1. Disputes Over Macro Theory and Policy19
C H A P T E R
Disputes Over Macro Theory and Policy

2. Vertical Aggregate Supply Curve Stable Aggregate Demand
CLASSICAL ECONOMICS AND KEYNES
Classical Economics
Adam Smith
Laissez-faire
The Classical View
Vertical Aggregate Supply Curve
Stable Aggregate Demand
Real Output Depends Upon…
Quantity of money possessed by households & businesses
Purchasing power of money is determined by the price level
Classical View – Tenets of Adam Smith 1 – 4
Vertical supply curve Qf
Real Output doesn’t Δ in response to Δ’s in PL as wages and other inputs would be flexible and adapt to PL Δ.
Economy Qf because of Say’s law, “supply creates its own demand”. Response is to “temporary” oversupply, hence wages and other inputs would adjust to Δ in PL
HENCE REAL OUTPUT DEPENDS ON - MS underlies AD. A stable MS will control growth.
Downward sloping DC is stable and solely responsible for setting PL.
Δ in MS will shift the DC but responsive flexible prices and wages will ensure Qf is maintained

3. Classical Theory AS P1
Price Level
AD1 Q1
Real Domestic Output

4. Classical Theory AS P1 P2 AD1 AD2 Q1 Price Level Real Domestic Output
Key here is that a decline in AD reduces PL yet classical school maintains that wages and prices are flexible and will lower to match P2 and consequently maintain Q1 or Qf.
AD2 Q1
Real Domestic Output

5. Keynesian Economics John Maynard Keynes, 1930s The Keynesian View
CLASSICAL ECONOMICS AND KEYNES
Keynesian Economics
John Maynard Keynes, 1930s
The Keynesian View
Prices and Wages Downwardly Inflexible
Active Government Policy Required to Stabilize the Economy
Horizontal Aggregate Supply Curve to Full-Employment
Unstable Aggregate Demand
Core to Keynesian View is that wages and prices are downwardly inflexible not flexible as maintained by the classicalists. PL acts as ASsr and is horizontal.
A decline in Qf (real output) has no effect on the PL. When Qf is reached, AS then becomes vertical.
AD is unstable from one period to the next even w/o Δ’s in the MS.
AD is unstable because of – Ig Ig component of AD is most likely to fluctuate and the impact is on Qf & employment, whilst the PL remains the same.
Active Govt. policy are essential to > AD and move economy back to Qf.

6. Keynesian View AS P1
Price Level
AD1 Q1
Real Domestic Output

7. Keynesian View AS P1
Price Level
AD1
AD2 Q2 Q1
Real Domestic Output

8. Mainstream View Ca + Ig + Xn + G = GDP Monetarist View M V = P Q = GDP
CAUSES OF MACRO INSTABILITY
Mainstream View
Changes in Investment
Ca + Ig + Xn + G = GDP
Adverse Aggregate Supply Shocks
Monetarist View
Equation of Exchange
Mainstream View – Most economists espouse this view – “the prevailing view”. Ca + Ig + Xn + G = GDP [AE = real output (GDP)]
Any change in one of the spending components shifts the AD Curve. Hence, equilibrium is changed in real output, the price level or both.
Ig is key component
Instability can also arise form AS: supply restrictions (rations), war, > cost of production, supply shocks = cost-push inflation.
Monetarist View – modern form of classical economics (more supply side oriented)
MS is the focus of the monetarist theory.
Price & wages are flexible and will adapt to PL changes.
With no Govt. interference, macroeconomic stability would be substantial.
Govt. has caused instability through minimum wage law; pro union legislation and commodity guarantees for some agricultural prices.
Govt. is clumsy, mistaken in its interpretation of the business cycle
Fundamental equation: MV = PQ (GDP). MS x V (the # of times dollar is spent on g/s per year) PQ = avg. price x quantity of all g/s.
Monetarists suggest that V is stable. Factors altering V are predictable and happen gradually. People & firms have a stable pattern for holding money.
If V is stable, equation suggests that there is a predictable relationship between MS & GDP
Monetarists argue that money policy is the single most important cause of macroeconomic instability; I.e. an > in MS = > in AD. Mainstream view Ig as cause
M V = P Q = GDP
Stable Velocity

9. Summary Mainstream View Monetarist View
CAUSES OF MACRO INSTABILITY
Summary
Mainstream View
Instability of Investment is the Main Cause of Output Changes
Monetary Policy is a Stabilizing Factor
Monetarist View
With a Stable Velocity, Nominal GDP Depends Upon the Money Supply

10. Real Business Cycle View
Real-Business-Cycle Theory
ASLR1
Price Level P1
3Rd Perspective –
Business cycles are caused by real factors affecting AS such as decline in productivity, which causes a decline in AS.
Real Business Cycle Theory - declines in GDP means less demand for MS. Demand decreases hence, MS <, AD falls but PL is the same because AS also declined.
Essentially a new Qf is found. Unemployment is permanent?
AD1 Q1
Real Domestic Output

11. Real Business Cycle View
Real-Business-Cycle Theory
ASLR2
ASLR1
Price Level P1
AD1 Q2 Q1
Real Domestic Output

12. Real Business Cycle View
Real-Business-Cycle Theory
ASLR2
ASLR1
Recession
With Stable
Price Levels
Price Level P1
AD1
AD2 Q2 Q1
Real Domestic Output

13. Coordination Failures
Real Business Cycle View
Real-Business-Cycle Theory
Coordination
Failures
ASLR2
ASLR1
Recession
With Stable
Price Levels
Price Level P1
Rather based on the “self-fulfilling” philosophy. If you think it will happen you prepare for it and hence, collectively, it becomes a reality.
Keys come form Fed or fiscal policy, Especially Fed policy.
AD1
AD2 Q2 Q1
Real Domestic Output

14. New Classical View Self-Correction? Rational Expectations Theory
DOES THE ECONOMY SELF-CORRECT?
New Classical View
Self-Correction?
Rational Expectations Theory
Speed of Adjustment
Unanticipated Price Changes “Price Level Surprises”
Fully Anticipated Price-Level Changes
Monetarists and Rational Expectation economists believe that the economy have automatic, internal mechanisms for self-correction. Leads later to = (“Don’t do something, just stand there”.)
FIGURE 19.3b demonstrates the process.
Main disagreement between new classical economists is over the speed of the adjustment process. Monetarists maintain a gradual change, 2 to 3 years not quick or immediate as the Rational Expectation theory holds. I.e. RET people anticipate some future outcome before they occur, making change very quick, even instantaneous as a result.
In RET: Unanticipated Δ’s – “Price Level Surprises” like an > in demand of U.S. goods by foreigners = > in AD = > PL. RET position is that firms MISTAKENLY adjust their production in response to what they PERCEIVE to be a relative price change in their product alone. Hence, any change in GDP is corrected because prices are FLEXIBLE and firms readjust output to its previous level.
Do wages > quickly as they are “flexible”?
In 19.3a why does economy move from a to b?
In RET: Fully anticipated PL Δ’s do not change real output, even for short periods. Firms are able to maintain profit and production levels.

15. An increase in AD Self- Correction ASLR AS1 P1 AD1 Q1 Price Level a
NEW CLASSICAL VIEW OF SELF-CORRECTION
An increase in AD
ASLR
AS1
Self-
Correction
Price Level P1 a
The sequence is for an unanticipated increase in AD
AD1 Q1
Real Domestic Output

16. An increase in AD Self- Correction ASLR AS1 P2 P1 AD2 AD1 Q1
NEW CLASSICAL VIEW OF SELF-CORRECTION
An increase in AD
ASLR
AS1
Self-
Correction
Price Level P2 b P1 a
AD2
The economy moves from a to b.
AD1 Q1
Real Domestic Output

17. An increase in AD Self- Correction AS2 ASLR AS1 P3 P2 P1 AD2 AD1 Q1
NEW CLASSICAL VIEW OF SELF-CORRECTION
An increase in AD
AS2
ASLR
AS1
Self-
Correction
Price Level P3 c P2 b P1 a
AD2
It then self corrects to c. The change isn’t quick or immediate as RET maintains because firms have “mistakenly” adjusted production to what they perceive to be a price change of their product alone”
On the other hand, an anticipated > in AD would move the economy directly from a to c.
Hence, when there is a price change, output or productivity shouldn’t change. Only the price level changes.
AD1 Q1
Real Domestic Output

18. Mainstream View Downward Wage Inflexibility Efficiency Wage Theory
DOES THE ECONOMY SELF-CORRECT?
Mainstream View
Downward Wage Inflexibility
Efficiency Wage Theory
Greater Work Effort
Lower Supervision Costs
Reduced Job Turnover
Insider-Outsider Theory and Relationships
Downward Wage Inflexibility – Keynes view. Wages and prices are inflexible downward for long periods of time because of:
Restrictions placed by minimum wage
Efficiency wages – greater productivity is achieved by > wages which lowers overall per unit production costs.
Less supervision
Less employee turnover
Morale effect
Insider vs. outsider – insiders keep their jobs even though outsiders might accept lower wages. EMPLOYERS PREFER A STABLE WORK FORCE.

19. Discretionary Monetary Policy Discretionary Fiscal Policy
RULES OR DISCRETION?
In Support of Policy Rules
Monetary Rule
Balanced Budget
In Defense of Discretionary Stabilization Policy
Discretionary Monetary Policy
Discretionary Fiscal Policy
Increased Macro Stability
Monetary rule would direct the Fed to expand MS each same rate as typical growth of GDP. Figure 19.4
> in MS tied to right shift in ASlr and ensure AD shifts right along with it.
The rule would promote steady growth with price stability
Few favor amendment requiring balanced budget.
Passivity in fiscal policy wont create deficits or surpluses. “Don’t do something, just stand there” philosophy
Monetarists and new classical economists believe fiscal policy is ineffective: expansionary policy crowds out private investment.
RET economists reject discretionary fiscal policy for same reason and reject monetary policy and believe it doesn’t work because the effects are “fully anticipated by the private sector”.
Mainstream defend discretionary stabilization policy arguing that velocity of MS is more variable and unpredictable, in short run Monetary policy can help offset Δ’s in AD. Monetarists believe velocity is basically stable.
Mainstreamers oppose balanced budget annually because it would intensify the business cycle by raising taxes, or cutting spending during a recession and the opposite during booms.
Mainstreamers support discretionary fiscal policy to combat recession or inflation even if it causes a deficit or surplus budget.
Discretionary fiscal and monetary policy have been 34% more stable than prior to 1946 when they weren’t used! A very strong argument for it. If it ain’t broke, don’t fix it. Monetarists and RET would maintain that it is broke and our philosophy would fix it.

20. Fed Increases The Money Supply Resulting in…
RATIONALE FOR A MONETARY RULE
Federal Reserve Increases Money Supply at the Long-Run Growth Rate of GDP
ASLR1
ASLR2
Fed Increases
The Money
Supply
Resulting in…
Price Level P1 P2
AD1 Q1 Q2
Real Domestic Output, GDP

21. Growth Without Inflation or Deflation
RATIONALE FOR A MONETARY RULE
Federal Reserve Increases Money Supply at the Long-Run Growth Rate of GDP
ASLR1
ASLR2
Growth
Without
Inflation or
Deflation
Price Level P1 P2
AD2
AD1 Q1 Q2
Real Domestic Output, GDP

22. RULES OR DISCRETION?
Summary of Alternative Views
Chapter Conclusions

23. KEY TERMS classical view Keynesian view monetarism
equation of exchange
velocity
real-business-cycle theory
coordination failures
rational expectations theory
new classical economics
price-level surprises
efficiency wage
insider-outsider theory
monetary rule
KEY TERMS
Copyright McGraw-Hill/Irwin 2002
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24. Supply And Demand Elasticities And Government-Set Prices Chapter 20
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Supply
And
Demand
Elasticities And
Government-Set Prices
Chapter 20