20 th Century Economic Theory Miss Varee AP Macroeconomics Spring 2008

5 Basic Macroeconomic Theories Classical Economics Classical Economics Keynesian Economics Keynesian Economics Monetarism Monetarism Supply Side Supply Side Rational Expectations Rational Expectations

Classical Economics Adam Smith Adam Smith Capitalism Capitalism Laissez ______ Laissez ______ Say’s Law: “______ Creates Its Own ______” Say’s Law: “______ Creates Its Own ______” Free Market Free Market Automatic Mechanisms Automatic Mechanisms Self-Regulating Self-Regulating Quantity Theory of $: MS & PL go up same % Quantity Theory of $: MS & PL go up same %

Keynesian Economics John Maynard Keynes John Maynard Keynes Anti-Laissez Faire Anti-Laissez Faire Fiscal Policy Tools are ??? Fiscal Policy Tools are ??? Increase “G” spending to solve unemployment (below GDP) Increase “G” spending to solve unemployment (below GDP) Deficit Spending paid during prosperity (increase “T”)  Crowd In Deficit Spending paid during prosperity (increase “T”)  Crowd In Demand Side Economists (AD) Demand Side Economists (AD) C & MEI C & MEI Multiplier Effect (G and T) Multiplier Effect (G and T) Keynesians believe that interest rates are sensitive to demand for money Keynesians believe that interest rates are sensitive to demand for money

Monetarism Milton Friedman Milton Friedman Direct relation between changes in MS and PL Direct relation between changes in MS and PL Changes in money growth rate is the cause of changes in PL  change in nominal GDP Changes in money growth rate is the cause of changes in PL  change in nominal GDP MPC changes every year and can’t predict “G” MPC changes every year and can’t predict “G” Self-correct (wages & PL) Self-correct (wages & PL) AD increases  MS ? AD increases  MS ? Interest rates change with the MS Interest rates change with the MS Monetary Rule: Increase MS 3- 5% year Monetary Rule: Increase MS 3- 5% year Fiscal Policy/Spending crowds out private spending Fiscal Policy/Spending crowds out private spending

Supply Side 1980 Ronald Reagan Ronald Reagan Focus on cutting costs— decrease “AS” Focus on cutting costs— decrease “AS” Lower marginal tax rates Lower marginal tax rates Uses tight money to fix inflation Uses tight money to fix inflation Laffer Curve: As tax rates decrease, tax revenues will increase bc people will become more productive. Laffer Curve: As tax rates decrease, tax revenues will increase bc people will become more productive. Balanced budget Balanced budget Cut taxes, government spending, and regulations Cut taxes, government spending, and regulations

Robert Lucas 1990 Business and Consumers use both Monetary & Fiscal policies Business and Consumers use both Monetary & Fiscal policies Self-interest make both ineffective Self-interest make both ineffective Monetary Rule Monetary Rule Balanced Budget Balanced Budget

Economic Growth How do we achieve economic growth? How do we achieve economic growth? -Increase Resources -Educate and Train LF -Technology (R & D) -Increase Capital Goods -Increase Inputs  “RUTCI”