Copyright 2008 The McGraw-Hill Companies 17-1 Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show 17 Disputes Over Macro Theory and Policy

Copyright 2008 The McGraw-Hill Companies 17-2 Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Chapter Objectives Differences Between Historical Keynesian and Classical Macro Perspectives Alternative Perspectives on the Causes of Macroeconomic Instability – Alternative Theory Viewpoints Equation of Exchange and Monetarism New Classical Economics – Self- Correction and Shocks Debate over Rules and Discretion in Conducting Stabilization Policy

Copyright 2008 The McGraw-Hill Companies 17-3 Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Classical Economics and Keynes The Classical View –Vertical Aggregate Supply Curve –Stable Aggregate Demand Keynesian View –Horizontal Aggregate Supply to Full Employment –Unstable Aggregate Demand

Copyright 2008 The McGraw-Hill Companies 17-4 Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Classical Economics and Keynes Price Level P2P2 P1P1 P1P1 QfQf QfQf QuQu Classical Theory Keynesian Theory Real Domestic Output AS AD 1 AD 2 a b c y x

Copyright 2008 The McGraw-Hill Companies 17-5 Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Causes of Macro Instability Mainstream View –Changes in Investment Spending C a + I g + X n + G = GDP –Adverse Aggregate Supply Shocks

Copyright 2008 The McGraw-Hill Companies 17-6 Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Causes of Macro Instability Monetarist View –Equation of Exchange MV = PQ –Velocity –Stable Velocity –Monetary Causes of Instability O 17.1O 17.2 W 17.1

Copyright 2008 The McGraw-Hill Companies 17-7 Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Causes of Macro Instability Real-Business-Cycle View –Real-Business-Cycle Theory Price Level P1P1 Real Domestic Output Q2Q2 Q1Q1 AD 1 AD 2 AS LR1 AS LR2

Copyright 2008 The McGraw-Hill Companies 17-8 Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Causes of Macro Instability Coordination Failures –Unemployment Equilibrium –Inflation Equilibrium

Copyright 2008 The McGraw-Hill Companies 17-9 Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Does the Economy Self-Correct? New Classical View of Self- Correction –Rational Expectations Theory –New Classical Economics –Speed of Adjustment –Unanticipated Price-Level Changes Price-Level Surprises –Fully Anticipated Price- Level Changes O 17.3 G 17.1

Copyright 2008 The McGraw-Hill Companies Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Does the Economy Self-Correct? New Classical View of Self-Correction AD 2 AD 1 AS 1 AS 2 AS LR Price Level P1P1 P2P2 P3P3 Real Domestic Output Q1Q1 Q2Q2 a b c

Copyright 2008 The McGraw-Hill Companies Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Does the Economy Self-Correct? New Classical View of Self-Correction AD 3 AD 1 AS 1 AS 3 AS LR Price Level P1P1 P4P4 P5P5 Real Domestic Output Q1Q1 Q4Q4 Q3Q3 a e d f

Copyright 2008 The McGraw-Hill Companies Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Does the Economy Self-Correct? Mainstream View of Self- Correction –Downward Wage Inflexibility –Efficiency Wage Theory Greater Work Effort Lower Supervision Costs Reduced Job Turnover Insider-Outsider Relationships –Insider-Outsider Theory O 17.4

Copyright 2008 The McGraw-Hill Companies Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Rules or Discretion? In Support of Policy Rules –Monetary Rule Inflation Targeting –Balanced Budget In Defense of Discretionary Stabilization Policy –Discretionary Monetary Policy –Discretionary Fiscal Policy Increased Macro Stability

Copyright 2008 The McGraw-Hill Companies Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Rationale for Monetary Rule Price Level P1P1 Real Domestic Output, GDP Q1Q1 Q2Q2 P2P2 AS LR1 AS LR2 AD 1 AD 2

Copyright 2008 The McGraw-Hill Companies Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Summary of Alternative Views Mainstream Macroeconomics (Keynesian) New Classical Economics –Monetarism –Rational Expectations Theory

Copyright 2008 The McGraw-Hill Companies Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show The Taylor Rule: Could a Robot Replace Ben Bernanke John Taylor Call for a New Monetarist Rule to Institutionalize Appropriate Fed Policy Rules Reflect Passive Monetary Policy Discretion Reflects Active Monetary Policy Taylor Suggests the Fed Explain Why They Deviate from the Rule Removing the Mystery of Fed Actions Process Would Increase Fed Credibility and Reduce Uncertainty Last Word

Copyright 2008 The McGraw-Hill Companies Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show 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

Copyright 2008 The McGraw-Hill Companies Classical Economics and Keynes Causes of Macro Instability Does the Economy Self- Correct? Rules or Discretion Rationale for a Monetary Rule Summary of Alternative Views Last Word Key Terms End Show Next Chapter Preview… International Trade