CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 1 of 42 PowerPoint Lectures for Principles of Macroeconomics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 2 of 42

PART IV FURTHER MACROECONOMICS ISSUES 18 © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster Fernando & Yvonn Quijano Prepared by: Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 4 of 42 Keynesian EconomicsMonetarismThe Velocity of MoneyThe Quantity Theory of MoneyInflation as a Purely Monetary PhenomenonThe Keynesian/Monetarist DebateNew Classical MacroeconomicsThe Development of New Classical Macroeconomics Rational ExpectationsEvaluating Rational-Expectations TheoryReal Business Cycle TheorySupply-Side EconomicsEvaluating Supply-Side EconomicsTesting Alternative MacroeconomicModels CHAPTER OUTLINE 18 PART IV FURTHER MACROECONOMICS ISSUES Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 5 of 42 Keynesian Economics In a broad sense, Keynesian economics is the foundation of modern macroeconomics. In a narrower sense, Keynesian refers to economists who advocate active government intervention in the economy. Two major schools decidedly against government intervention developed: monetarism and new classical economics.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 6 of 42 Monetarism The main message of monetarists is that money matters. Monetarism, however, is usually considered to go beyond the notion that money matters.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 7 of 42 In the model of aggregate supply and aggregate demand, money matters because: a.Changes in the money supply affect the AD curve. b.Changes in the money supply shifts affect the AS curve in the short run. c.Changes in the money supply shifts affect the AS curve in the long run. d. All of the above.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 8 of 42 In the model of aggregate supply and aggregate demand, money matters because: a.Changes in the money supply affect the AD curve. b.Changes in the money supply shifts affect the AS curve in the short run. c.Changes in the money supply shifts affect the AS curve in the long run. d. All of the above.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 9 of 42 Monetarism The Velocity of Money velocity of money The number of times a dollar bill changes hands, on average, during a year; the ratio of nominal GDP to the stock of money. The income velocity of money (V) is the ratio of nominal GDP to the stock of money (M):

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 10 of 42 Monetarism The Velocity of Money We can expand this definition slightly by noting that nominal income (GDP) is equal to real output (income) (Y) times the overall price level (P): Through substitution: or

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 11 of 42 Monetarism The Velocity of Money quantity theory of money The theory based on the identity M × V ≡ P × Y and the assumption that the velocity of money (V) is constant (or virtually constant).

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 12 of 42 Monetarism The Quantity Theory of Money The key assumption of the quantity theory of money is that the velocity of money is constant (or virtually constant) over time. If we let V denote the constant value of V, the equation for the quantity theory can be written as follows:

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 13 of 42 Monetarism The Quantity Theory of Money Testing the Quantity Theory of Money Velocity has not been constant over the period from 1960 to There is a long-term trend—velocity has been rising. There are also fluctuations, some of them quite large.  FIGURE 18.1The Velocity of Money, 1960 I–2007 IV

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 14 of 42 Monetarism Inflation as a Purely Monetary Phenomenon Inflation is always a monetary phenomenon. If the money supply does not change, the price level will not change. The view that changes in the money supply affect only the price level, without a change in the level of output, is called the “strict monetarist” view. Almost all economists agree that sustained inflation is purely a monetary phenomenon. Inflation cannot continue indefinitely without increases in the money supply.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 15 of 42 The “strict monetarist” view states that: a.Changes in aggregate demand cause an increase in both aggregate income and the price level. b.Inflation is a real phenomenon, not a purely monetary phenomenon. c.Changes in the money supply affect only the price level (P), not real output (Y). d.Since velocity is constant, a change in M affects both P and Y.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 16 of 42 The “strict monetarist” view states that: a.Changes in aggregate demand cause an increase in both aggregate income and the price level. b.Inflation is a real phenomenon, not a purely monetary phenomenon. c.Changes in the money supply affect only the price level (P), not real output (Y). d.Since velocity is constant, a change in M affects both P and Y.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 17 of 42 Monetarism The Keynesian/Monetarist Debate Milton Friedman has been the leading spokesman for monetarism over the last few decades. Most monetarists do not advocate an activist monetary policy stabilization. Monetarists advocate a policy of steady and slow money growth, at a rate equal to the average growth of real output (Y). Keynesianism and monetarism are at odds with each other.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 18 of 42 New Classical Macroeconomics The challenge to Keynesian and related theories has come from a school sometimes referred to as the new classical macroeconomics. Like monetarism and Keynesianism, this term is vague. No two new classical macroeconomists think exactly alike, and no single model completely represents this school.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 19 of 42 Most monetarists, including Milton Friedman, blame most of the instability in the economy on: a.The volatility of investment spending. b.Changes in aggregate demand. c.Changes in aggregate supply. d.The federal government.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 20 of 42 Most monetarists, including Milton Friedman, blame most of the instability in the economy on: a.The volatility of investment spending. b.Changes in aggregate demand. c.Changes in aggregate supply. d.The federal government.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 21 of 42 New Classical Macroeconomics The Development of New Classical Macroeconomics On the theoretical level, new classical macroeconomists argue that traditional models have assumed that expectations are formed in naive ways. Naive expectations are inconsistent with the assumptions of microeconomics. If people are out to maximize utility and profits, they should form their expectations in a smarter way. New classical theories were an attempt to explain the apparent breakdown in the1970s of the simple inflation-unemployment trade-off predicted by the Phillips Curve.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 22 of 42 Which of the following events helped motivate the formulation of new classical economics? a.The Great Depression. b.The mercantilist revolution and the birth of laissez faire. c.The stagflation of the 1970s. d.The turnaround from federal budget deficits to surpluses during the Clinton administration.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 23 of 42 Which of the following events helped motivate the formulation of new classical economics? a.The Great Depression. b.The mercantilist revolution and the birth of laissez faire. c.The stagflation of the 1970s. d.The turnaround from federal budget deficits to surpluses during the Clinton administration.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 24 of 42 New Classical Macroeconomics Rational Expectations rational-expectations hypothesis The hypothesis that people know the “true model” of the economy and that they use this model to form their expectations of the future.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 25 of 42 New Classical Macroeconomics Rational Expectations If firms have rational expectations and if they set prices and wages on this basis, then, on average, prices and wages will be set at levels that ensure equilibrium in the goods and labor markets. Rational Expectations and Market Clearing

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 26 of 42 When expectations are rational, which of the following stabilization policies is more desirable? a.Fiscal policy tools as the preferred means of stabilization. b.Monetary policy tools as the preferred means of stabilization. c.Intervention only when unpredictable shocks affect the economy. d. No need for government stabilization policies of any kind.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 27 of 42 When expectations are rational, which of the following stabilization policies is more desirable? a.Fiscal policy tools as the preferred means of stabilization. b.Monetary policy tools as the preferred means of stabilization. c.Intervention only when unpredictable shocks affect the economy. d. No need for government stabilization policies of any kind.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 28 of 42 New Classical Macroeconomics Rational Expectations Lucas supply function The supply function embodies the idea that output (Y) depends on the difference between the actual price level and the expected price level. The Lucas Supply Function price surprise Actual price level minus expected price level.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 29 of 42 New Classical Macroeconomics Rational Expectations The Lucas Supply Function How Are ExpectationsFormed? How are expectations in fact formed? Are expectations rational, as some macro- economists believe, reflecting an accurate understanding of how the economy works? Or are they formed in simpler, more mechanical ways? A recent research paper by Ronnie Driver and Richard Windram from the Bank of England sheds some light on this issue.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 30 of 42 New Classical Macroeconomics Rational Expectations Policy Implications of the Lucas Supply Function Rational-expectations theory combined with the Lucas supply function proposes a very small role for government policy in the economy.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 31 of 42 To derive his supply function, Lucas starts with the idea that: a.People and firms are specialists in production but generalists in consumption. b.People and firms are specialists in consumption but generalists in production. cPeople are generalists in both consumption and production. dFirms are specialists in production, and households are specialists in consumption.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 32 of 42 To derive his supply function, Lucas starts with the idea that: a.People and firms are specialists in production but generalists in consumption. b.People and firms are specialists in consumption but generalists in production. cPeople are generalists in both consumption and production. dFirms are specialists in production, and households are specialists in consumption.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 33 of 42 New Classical Macroeconomics Evaluating Rational-Expectations Theory If expectations are not rational, there are likely to be unexploited profit opportunities—most economists believe such opportunities are rare and short-lived. The argument against rational expectations is that it required households and firms to know too much. People must know the true model (or at least a good approximation of the true model) to form rational expectations, and this knowledge is a lot to expect.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 34 of 42 New Classical Macroeconomics Real Business Cycle Theory real business cycle theory An attempt to explain business cycle fluctuations under the assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 35 of 42 In the context of the AS/AD model, if prices and wages are perfectly flexible, then: a.The AS curve is vertical in the long run but not in the short run. b.Events that shift the AD curve have a strong impact on real output. c.The AS curve is vertical, even in the short run. d.Nominal wages are always ahead of real wages.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 36 of 42 In the context of the AS/AD model, if prices and wages are perfectly flexible, then: a.The AS curve is vertical in the long run but not in the short run. b.Events that shift the AD curve have a strong impact on real output. c.The AS curve is vertical, even in the short run. d.Nominal wages are always ahead of real wages.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 37 of 42 Supply-Side Economics Orthodox macro theory consists of demand- oriented theories that failed to explain the stagflation of the 1970s. Supply-side economists believe that the real problem was that high rates of taxation and heavy regulation had reduced the incentive to work, to save, and to invest. What was needed was not a demand stimulus but better incentives to stimulate supply.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 38 of 42 Supply-Side Economics The Laffer Curve The Laffer curve shows that the amount of revenue the government collects is a function of the tax rate. It shows that when tax rates are very high, an increase in the tax rate could cause tax revenues to fall. Similarly, under the same circumstances, a cut in the tax rate could generate enough additional economic activity to cause revenues to rise.  FIGURE 18.2The Laffer Curve

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 39 of 42 Refer to the figure below. At which point should tax rates be cut? a.At point A. b.At point B. c.At both points A and B. d.At neither point A nor B.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 40 of 42 Refer to the figure below. At which point should tax rates be cut? a.At point A. b.At point B. c.At both points A and B. d.At neither point A nor B.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 41 of 42 Supply-Side Economics The Laffer Curve Laffer curve With the tax rate measured on the vertical axis and tax revenue measured on the horizontal axis, the Laffer curve shows that there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 42 of 42 Supply-Side Economics Among the criticisms of supply-side economics is that it is unlikely a tax cut would substantially increase the supply of labor. When households receive a higher after-tax wage, they might have an incentive to work more, but they may also choose to work less. Evaluating Supply-Side Economics

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 43 of 42 Testing Alternative Macroeconomic Models Models differ in ways that are hard to standardize. If people have rational expectations, they are using the true model, but there is no way to know what model is in fact the true one. There is only a small amount of data available to test macroeconomic hypotheses—only eight business cycles since 1950.

CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Macroeconomics 9e by Case, Fair and Oster 44 of 42 REVIEW TERMS AND CONCEPTS Laffer Curve Lucas supply function price surprise quantity theory of money rational-expectations hypothesis real business cycle theory velocity of money