1. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 18 Prepared by: Fernando Quijano and Yvonn Quijano Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply Side Economics

2. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Keynesian Economics In a broad sense, Keynesian economics is the foundation of modern macroeconomics. In a narrower sense, Keynesian refers to economists who advocate active government intervention in the economy.In a broad sense, Keynesian economics is the foundation of modern macroeconomics. In a narrower sense, Keynesian refers to economists who advocate active government intervention in the economy. Two major schools decidedly against government intervention have developed: monetarism and new classical economics.Two major schools decidedly against government intervention have developed: monetarism and new classical economics.

3. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Monetarism The main message of monetarism is that money matters.The main message of monetarism is that money matters. The monetarist analysis of the economy places emphasis on the velocity of money, or the number of times a dollar bill changes hands, on average, during a year; the ratio of nominal GDP to the stock of money (M):The monetarist analysis of the economy places emphasis on the velocity of money, or the number of times a dollar bill changes hands, on average, during a year; the ratio of nominal GDP to the stock of money (M): or

4. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Quantity Theory of Money The quantity theory of money is a theory based on the identity, which assumes that the velocity of money (V) is constant. Then, the theory can be written as the following equality:The quantity theory of money is a theory based on the identity, which assumes that the velocity of money (V) is constant. Then, the theory can be written as the following equality: If there is equilibrium in the money market, then the quantity of money supplied is equal to the quantity of money demanded. When M is taken to be the quantity of money demanded, this equality would make the quantity of money demanded dependent on nominal GDP, but not the interest rate.If there is equilibrium in the money market, then the quantity of money supplied is equal to the quantity of money demanded. When M is taken to be the quantity of money demanded, this equality would make the quantity of money demanded dependent on nominal GDP, but not the interest rate.

5. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Quantity Theory of Money Recent data on the U.S. economy shows that the demand for money does not appear to depend only on nominal income, but also on the interest rate.Recent data on the U.S. economy shows that the demand for money does not appear to depend only on nominal income, but also on the interest rate. Also, the velocity of money is far from constant. There is a rising long-term trend in velocity, but fluctuations around this trend have been quite large.Also, the velocity of money is far from constant. There is a rising long-term trend in velocity, but fluctuations around this trend have been quite large. However, whether velocity is constant or not may depend partly on how we measure the money supply.However, whether velocity is constant or not may depend partly on how we measure the money supply.

6. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Velocity of Money, 1960 I – 2000 II

7. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Inflation is Purely a Monetary Phenomenon Inflation (an increase in P) is always a purely monetary phenomenon. If the money supply does not change, the price level will not change. The view that changes in the money supply affect only the price level, without a change in the level of output, is called the “strict monetarist” view.Inflation (an increase in P) is always a purely monetary phenomenon. If the money supply does not change, the price level will not change. The view that changes in the money supply affect only the price level, without a change in the level of output, is called the “strict monetarist” view. This view is not compatible with a nonvertical AS curve in the AS/AD model. However, almost all economists agree that sustained inflation is purely a monetary phenomenon.This view is not compatible with a nonvertical AS curve in the AS/AD model. However, almost all economists agree that sustained inflation is purely a monetary phenomenon.

8. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Inflation is Purely a Monetary Phenomenon The “strict monetarist” view is not compatible with a nonvertical AS curve because, if the AS curve is nonvertical, an increase in M, which shifts the AD curve to the right, increases both P and Y.The “strict monetarist” view is not compatible with a nonvertical AS curve because, if the AS curve is nonvertical, an increase in M, which shifts the AD curve to the right, increases both P and Y.

9. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Keynesian/Monetarist Debate Milton Friedman has been the leading spokesman for monetarism over the last few decades.Milton Friedman has been the leading spokesman for monetarism over the last few decades. Most monetarists argue that inflation in the United States could have been avoided if only the Fed had not expanded the money supply so rapidly.Most monetarists argue that inflation in the United States could have been avoided if only the Fed had not expanded the money supply so rapidly.

10. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Keynesian/Monetarist Debate Most monetarists do not advocate an activist monetary policy stabilization— expanding the money supply during bad times and slowing its growth during good times.Most monetarists do not advocate an activist monetary policy stabilization— expanding the money supply during bad times and slowing its growth during good times. Time lags are the most common argument against such management.Time lags are the most common argument against such management. Monetarists advocate a policy of steady and slow money growth, at a rate equal to the average growth of real output (Y).Monetarists advocate a policy of steady and slow money growth, at a rate equal to the average growth of real output (Y).

11. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Keynesian/Monetarist Debate Many Keynesians advocate the application of coordinated monetary and fiscal policy tools to reduce instability in the economy— to fight inflation and unemployment.Many Keynesians advocate the application of coordinated monetary and fiscal policy tools to reduce instability in the economy— to fight inflation and unemployment. Others reject the strict monetarist position in favor of the view that both monetary and fiscal policies make a difference and at the same time believe the best possible policy is basically noninterventionist.Others reject the strict monetarist position in favor of the view that both monetary and fiscal policies make a difference and at the same time believe the best possible policy is basically noninterventionist.

12. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair New Classical Macroeconomics On the theoretical level, new classical macroeconomists argue that traditional models have assumed that expectations are formed in naive ways.On the theoretical level, new classical macroeconomists argue that traditional models have assumed that expectations are formed in naive ways. Naive expectations are inconsistent with the assumptions of microeconomics. If people are out to maximize utility and profits, they should form their expectations in a smarter way.Naive expectations are inconsistent with the assumptions of microeconomics. If people are out to maximize utility and profits, they should form their expectations in a smarter way.

13. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair New Classical Macroeconomics On the empirical level, new classical theories were an attempt to explain the apparent breakdown in the 1970s of the simple inflation-unemployment trade-off predicted by the Phillips Curve.On the empirical level, new classical theories were an attempt to explain the apparent breakdown in the 1970s of the simple inflation-unemployment trade-off predicted by the Phillips Curve.

14. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Rational Expectations The rational-expectations hypothesis assumes people know the “true model” of the economy and that they use this model to form their expectations of the future.The rational-expectations hypothesis assumes people know the “true model” of the economy and that they use this model to form their expectations of the future. By “true” model we mean a model that is on average correct, even though predictions are not exactly right all the time.By “true” model we mean a model that is on average correct, even though predictions are not exactly right all the time.

15. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Rational Expectations People are said to have rational expectations if they use “all available information” in forming their expectations.People are said to have rational expectations if they use “all available information” in forming their expectations. Because there are costs associated with making a wrong forecast, it is not rational to overlook information, as long as the costs of acquiring that information do not outweigh the benefits of improving its accuracy.Because there are costs associated with making a wrong forecast, it is not rational to overlook information, as long as the costs of acquiring that information do not outweigh the benefits of improving its accuracy.

16. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Rational Expectations and Market Clearing If firms have rational expectations, on average, prices and wages will be set at levels that ensure equilibrium in the goods and labor markets. In other words, on average, there will be no unemployment.If firms have rational expectations, on average, prices and wages will be set at levels that ensure equilibrium in the goods and labor markets. In other words, on average, there will be no unemployment. When expectations are rational, disequilibrium exists only temporarily as a result of random, unpredictable shocks.When expectations are rational, disequilibrium exists only temporarily as a result of random, unpredictable shocks. On average, all markets clear and there is full employment. There is no need for government stabilization.On average, all markets clear and there is full employment. There is no need for government stabilization.

17. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Lucas Supply Function The Lucas supply function is the supply function that embodies the idea that output (Y) depends on the difference between the actual price level (P) and the expected price level (P e ):The Lucas supply function is the supply function that embodies the idea that output (Y) depends on the difference between the actual price level (P) and the expected price level (P e ): The difference between the actual price level and the expected price level is the price surprise.The difference between the actual price level and the expected price level is the price surprise.

18. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Lucas Supply Function The rationale for the Lucas supply function is that unexpected increases in the price level can fool workers and firms into thinking that relative prices have changed, causing them to alter the amount of labor or goods they choose to supply.The rationale for the Lucas supply function is that unexpected increases in the price level can fool workers and firms into thinking that relative prices have changed, causing them to alter the amount of labor or goods they choose to supply. Rational-expectations theory, combined with the Lucas supply function, proposes a very small role for government policy in the economy.Rational-expectations theory, combined with the Lucas supply function, proposes a very small role for government policy in the economy.

19. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Evaluating Rational-Expectations Theory If expectations are not rational, there are likely to be unexploited profit opportunities—most economists believe such opportunities are rare and short-lived.If expectations are not rational, there are likely to be unexploited profit opportunities—most economists believe such opportunities are rare and short-lived. The argument against rational expectations is that it required households and firms to know too much. People must know the true model, or at least a good approximation of it, and this is a lot to expect.The argument against rational expectations is that it required households and firms to know too much. People must know the true model, or at least a good approximation of it, and this is a lot to expect.

20. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Real Business Cycle Theory The real business cycle theory is an attempt to explain business cycle fluctuations under assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks.The real business cycle theory is an attempt to explain business cycle fluctuations under assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks. If the AS curve is vertical, shifts in AD cannot account for real output fluctuations.If the AS curve is vertical, shifts in AD cannot account for real output fluctuations.

21. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Supply-Side Economics Orthodox macro theory consists of demand-oriented theories that failed to explain the stagflation of the 1970s.Orthodox macro theory consists of demand-oriented theories that failed to explain the stagflation of the 1970s. Supply-side economists believe that the real problem was that high rates of taxation and heavy regulation had reduced the incentive to work, to save, and to invest. What was needed was not a demand stimulus but better incentives to stimulate supply.Supply-side economists believe that the real problem was that high rates of taxation and heavy regulation had reduced the incentive to work, to save, and to invest. What was needed was not a demand stimulus but better incentives to stimulate supply.

22. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Laffer Curve The Laffer Curve shows the amount of revenue the government collects is a function of the tax rate.The Laffer Curve shows the amount of revenue the government collects is a function of the tax rate. 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.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.

23. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 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.Among the criticisms of supply-side economics is that it is unlikely a tax cut would substantially increase the supply of labor. When households receive a higher after- tax wage, they might have an incentive to work more, but they may also choose to work less.When households receive a higher after- tax wage, they might have an incentive to work more, but they may also choose to work less.

24. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Testing Alternative Macro Models Models differ in ways that are hard to standardize.Models differ in ways that are hard to standardize. If people have rational expectations, they are using the true model, but there is no way to know what model is in fact the true one.If people have rational expectations, they are using the true model, but there is no way to know what model is in fact the true one. There is only a small amount of data available to test macroeconomic hypotheses—only seven business cycles since 1950.There is only a small amount of data available to test macroeconomic hypotheses—only seven business cycles since 1950.