1. CASE  FAIR  OSTER MACROECONOMICS PRINCIPLES OF
E L E V E N T H E D I T I O N
CASE  FAIR  OSTER
PEARSON
Prepared by: Fernando Quijano w/Shelly Tefft

3. 18 Alternative Views in Macroeconomics Keynesian Economics Monetarism
C H A P T E R O U T L I N E
Alternative Views in Macroeconomics 18
Keynesian Economics
Monetarism
The Velocity of Money
The Quantity Theory of Money
The Keynesian/Monetarist Debate
Supply-Side Economics
The Laffer Curve
Evaluating Supply-Side Economics
New Classical Macroeconomics
The Development of New Classical Macroeconomics
Rational Expectations
Real Business Cycle Theory and New Keynesian Economics
Evaluating the Rational Expectations Assumption
Testing Alternative Macroeconomic Models

4. Keynesian Economics
In one sense, Keynesian economics is the foundation of all of macroeconomics.
Used more narrowly in recent years, Keynesian sometimes refers to economists who advocate active government intervention in the macroeconomy.
We begin with an old debate—that between Keynesians and monetarists.

5. 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):

6. 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
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).

7. 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:

8. Testing the Quantity Theory of Money
 FIGURE The Velocity of Money, 1960 I–2010 I
Velocity has not been constant over the period from 1960 to 2012.
This was a long-term positive trend, which has now reversed.

9. The Keynesian/Monetarist Debate
The debate between Keynesians and monetarists was perhaps the central controversy in macroeconomics in the 1960s.
Monetarists were skeptical of the Fed’s ability to “manage” the economy—to expand the money supply during bad times and contract it during good times.
The leading spokesman for monetarism, Milton Friedman, advocated a policy of steady and slow money growth—specifically, that the money supply should grow at a rate equal to the average growth of real output (income) (Y).
While not all Keynesians advocated an activist federal government, many advocated the application of coordinated monetary and fiscal policy tools to reduce instability in the economy—to fight inflation and unemployment.
The debate between Keynesians and monetarists subsided with the advent of what we will call “new classical macroeconomics.”

10. Supply-Side Economics
The theories we have been discussing are “demand-oriented.” Supply-side economics, as the name suggests, focuses on the supply side.
In the late 1970s and early 1980s, supply-siders argued that the real problem with the economy was not demand, but high rates of taxation and heavy regulation that reduced the incentive to work, to save, and to invest. What was needed was not a demand stimulus, but better incentives to stimulate supply.
At their most extreme, supply-siders argued that the incentive effects of supply-side policies were likely to be so great that a major cut in tax rates would actually increase tax revenues.
Even though tax rates would be lower, more people would be working and earning income and firms would earn more profits, so that the increases in the tax bases (profits, sales, and income) would then outweigh the decreases in rates, resulting in increased government revenues.

11. The Laffer Curve
 FIGURE 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.
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.

12. Evaluating 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.
In theory, a tax cut could even lead to a reduction in labor supply.
Research done during the 1980s suggests that tax cuts seem to increase the supply of labor somewhat but that the increases are very modest.
Traditional theory suggests that a huge tax cut will lead to an increase in disposable income and, in turn, an increase in consumption spending (a component of aggregate expenditure).
Although an increase in planned investment (brought about by a lower interest rate) leads to added productive capacity and added supply in the long run, it also increases expenditures on capital goods (new plant and equipment investment) in the short run.

13. New Classical Macroeconomics
The challenge to Keynesian and related theories has come from a school sometimes referred to as the new classical macroeconomics.
No two new classical macroeconomists think exactly alike, and no single model completely represents this school.
The Development of New Classical Macroeconomics
Keynes recognized that expectations (in the form of “animal spirits”) play a big part in economic behavior. The problem is that traditional models assume that expectations are formed in naive ways, which is inconsistent with the assumptions of microeconomics.
If, as microeconomic theory assumes, people are out to maximize their satisfaction and firms are out to maximize their profits, they should form their expectations in a smarter way.
In this view, forward-looking, rational people compose households and firms.

14. 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.
Rational Expectations and Market Clearing
If firms have rational expectations and if they set prices and wages on this basis, on average, prices and wages will be set at levels that ensure equilibrium in the goods and labor markets.
When expectations are rational, disequilibrium in any market is only temporary because firms, on average, set market-clearing wages and prices.
In this world (on average), all markets clear and there is full employment thus no need for government stabilization policies.

15. How Are Expectations Formed?
E C O N O M I C S I N P R A C T I C E
How Are Expectations Formed?
A current debate among macroeconomists and policy makers is how people form expectations about the future state of the economy.
Do expectations reflect an accurate understanding of how the economy works or are they formed in simpler, more mechanical ways?
Research conducted in England since 1999 suggests that to the extent that gas prices increase and media attention to inflation increases, inflationary expectations will increase.
THINKING PRACTICALLY
Why do you think that consumers are so sensitive to gas prices in forming their expectations?

16. The Lucas Supply Function
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.
price surprise Actual price level minus expected price level.

17. Policy Implications of the Lucas Supply Function
The Lucas supply function in combination with the assumption that expectations are rational implies that anticipated policy changes have no effect on real output.
The general conclusion is that any announced policy change—in fiscal policy or any other policy—has no effect on real output because the policy change affects both actual and expected price levels in the same way.
Rational-expectations theory combined with the Lucas supply function proposes a very small role for government policy in the economy.

18. Real Business Cycle Theory and New Keynesian Economics
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.
new Keynesian economics A field in which models are developed under the assumptions of rational expectations and sticky prices and wages.

19. Evaluating the Rational Expectations Assumption
When expectations are not rational, there are likely to be unexploited profit opportunities, and most economists believe such opportunities are rare and short-lived.
The argument against rational expectations is that it requires households and firms to know too much while the gain from learning the true model (or a good approximation of it) may not be worth the cost.
Although the assumption that expectations are rational seems consistent with the satisfaction-maximizing and profit-maximizing postulates of microeconomics, such an assumption is more extreme and demanding because it requires more information on the part of households and firms.
In the final analysis, the issue is empirical.

20. Testing Alternative Macroeconomic Models
Macroeconomists cannot test their models against one another to see which performs best because:
Macroeconomic models differ in ways that are hard to standardize.
The rational expectations hypothesis assumes (1) that expectations are formed rationally and (2) that the model being used is the true one.
The small amount of data available leaves considerable room for disagreement, a range needing more time to narrow.

21. R E V I E W T E R M S A N D C O N C E P T S
Laffer curve
Lucas supply function
new Keynesian economics
price surprise
quantity theory of money
rational expectations hypothesis
real business cycle theory
velocity of money
Equations: