2. 19 - 1 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show Disputes Over Macro Theory and Policy 19 C H A P T E R

3. 19 - 2 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show CLASSICAL ECONOMICS AND KEYNES Classical Economics Adam Smith - 1776 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

4. 19 - 3 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show Classical Theory P1P1 Q1Q1 Price Level Real Domestic Output AS AD 1

5. 19 - 4 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show Classical Theory P1P1 Q1Q1 P2P2 Price Level Real Domestic Output AS AD 1 AD 2

6. 19 - 5 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show 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

7. 19 - 6 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show Keynesian View P1P1 Q1Q1 Price Level Real Domestic Output AS AD 1

8. 19 - 7 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show Keynesian View P1P1 Q1Q1 Price Level Real Domestic Output AS AD 1 AD 2 Q2Q2

9. 19 - 8 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show CAUSES OF MACRO INSTABILITY C a + I g + X n + G = GDP Equation of Exchange M V = P Q = GDP Changes in Investment Mainstream View Monetarist View Adverse Aggregate Supply Shocks Stable Velocity

10. 19 - 9 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show CAUSES OF MACRO INSTABILITY Instability of Investment is the Main Cause of Output Changes Monetary Policy is a Stabilizing Factor Mainstream View Monetarist View With a Stable Velocity, Nominal GDP Depends Upon the Money Supply Summary

11. 19 - 10 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show Real Business Cycle View Real-Business-Cycle Theory P1P1 Price Level Real Domestic Output AS LR1 AD 1 Q1Q1

12. 19 - 11 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show Real Business Cycle View Real-Business-Cycle Theory P1P1 Q2Q2 Price Level Real Domestic Output AS LR1 AD 1 Q1Q1 AS LR2

13. 19 - 12 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show Real Business Cycle View Real-Business-Cycle Theory P1P1 Q2Q2 Price Level Real Domestic Output AS LR1 AD 1 AD 2 Q1Q1 AS LR2 Recession With Stable Price Levels

14. 19 - 13 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show Real Business Cycle View Real-Business-Cycle Theory P1P1 Q2Q2 Price Level Real Domestic Output AS LR1 AD 1 AD 2 Q1Q1 AS LR2 Recession With Stable Price Levels Coordination Failures Coordination Failures

15. 19 - 14 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show 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

16. 19 - 15 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show Q1Q1 Price Level Real Domestic Output AD 1 AS LR P1P1 An increase in AD AS 1 Self- Correction a NEW CLASSICAL VIEW OF SELF-CORRECTION

17. 19 - 16 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show P2P2 Q1Q1 Price Level Real Domestic Output AD 2 AD 1 AS LR P1P1 An increase in AD AS 1 Self- Correction a b NEW CLASSICAL VIEW OF SELF-CORRECTION

18. 19 - 17 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show P2P2 Q1Q1 Price Level Real Domestic Output AD 2 AD 1 AS LR P1P1 An increase in AD AS 1 AS 2 P3P3 Self- Correction a b c NEW CLASSICAL VIEW OF SELF-CORRECTION

19. 19 - 18 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show Mainstream View Downward Wage Inflexibility Efficiency Wage Theory Greater Work Effort Lower Supervision Costs Reduced Job Turnover Insider-Outsider Theory and Relationships DOES THE ECONOMY SELF-CORRECT?

20. 19 - 19 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show RULES OR DISCRETION? Monetary Rule Balanced Budget In Support of Policy Rules In Defense of Discretionary Stabilization Policy Discretionary Monetary Policy Discretionary Fiscal Policy Increased Macro Stability

21. 19 - 20 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show RATIONALE FOR A MONETARY RULE Federal Reserve Increases Money Supply at the Long-Run Growth Rate of GDP P1P1 Q1Q1 Price Level Real Domestic Output, GDP AD 1 Q2Q2 AS LR1 Fed Increases The Money Supply Resulting in… AS LR2 P2P2

22. 19 - 21 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show RATIONALE FOR A MONETARY RULE Federal Reserve Increases Money Supply at the Long-Run Growth Rate of GDP P1P1 Q1Q1 Price Level Real Domestic Output, GDP AS LR2 AD 2 AD 1 Q2Q2 AS LR1 Growth Without Inflation or Deflation P2P2

23. 19 - 22 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show RULES OR DISCRETION? Summary of Alternative Views Chapter Conclusions

24. 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 ENDBACK Copyright McGraw-Hill/Irwin 2002

25. 19 - 24 Copyright McGraw-Hill/Irwin, 2002 Classical Economics and Keynes Classical Theory Keynesian View Causes of Macro Instability Real Business Cycle View Does the Economy Self- Correct? New Classical View of Self-Correction Rules or Discretion Rationale for Monetary Rule Key Terms Previous Slide Next Slide End Show Next: Supply And Demand Elasticities And Government-Set Prices Chapter 20