The Roots of Modern Macroeconomics

The Roots of Modern Macroeconomics Setting the Scene: Three Key Issues

THREE KEY ISSUES Issue 1: Flexibility of prices and wages the right: flexible prices and wages the left: price and wage rigidities Issue 2: Flexibility of aggregate supply the right: aggregate supply determined independently of aggregate demand 2

Different aggregate supply curves: (a) AS Price level O Y National output

Different aggregate supply curves: (a) AS Price level P1 AD1 O Y National output

Different aggregate supply curves: (a) AS Price level P2 P1 AD2 AD1 O Y National output

THREE KEY ISSUES Issue 1: Flexibility of prices and wages the right: flexible prices and wages the left: price and wage rigidities Issue 2: Flexibility of aggregate supply the right: aggregate supply determined independently of aggregate demand the left: aggregate supply responsive to changes in aggregate demand 2

Different aggregate supply curves: (b) Price level P AS O National output

Different aggregate supply curves: (b) Price level P AS Y1 AD1 O National output

Different aggregate supply curves: (b) Price level P AS Y2 AD2 AD1 O Y1 National output

THREE KEY ISSUES Issue 1: Flexibility of prices and wages the right: flexible prices and wages the left: price and wage rigidities Issue 2: Flexibility of aggregate supply the right: aggregate supply determined independently of aggregate demand the left: aggregate supply responsive to changes in aggregate demand some consensus on nature of short-run AS curve 2

Different aggregate supply curves: (c) AS Price level O National output

Different aggregate supply curves: (c) AS Price level P1 Y1 AD1 O National output

Different aggregate supply curves: (c) AS Price level P2 Y2 P1 AD2 AD1 O Y1 National output

THREE KEY ISSUES Issue 3: The role of expectations in the working of the market the right: expectations adjust rapidly to changes in prices the left: expectations of prices depend on expectations of output and employment 4

The Roots of Modern Macroeconomics Classical Macroeconomics

CLASSICAL MACROECONOMICS Classical analysis of output and employment markets clear labour market market for loanable funds 5

The market for loanable funds Saving (supply) Rate of interest Investment (demand) O Quantity of loanable funds

The market for loanable funds Saving (supply) r1 Rate of interest Investment (demand) O Quantity of loanable funds

The market for loanable funds Saving (supply) r1 Rate of interest Investment (demand) O Quantity of loanable funds

The market for loanable funds Saving (supply) Rate of interest r2 Investment (demand) O Quantity of loanable funds

The market for loanable funds Saving (supply) Rate of interest r2 Investment (demand) O Quantity of loanable funds

The market for loanable funds Saving (supply) Rate of interest re Investment (demand) O Quantity of loanable funds

CLASSICAL MACROECONOMICS Classical analysis of output and employment markets clear labour market market for loanable funds market for imports and exports: the gold standard 5

CLASSICAL MACROECONOMICS Classical analysis of output and employment markets clear labour market market for loanable funds market for imports and exports: the gold standard Say’s law 5

CLASSICAL MACROECONOMICS Classical analysis of output and employment markets clear labour market market for loanable funds market for imports and exports: the gold standard Say’s law Classical analysis of prices and inflation 5

CLASSICAL MACROECONOMICS Classical analysis of output and employment markets clear labour market market for loanable funds market for imports and exports: the gold standard Say’s law Classical analysis of prices and inflation the quantity theory of money 5

CLASSICAL MACROECONOMICS Classical analysis of output and employment markets clear labour market market for loanable funds market for imports and exports: the gold standard Say’s law Classical analysis of prices and inflation the quantity theory of money the equation of exchange: MV = PY 5

CLASSICAL MACROECONOMICS Classical analysis of output and employment markets clear labour market market for loanable funds market for imports and exports: the gold standard Say’s law Classical analysis of prices and inflation the quantity theory of money the equation of exchange: MV = PY implications for monetary policy 5

CLASSICAL MACROECONOMICS The Great Depression and the return to the gold standard the depression of the 1920s 6

UK unemployment and inflation: 1919 - 38

UK unemployment and inflation: 1919 - 38

CLASSICAL MACROECONOMICS The Great Depression and the return to the gold standard the depression of the 1920s return to the gold standard 6

CLASSICAL MACROECONOMICS The Great Depression and the return to the gold standard the depression of the 1920s return to the gold standard effects on the economy 6

CLASSICAL MACROECONOMICS The Great Depression and the return to the gold standard the depression of the 1920s return to the gold standard effects on the economy the policy response 6

CLASSICAL MACROECONOMICS The Great Depression and the return to the gold standard the depression of the 1920s return to the gold standard effects on the economy the policy response classical rejection of public works 6

CLASSICAL MACROECONOMICS The Great Depression and the return to the gold standard the depression of the 1920s return to the gold standard effects on the economy the policy response classical rejection of public works the fear of inflation 6

CLASSICAL MACROECONOMICS The Great Depression and the return to the gold standard the depression of the 1920s return to the gold standard effects on the economy the policy response classical rejection of public works the fear of inflation the problem of crowding out 6

The effect of printing extra money: the classical analysis AD2 AD1 AS Price level P2 P1 O Q1 National output

The Roots of Modern Macroeconomics The Keynesian Revolution

THE KEYNESIAN REVOLUTION Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand 7

The problem of demand deficiency in the labour market ASL ADL2 Real wage rate (W / P) W1 ADL1 O Quantity of labour

THE KEYNESIAN REVOLUTION Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means of increasing investment 7

Disequilibrium in the market for loanable funds Savings 2 Savings 1 Rate of interest r1 r2 Investment O Quantity of loanable funds

THE KEYNESIAN REVOLUTION Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means of increasing investment rejection of simple quantity theory 7

THE KEYNESIAN REVOLUTION Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means of increasing investment rejection of simple quantity theory rejection of a balanced budget 7

THE KEYNESIAN REVOLUTION Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means of increasing investment rejection of simple quantity theory rejection of a balanced budget Keynes’ analysis of employment and inflation 7

THE KEYNESIAN REVOLUTION Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means of increasing investment rejection of simple quantity theory rejection of a balanced budget Keynes’ analysis of employment and inflation the importance of aggregate demand 7

The effects of increases in aggregate demand on national output Price level O YP National output

The effects of increases in aggregate demand on national output AD4 AS AD3 AD2 Price level AD1 O Y1 Y2 Y3 Y4 YP National output

THE KEYNESIAN REVOLUTION Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means of increasing investment rejection of simple quantity theory rejection of a balanced budget Keynes’ analysis of employment and inflation the importance of aggregate demand the multiplier process 7

The circular flow of income

The circular flow of income Cd

The circular flow of income Incomes Cd

The circular flow of income Incomes Cd W = S + T + M

The circular flow of income J = I + G + X Incomes Cd W = S + T + M

The circular flow of income J = I + G + X Incomes Cd W = S + T + M

The circular flow of income J = I + G + X Incomes Cd W = S + T + M

The circular flow of income J = I + G + X Incomes Cd W = S + T + M

THE KEYNESIAN REVOLUTION Keynes’ policy recommendations demand management by fiscal and monetary policies Keynesian policies in 1950s and 60s stop–go policies criticisms of short-term demand management the breakdown of the Phillips curve 8

The Roots of Modern Macroeconomics The Monetarist– Keynesian Debate

THE MONETARIST–KEYNESIAN DEBATE The monetarist counter-revolution the restatement of the quantity theory rejection of Keynesian demand management policies the problem of inflationary expectations reappraisal of the Phillips curve unemployment inflation 9

The monetarist version of the long-run Phillips curve Inflation (%) O Un Unemployment

(a) Keynesian aggregate supply curve AS YP Ymax Price level O National output

(b) Keynesian Phillips curve Umin Inflation (%) O Unemployment

THE MONETARIST–KEYNESIAN DEBATE The monetarist counter-revolution the restatement of the quantity theory rejection of Keynesian demand management policies the problem of inflationary expectations reappraisal of the Phillips curve unemployment inflation monetarist policies 9

THE MONETARIST–KEYNESIAN DEBATE The monetarist counter-revolution the restatement of the quantity theory rejection of Keynesian demand management policies the problem of inflationary expectations reappraisal of the Phillips curve unemployment inflation monetarist policies attempts at such policies in the 1980s 9

THE MONETARIST–KEYNESIAN DEBATE Modern-day Keynesians inflation unemployment structural problems hysteresis low capital stock deskilling insiders and outsiders criticisms of monetarism Keynesian policy proposals 10

The Roots of Modern Macroeconomics The Current Position

THE CURRENT POSITION The current range of views new classical / rational expectations school moderate monetarists moderate Keynesians (new Keynesians) extreme Keynesians the radical left eclectic economists 11

THE CURRENT POSITION A mainstream consensus? short-run effects of changes in AD long-run effects of changes in AD no simple trade-off between inflation and unemployment role of expectations effects of excessive growth in the money supply importance of supply-side policies erosion of governments' power by the process of globalisation