960 I – 2003 II The velocity of money is far from constant. There is a rising long-term trend, but fluctuations around this trend have been quite large.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 38 Inflation as a Purely Monetary Phenomenon Inflation is always a monetary phenomenon. If the money supply does not change, the price level will not change. The view that changes in the money supply affect only the price level, without a change in the level of output, is called the “strict monetarist” view.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 38 Inflation as a Purely Monetary Phenomenon The “strict monetarist” view is not compatible with a nonvertical AS curve. Almost all economists agree that sustained inflation is purely a monetary phenomenon. Inflation cannot continue indefinitely without increases in the money supply.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 38 The Keynesian/Monetarist Debate Milton Friedman has been the leading spokesman for monetarism over the last few decades. Most monetarists argue that inflation in the United States could have been avoided if only the Fed had not expanded the money supply so rapidly.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 38 The Keynesian/Monetarist Debate Most monetarists do not advocate an activist monetary policy stabilization—expanding the money supply during bad times and slowing its growth during good times.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 38 The Keynesian/Monetarist Debate Time lags are the most common argument against such management. Monetarists advocate a policy of steady and slow money growth, at a rate equal to the average growth of real output (Y).

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 38 The Keynesian/Monetarist Debate Many Keynesians advocate the application of coordinated monetary and fiscal policy tools to reduce instability in the economy—to fight inflation and unemployment.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 38 The Keynesian/Monetarist Debate Others reject the strict monetarist position in favor of the view that both monetary and fiscal policies make a difference and at the same time believe the best possible policy is basically noninterventionist.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 38 New Classical Macroeconomics On the theoretical level, new classical macroeconomists argue that traditional models have assumed that expectations are formed in naive ways.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 38 New Classical Macroeconomics Naive expectations are inconsistent with the assumptions of microeconomics. If people are out to maximize utility and profits, they should form their expectations in a smarter way.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 38 New Classical Macroeconomics On the empirical level, new classical theories were an attempt to explain the apparent breakdown in the 1970s of the simple inflation- unemployment trade-off predicted by the Phillips Curve.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 38 Rational Expectations The rational-expectations hypothesis assumes people know the “true model” of the economy and that they use this model to form their expectations of the future. By “true” model we mean a model that is on average correct in forecasting inflation.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 38 Rational Expectations People are said to have rational expectations if they use “all available information” in forming their expectations.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 38 Rational Expectations Because there are costs associated with making a wrong forecast, it is not rational to overlook information, as long as the costs of acquiring that information do not outweigh the benefits of improving its accuracy.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 38 Rational Expectations and Market Clearing If firms have rational expectations, on average, prices and wages will be set at levels that ensure equilibrium in the goods and labor markets. In other words, on average, there will be no unemployment.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 38 Rational Expectations and Market Clearing When expectations are rational, disequilibrium exists only temporarily as a result of random, unpredictable shocks. On average, all markets clear and there is full employment. There is no need for government stabilization.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 38 The Lucas Supply Function The Lucas supply function is the supply function that embodies the idea that output (Y) depends on the difference between the actual price level (P) and the expected price level (P e ):

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 38 The Lucas Supply Function The difference between the actual price level and the expected price level is the price surprise.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 38 The Lucas Supply Function The rationale for the Lucas supply function is that unexpected increases in the price level can fool workers and firms into thinking that relative prices have changed, causing them to alter the amount of labor or goods they choose to supply.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 38 The Lucas Supply Function Rational-expectations theory, combined with the Lucas supply function, proposes a very small role for government policy in the economy.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 38 Evaluating Rational-Expectations Theory If expectations are not rational, there are likely to be unexploited profit opportunities—most economists believe such opportunities are rare and short-lived.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 38 Evaluating Rational-Expectations Theory The argument against rational expectations is that it required households and firms to know too much. People must know the true model, or at least a good approximation of it, and this is a lot to expect.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 38 Real Business Cycle Theory The real business cycle theory is an attempt to explain business cycle fluctuations under assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 38 Supply-Side Economics Orthodox macro theory consists of demand-oriented theories that failed to explain the stagflation of the 1970s. Supply-side economists believe that the real problem was that high rates of taxation and heavy regulation had reduced the incentive to work, to save, and to invest. What was needed was not a demand stimulus but better incentives to stimulate supply.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 33 of 38 The Laffer Curve With the tax rate measured on the vertical axis and tax revenue measured on the horizontal axis, the Laffer curve shows there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 34 of 38 The Laffer Curve The Laffer curve shows the amount of revenue the government collects is a function of the tax rate.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 35 of 38 The Laffer Curve When tax rates are very high, an increase in the tax rate could cause tax revenues to fall. Similarly, a cut in the tax rate could generate enough additional economic activity to cause revenues to rise.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 36 of 38 Evaluating Supply-Side Economics Among the criticisms of supply-side economics is that it is unlikely a tax cut would substantially increase the supply of labor. When households receive a higher after-tax wage, they might have an incentive to work more, but they may also choose to work less.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 37 of 38 Testing Alternative Macroeconomic Models Models differ in ways that are hard to standardize. If people have rational expectations, they are using the true model, but there is no way to know what model is in fact the true one. There is only a small amount of data available to test macroeconomic hypotheses—only eight business cycles since 1950.

C H A P T E R 19: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 38 of 38 Review Terms and Concepts Laffer curve Laffer curve Lucas supply function Lucas supply function price surprise price surprise quantity theory of money quantity theory of money rational expectations hypothesis rational expectations hypothesis real business cycle theory real business cycle theory velocity of money velocity of money