1. Section 6: Modules 35 & 36

2. Module 35: History of Views
Money & Price Level
Classicals believe prices are flexible, making Agg S vertical, even in short run
An increase in MS leads to proportional rise in Agg PL w/ no effect on Agg Output
As a result, increases in MS lead to inflation only

3. John Maynard Keynes Great Depression changed thinking
Made economists believe in short run importance
2 thoughts on Depression
1)just a bump that would fix itself
2)bigger problem that needed fixing
Keynes compared economy to a car
Just needed a tune up; not an overhaul

4. Keynes Continued
1)emphasized short run effects on Agg Demand on Agg Output; not long run Price Level
2)created idea of short run Ag Supply & shifts in Ag Demand affect Ag Output, Prices, & Unemp
“In the long run, we are all dead”

5. More Keynes
Prior to Keynes, economists believed if MS was constant, all would be ok
Keynes said business confidence was key
Due to ‘animal spirits,’ business cycles appear
Classicals said declines in business confidence would have no effect on PL or Ag Output

6. Fighting Recessions
Keynes’s work legitimized fiscal & monetary policies
Not all agree however Think Liquidity Trap
Milton Friedman believed that business cycles are attributed to fluctuations in MS
Depression was avoidable if MS hadn’t contracted
Monetary Policy better b/c fiscal policy has to decide
1)who gets tax cuts or 2)who gets govt spending
Shift to monetary policy is insulated from political process (when r decrease, it decreases for all)

7. Monetarism Belief that GDP will grow if MS grows steadily
Central bank (Fed) should target a constant growth rate (3%) & maintain no matter what
Friedman believed short run importance but also believe policy makers make economy worse
He argued time lags are problematic w/ policies
Said crowding out occurs when MS is constant & expansionary fiscal policy is used

8. Probs w/ Keynes
Believed that the rightward shift of AD is smaller than multiplier indicated & w/ constant money supply, there was no point to fiscal policy
All that occurred was that interest rates increased which reduced investment by businesses & households
Friedman argued for ‘autopilot’ by Fed
Monetary policy rule = formula for its actions & leaves little discretion

9. Quantity Theory of Money
Emphasizes positive relationship between PL & the MS
Relies on velocity of money; the ratio of nominal GDP to MS
Velocity is # of times $1 turns over per yr between buyers & sellers
Ex: you tip a pizza driver, he buys lunch, etc
Equation is M x V = P x Y
Where M is MS; V is velocity; P is Ag Price Level; Y is rGDP
Belief is velocity is stable in short run & changed slowly in LR
Claim is steady growth in MS means steady growth in GDP

10. Money Velocity Equation
How does a 5% increase in the MS affect the price level?
V is usually constant b/c consumers don’t often change spending habits in long run
Y is not impacted by price level or MS in the long run
P will increase by 5% to offset the increase of 5% in MS

11. Class Problem
1) If the money supply is 20, the velocity is 5, and the price level is 10, calculate the output.
2) If the money supply and velocity are constant and the output increases, what must be true of the price level?
3) If the velocity and output are constant, what must be true of the price level if the money supply increases?

12. Political Business Cycle
Using macroeconomic policy to serve political ends
Evidence shows correlation between state of economy & election w/in months of election
Temptation is to pump up economy before election
Economy should be insulated from politics

13. Supply Side Economics Belief that cuts in taxes would spur growth
Some even believe that it would increase taxes due to increase in GDP
Supply-Siders believe that tax cuts would increase potential output, but this is not proved yet
*Increases incentives to work & invest

14. Inflation & Natural Rate of Unemployment
Recall NAIRU
(low unemp = high inflation) & (high unem = low inflation)
Inflation is embedded in expectations
To avoid accelerating inflation, unemployment must be high enough that actual inflation = expected inflation
This is the natural rate hypothesis
Govt cannot keep unempl below natural rate it is asked to keep unempl steady
Once inflation becomes embedded, rising prices will happen even if unempl increases
Ex: 1970s
Macroeconomic policy should stabilize economy instead of seeking a low unemployment rate

15. New Classical Economists
Returned to idea of Ag Demand affecting only Ag Price Level; not Ag Output
Based on 2 concepts:
1)Rational Expectations-indiv & firms make decisions optimally
People make decisions based on future expectations
2)Real Business Cycle Theory-slowdowns in productivity shift Ag Supply left; recovery occurs & shifts Ag Supply to right

16. Differing Viewpoints Classicals Keynesians Monetarists Primary Concern
Economy will fix itself in long run
Agg Demand can impact Agg Output
MS is important; deals w/ velocity of $
Fiscal Policy
Laissez-Faire
Essential during booms/busts
Not Needed
Monetary Policy
Important to keep economy moving
Should target growth rate & use MS to achieve target
View of Agg Supply
Vertical b/c any shift will immediately change PL
Upward sloping & can shift in short run
Upward sloping

17. Mod 36 Macro Consensus Points just about everyone now agrees on:
1)Monetary policy should play the main role in stabilization policy
2)The central bank should be independent, insulated from political pressures, in order to avoid a political business cycle
3)Discretionary fiscal policy should be used sparingly, both because of policy lags and because of the risks of a political business cycle

18. Consensus
Modern consensus is Monetary & Fiscal policy work only in short run
Discretionary fiscal policy is considered unadvisable except in special times

19. Do you understand this???