Macroeconomic Theories Classical & Keynesian versus New Classical & Supply Side

CLASSICAL VIEW Markets are naturally self regulating No government intervention necessary Recessions are temporary Wages & prices are flexible Savings = Investment Says law: Supply will create its own demand Against: minimum wages, welfare & Gov’t assistance Great Depression challenged Classical View

Aggregate Supply and Aggregate Demand in Classical Economics 9-2b Classical View FIGURE 9-1 Aggregate Supply and Aggregate Demand in Classical Economics

KEYNSIAN VIEW Economy is inherently unstable & not self adjusting Recessions are long & often permanent Major government intervention necessary to stimulate AD Wages & prices are sticky or fixed Support welfare & Gov’t assistance Lack of consumer demand caused great depression AS curve is very flat or horizontal Interest rates changes are not effective during recession Money Demand not very sensitive to interest rates

Keynesian View

Macroeconomic Debates Two major schools decidedly against government intervention have developed: Monetarism & New Classical Economics

Monetarism Main message: money matters & the economy self-regulates Monetarism believes in the Quantity Theory of Money MV = PQ, Inflation is purely a monetary phenomena Generally do not advocate activist monetary policy stabilization: expanding money supply during bad times and slowing during good Focus on price stability Theory not compatible with upward sloping AS curve GDP is an imperfect measure of transactions to use in calculating velocity because it does not include transactions in intermediate goods or in existing assets, some of which are made using money and do influence the number of times money changes hands during a year.

New Classical Attempted to explain stagflation of 1970’s Business Cycles happen, but recessions are temporary AS could be broken down into Short-run & Long run curves Government intervention is unnecessary Prices/wages are flexible in long run, sticky in short-run People make decisions on rational expectations This explains “shocks” to the system

Aggregate Supply in the New Classical Model Both models can be used as a “New Classical Model” FIGURE 9-5 Aggregate Supply in the New Classical Model SRAS LR

Supply-Side Policy Government Incentives Matter Goal: use incentives to shift the aggregate supply curve right The supply-side toolbox consists of: Tax cuts to stimulate work effort, saving, and investment Deregulation to reduce production cost/stimulate investment. Expenditures on education training/research expands capacity to produce Immigration policies alter the size/skill of labor force

9-4 Summary No theory is designed to explain all the complex relationships of a macroeconomy There is no simple relationships that can be easily manipulated to neatly solve various problems as they arise. Assessing economic theories would be easier if we lived in closed economies.