ECON 521 Special Topics in Economic Policy CHAPTER THREE The Fundamental Macro Policy Debate

I. Overview Theory -- An assertion about the causes of observed behavior, in order to predict outcomes. Model -- A formalization of a theory, done to make brief predictions. Classical Versus Keynesian Macroeconomic Theories --The Fundamental Debate

II. Equilibrium & the Natural Level of Real GDP Fundamental Prediction of Keynesian models -- Y* is not necessarily equal to Y N. Classical Prediction: Self-correcting economy  Y* = Y N. (Business cycle represents deviations from equilibrium)

III. Classical Thought --The Economy (Adam Smith) Classical Macroeconomics -- Because the nominal wage rate (W), prices (P), and interest rates (i) are flexible, the economy will automatically correct itself without need of policy.

(1) Classical Response to Accelerating Economy (Y > Y N ) W   labor less attractive to hire P   goods and services more expensive to purchase i   higher cost of borrowing, causing less durable goods consumption and investment

(2) Classical Response to Sluggish Economy (Y < Y N ) W   labor more attractive to hire P   goods and services cheaper to purchase i   cheaper cost of borrowing, prompting more durable goods consumption and investment

IV. Keynesian Thought – The Economy (1936) Keynesian Macroeconomics -- Because the nominal wage rate (W), prices (P), or interest rates (i) are inflexible, the economy will not automatically correct itself, and therefore needs overt policy. Possible Reasons for Inflexibility or Stickiness W  long-term labor contracts P  costly for firms to change prices for goods they produce i  Federal Reserve target variable for monetary policy

(1) Keynesian Predictions Y* < Y N (sluggish economy) Y* > Y N (accelerating inflation) Y* = Y N (desired economy) If Y*  Y N, then one needs economic policy to achieve a new equilibrium closer to Y N.

(2) Keynesian Economic Policy Response Recall; Purpose -- to move Y* closer to Y N. Method -- change autonomous expenditure (C 0, I 0, G 0 ). If economy is sluggish (Y* < Y N ), increase autonomous expenditure. If economy has accelerating inflation (Y* > Y N ), decrease autonomous expenditure.

(3) Keynesian Strategies for Policy Expansionary Policy -- Policy designed to address a sluggish economy (Y* < Y N ). Contractionary Policy -- Policy designed to address an overstimulated, or accelerated inflation economy (Y* > Y N ).

V. Practical Thoughts – Classical v.s Keynesian There are several Keynesian models, all based upon inflexibility. Was the Great Depression an aberration? What better represents the macro economy?