Chapter 15 A Century of Economic Theory Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 15-1

Objectives The equation of exchange The quantity theory of money Classical economics Keynesian economics The monetarist school Supply-side economics The rational expectations theory 15-2 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Equation of Exchange Much of the Keynesian-Monetarist debate revolves around the quantity theory of money which itself is based on the equation of exchange –The equation of exchange and the quantity theory of money are easy to confuse –Perhaps because the equation of exchange is used to explain the quantity theory of money 15-3 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Equation of Exchange The equation of exchange is MV = PQ –M is the total dollars in the nation’s money supply –V is the number of times per year each dollar is spent [i.e., velocity] –P is the average price of all the goods and services sold during the year –Q is the quantity of goods and services sold during the year 15-4 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

15-5 The Equation of Exchange M times V (MV) would be total spending. Total spending by a nation during a given year is GDP. Therefore, MV = GDP P times Q (PQ) is the total amount of money received by sellers of all final goods and services produced by a nation during a given year. This also is GDP. Therefore, PQ = GDP Things equal to the same thing are equal to each other, therefore, MV = PQ

Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved The Equation of Exchange The following example will be in billions of dollars without the dollar signs MV = PQ 900 X 9 = PQ 8,100 = PQ 8,100 = 81 X Q 8,100 = 81 X 100 8,100 = 8,100 The equation of exchange must always balance, as must all equations.

The Quantity Theory of Money 15-7 The Crude version of the Quantity Theory of Money This version holds that when the money supply (M) changes by a certain percentage, the price level (P) changes by that same percentage MV = PQ 900 X 9 = 81 X X 9 = 162 X ,200 = 16,200 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Quantity Theory of Money 15-8 The Crude version of the Quantity Theory of Money This version holds that when the money supply (M) changes by a certain percentage, the price level (P) changes by that same percentage MV = PQ 900 X 9 = 81 X X 9 = 162 X ,200 = 16,200 If V and Q remain constant, the crude version of the quantity theory of money is correct Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

A Closer Look at Q and V Since 1950 V has risen fairly steadily from about three to nearly seven During recessions, production, and therefore Q will fall –Q fell at an annual rate of about 4 percent during the recession During recoveries, production picks up, so we go from a declining Q to a rising Q Obviously, neither V or Q are constant Therefore, the crude version of the quantity theory of money is not valid 15-9 Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

15-10 The Quantity Theory of Money The sophisticated version of the “Quantity Theory of Money” assumes any short-term changes in V are either very small or predictable But what happens next is entirely up to the level of production, Q Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Sophisticated Quantity Theory of Money If we are well below full employment, an increase in M will lead mainly to an increase in Q If we are close to or at full employment, an increase in M will lead mainly to an increase in P Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Hypothetical Aggregate Supply Curve

Classical Economics The classical school of economics was mainstream from roughly 1775 to 1930 The classical school has the following tenets –Say’s law is operating –Savings will be invested –Interest rate mechanism –Quantity theory of money Assume V and Q are constant –Flexible wages and prices –Recessions cure themselves Government can’t cure recessions Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Keynesian Economics The Keynesian school has the following tenets –The problem with recessions is inadequate demand –The only hope is for the government to spend enough money to raise aggregate demand sufficiently to get people back to work The government could print the money or borrow it If enough (newly created money) was spent, the recession would end –No one would invest in new plant and equipment when much of their capacity was idle –Wages and prices were not downwardly flexible because of institutional barriers –If M rises, people may not spend the additional money, but just hold it So much for the quantity theory of money Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Monetarist School The Importance of the Rate of Monetary Growth –Milton Friedman, an economist who did exhaustive studies of the relationship between the rate of growth of the money supply concluded The United States has never had a serious inflation that was not accompanied by rapid monetary growth When the money supply has grown slowly, the country has had no inflation Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Monetarist School The Importance of the Rate of Monetary Growth Building on the quantity theory of money, the monetarists agree with the classicals that when the money supply grows, the price level rises, albeit not at exactly the same rate Recessions are caused when the Federal Reserve increases the money supply at less than the rate needed by business – say, anything less than 3 percent a year By and large the facts have borne out the monetarists’ analysis Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Monetarist School The Basic Propositions of Monetarism –The key to stable economic growth is a constant rate of increase in the money supply of at least 3 percent a year Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Basic Propositions of Monetarism The Key to Stable Economic Growth Is a Constant Rate of Increase in the Money Supply Expansionary Monetary Policy Will Only Temporarily Depress Interest Rates Expansionary Monetary Policy Will Only Temporarily Reduce the Unemployment Rate Expansionary Monetary Policy Will Only Temporarily Raise Output and Employment Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Monetarist School The Decline of Monetarism –Monetarism’s popularity started to decline in the late 1970s and early 1980s –The Fed’s policy on monetary growth, sky high interest rates, combined with two recessions seemed to cause people to look elsewhere for their economic gurus Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Supply-Side Economics Supply-side economics came into vogue in the early 1980s Supply-siders mantra was to cut tax rates, government spending, and government regulation The object of supply-siders is to raise aggregate supply work effectthe savings and investment effectthe elimination of productive market exchangesMany of the undesirable effects of high marginal tax rates are the work effect, the savings and investment effect, and the elimination of productive market exchanges Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Work Effect Facing high marginal tax rates, many people refuse to work more than a certain number of hours overtime or take on second jobs and other forms of extra work –Instead, they opt for more leisure time –Output is less when people work less –When people work less, their income is less –Why work if the government gets most of the money? Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Saving and Investment Effect High marginal tax rates on interest income will provide a disincentive to save, or at least to make savings available for investment purposes People who borrow money for investment purposes hope that this will lead to greater profits –But, if these profits are subject to a high marginal tax rate, once again there is a disincentive to invest The economy will stagnate Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Elimination of Productive Market Exchanges –A productive market exchange is when you work at what your are good at and hire someone who is working at what they are good at to do something for you –There is a serious misallocation of labor (perhaps hundreds of millions of dollars) when the productive market exchange is eliminated because of high marginal tax rates It will pay you to work less at what you are good at to do another job that you are not so good at (you don’t hire some one is is better at it than you to do it) Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Laffer Curve Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. The rationale of the Laffer curve is that when marginal tax rates are too high, we can raise tax revenues by lowering them

Rational Expectation Theory Rational expectations theory is based on three assumptions –Individuals and firms learn through experience to anticipate the consequences of changes in monetary and fiscal policy –They act instantaneously to protect their economic interest thus nullifying the intended effects –All resource and product markets are purely competitive Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Rational Expectation Theory Rational expectations theorists say the government should do as little as possible Basically, then, the government should figure out the right policies to follow and stick to them The right policies are –Steady monetary growth of 3 to 4 percent a year –A balanced budget Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Rational Expectation Theory Criticism of the rational expectations school –Is it reasonable to expect individuals and business firms to accurately predict the consequences of macroeconomic policy? –Our economic markets are not purely competitive: some are not competitive at all –The rigidities imposed by contracts restrict adjustments to changing economic conditions Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

The Economic Behaviorists Economic behaviorists are a hot new group of young economists who are complete new- comers to the economic theory scene They maintain that while the mainstream beliefs that rational behavior and economic self-interest are important, they are not the only motivating factors Their goal is to apply a wider range of psychological concepts to economic theory Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Conclusion “Each of the major schools of economic thought can be useful on occasion. The insights of Keynesian economics proved appropriate for Western societies attempting to get out of the depression in the 1930s. The tools of monetarism were powerfully effective in squeezing out the inflationary force of the 1970s. Supply-side economics played an important role in getting the public to understand the high cost of taxation and thus to support tax reform in the 1980s. But sensible public policy cannot long focus on any one objective or be limited to one policy approach” –Murray Weidenbaum Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Current Issue: Is George W. Bush a Supply-Sider or a Keynesian? President Bush did make supply-side tax cuts as well as Keynesian spending increases –But, he continued huge deficit spending increases in non-recession years –Keynes would have recommended spending cuts and reduced deficit spending in non-recession years –Supply-side economists hold that tax cuts should lead to reductions in government spending, not huge spending increases as did Bush Guess what? George W. Bush is neither a Keynesian or Supply-Sider Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.