Chapter 14 Macroeconomic Debate

Views Activists – do something Economy is unstable Must use Macroeconomic Policy Activist favor Discretionary Monetary and Fiscal policy To Fine Tune the Economy Functional Finance Don’t favor requirements to balance the budget Fine tuning in response to a change in the economy

Passivists – economy will correct itself Passivists – economy will correct itself Policy rules for economic growth Policy rules for economic growth Milton Friedman: Father of Monetarism Milton Friedman: Father of Monetarism Economy is stable and will settle at the long run Natural (Potential) GDP Economy is stable and will settle at the long run Natural (Potential) GDP Quantity Theory of Money: In the long run increases in the money supply cause inflation Quantity Theory of Money: In the long run increases in the money supply cause inflation Irving Fisher: Father of Modern Monetary Theory, Quantity Theory of Money and the Equation of Exchange Irving Fisher: Father of Modern Monetary Theory, Quantity Theory of Money and the Equation of Exchange

Equation of Exchange: MV = PQ M = Money Supply V = Velocity of Money P = Price Level (CPI) Q = Real GDP PQ = Nominal GDP MV = GDP V is Stable if M2 is the money supply Long Run –Q is constant at the Natural (potential) GDP. Increases in M cause inflation Long Run Phillips Curve Long Run Aggregate Supply At the Potential GDP with Expected Price Level

Policy Rules: Increasing the M at a constant rate to increase the aggregate demand at the same rate as the aggregate supply promote economic growth without increasing inflation Policy Rules: Increasing the M at a constant rate to increase the aggregate demand at the same rate as the aggregate supply promote economic growth without increasing inflation

Discretion or Rules Passivists favor Policy rules: Increasing the M at a constant rate to promote economic growth Activist favor Discretionary Monetary and Fiscal policy

Inflation Targeting Setting a specific inflation rate as the goal Setting a specific inflation rate as the goal If the actual inflation rate is greater than the target use tight money policy If the actual inflation rate is greater than the target use tight money policy If the actual inflation rate is less than the target use easy money policy If the actual inflation rate is less than the target use easy money policy

New Theories Expectations Adaptive Expectations – using the past to form future expectations Wars cause increased GDP Rational Expectations - using the past and all present knowledge to form expectations People form expectations based on all available information and act accordingly Tax cut will be spent since economy will be improving due to the war Real Business Cycle Theory – Supply shocks cause economic fluctuations New Growth Theory – our unlimited wants will lead us to greater productivity and perpetual economic growth Human Capital Growth and Choices Discoveries and Choices Discoveries and profits