1. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 1 Extension Chapter 6 The development of macroeconomic debates

2. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 2 Learning objectives 1.Review the classical and Keynesian views of the economy and then present them within a simplified aggregate demand–aggregate supply framework. 2.Examine the monetarist position, and its emphasis on the money supply through a development of the equation of exchange. 3.Briefly describe rational expectations theory (RET) and its implications for policy makers. 4.Review supply-side economics and its implications. 5.Discuss the insights that these alternative views have provided for us on the operation of the macroeconomy.

3. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 3 Classical employment theory Underspending in a capitalist economy was highly unlikely, and prices and wages adjust very rapidly to ensure full employment at all times. Two basic assumptions of the classical theory are: –underspending is most unlikely to occur –prices and wages adjust to ensure that a decline in spending would not result in a fall in real output, employment and real incomes.

4. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 4 Say’s law The foundation of the classical theory is Say’s law: –The very act of producing goods generates an amount of income exactly equal to the value of the goods produced. –Production of output automatically generates the incomes required to purchase this output, i.e. supply creates its own demand.

5. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 5 Problems with Say’s law Saving: a complicating factor –If households saved a given portion of their income, supply would not create its own demand. –Saving would cause a deficiency of consumption, resulting in unsold goods, unemployment and falling income.

6. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 6 Problems with Say’s law (cont.) Saving, investment and the interest rate –The money market will ensure that the interest rate (the price of money) would adjust to bring about equilibrium between saving and investment. –The interest rate will ensure that the leakage from the income–expenditure stream will reappear as investment dollars.

7. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 7 Classical view of the money market I Rate of interest (%) Dollars saved and invested I Dollars saved/invested I r r 1 Rate of interest (%) S S (saving) I S’ r 2 Increase in saving Increase in Investment q q’

8. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 8 Classical employment theory Price–wage flexibility –The assumption that all prices, including wages and interest rates, are flexible and will rapidly adjust to remove disequilibria. Classical theory and laissez faire –The price system ensured that price–wage flexibility and fluctuations in the interest rate were capable of maintaining full employment.

9. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 9 Keynesian economics The Great Depression of the 1930s Keynes and Keynesian economics –Keynes (1936), General Theory of Employment, Interest and Money –The capitalist economy is inherently unstable and likely to achieve equilibrium with considerable unemployment or severe inflation, and the possibility of persistent unemployment.

10. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 10 Keynesian economics (cont.) Unlinking of savings and investment plans Savers and investors are different groups –Saving and investment decisions are made by different groups of individuals. –Firms also save in the form undistributed profits. Savers and investors are differently motivated –Savings decisions are motivated by diverse considerations. –Motivations for business investment are complex.

11. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 11 Money balances and banks Savings and investment plans can be at odds and result in fluctuations in total output, income, employment and the price level. Discrediting price–wage flexibility The existence of price–wage flexibility –Prices and wages are inflexible downwards –It is doubtful that price–wage declines would alleviate widespread unemployment. Keynesian economics (cont.)

12. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 12 AD–AS in the classical theory Vertical aggregate supply curve –Exclusively determines level of real domestic output Stable down-sloping aggregate demand –Exclusively determines price level

13. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 13 Classical view of the macroeconomy Price level Real gross domestic output QfQf AS P1P1 AD 1 AD 2 P2P2

14. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 14 Keynesian view of AD–AS Horizontal aggregate supply curve –SR prices and wages are downwardly inflexible Unstable aggregate demand –Especially investment –Demand management and stabilisation policies by the government are required.

15. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 15 Keynesian view of the macroeconomy P1P1 QfQf Price level Real gross domestic output AD 1 QuQu AS AD 2

16. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 16 Monetarism Monetarism is built on classical foundations –Assumes price and wage flexibility Markets are competitive with a high degree of macroeconomic stability. Monetarists argue that government policies interfere with competition and promote downwards price-wage inflexibility. –Minimum wages, pro-union legislation, rural price supports, pro-business monopoly legislation, etc.

17. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 17 Monetarism (cont.) Economy is essentially stable –Competitive markets cause adjustments to product and resource prices and not output and employment. Government creates rigidities and weaknesses in the market. –Government intervention must be avoided:  inefficient, harmful to incentives, and policy mistakes that destabilise the economy.

18. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 18 Keynesian aggregate expenditure equation C + I + G + NX = GDP Aggregate spending by buyers equals total value of goods and services bought. Money plays a secondary role. Involves a lengthy transmission mechanism.

19. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 19 Monetarist equation of exchange MV = PQ where M is the supply of money V is the velocity of money P is the price level Q is the physical volume of goods and services produced MV refers to actual spending whereas C + I + G + NX refers to planned expenditure.

20. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 20 Monetarist equation of exchange (cont.) Simple and direct transmission mechanism –Change in money supply causes a change in GDP

21. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 21 Velocity of money (V) Defined as the number of times per year the average dollar is spent on final goods and services. Monetarists: V is stable or on a steady long-term trend –Why? Money is the primary medium of exchange. –Store-of-money function is inconsequential –Over time transactions demand increases steadily Keynesians: V is unstable –Why? Money is held for transactions and as assets. –No dependable relationship between M and V

22. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 22 The money supply and the level of GDP 1959–60 to 2009–10

23. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 23 The velocity of money and interest rate 1959–60 to 2009–10

24. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 24 Fiscal policy debate The monetarists believe that: –fiscal policy is weak due to crowding-out effects –financing deficits by selling securities crowds out private investment –there is a relatively inelastic demand-for-money curve –there is a relatively elastic investment demand curve –they should argue for the use of monetary rules.

25. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 25 Fiscal policy debate (cont.) Keynesians believe that: –the crowding-out of investment is insubstantial –there is a relatively elastic demand-for-money curve –there is a relatively inelastic investment demand curve.

26. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 26 Monetary mismanagement According to monetarists, the two sources of monetary mismanagement are: 1.irregular time lags 2.wrong target: interest rates vs money supply.

27. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 27 Monetary rule According to monetarists, monetary authorities should stabilise the rate of growth of the money supply, not the interest rate. Keynesians argue against this –V is variable both cyclically and in the long run –A money rule could contribute to fluctuations

28. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 28 AD–AS analysis: Keynesians vs monetarists Monetarists believe that the AS curve is relatively steep. Any change in AD through monetary policy will have little impact on equilibrium real GDP, but will result in large increases in the price level.

29. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 29 Monetarist AD–AS perspective Price level Real gross domestic output AS AD 1 AD 2 P1P1 GDP 1 GDP 2 P2P2

30. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 30 AD–AS analysis: Keynesians vs monetarists (cont.) Keynesians believe that the AS curve is relatively flat. Thus, changes in AD through fiscal or monetary policy will have a larger impact on equilibrium real GDP but only a small impact on the price level.

31. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 31 Keynesian AD–AS perspective Price level Real gross domestic output AS AD 1 AD 2 P1P1 GDP 1 GDP 2 P2P2

32. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 32 Rational expectations theory (RET) Also known as new-classical economics. Businesses, consumers and workers understand the workings of the economy and use this knowledge to assess the anticipated effects of current economic policies on the future state of the economy in order to further their own self-interest.

33. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 33 Rational expectations theory (cont.) Basic concepts: –Expectations about the future trigger economic decisions and therefore determine outcomes. –Assumes all markets are purely competitive  Prices and wages are highly flexible –Markets instantly adjust to new changes. –AS curve is vertical.

34. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 34 RET and policy frustration Aggregated responses of the public will make discretionary stabilisation policies ineffective. Increases in AD will result in an offsetting increase in the price level, leaving output and employment unchanged. Compared to traditional classical theory: RET does not result in temporary lapses from full-employment level of output.

35. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 35 RET and the AD–AS model Q1Q1 Price level Real domestic output AS AD 1 P1P1 a P2P2 AD 2 b

36. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 36 Rational expectations theory (cont.) Further consequences: –Pro-cyclical policy: businesses may come to expect tax relief whenever a recession occurs and postpone investment purchases. Evaluation –Behaviour  Knowledge and understanding about the workings of the economy may be overstated by RET. –Sticky prices –Markets are not purely competitive. –Policy and stability  Empirical evidence that economic policy does affect GDP and employment

37. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 37 Supply-side economics Economic disturbance can be generated from the supply side. Change in aggregate supply is an active force in determining the levels of inflation and unemployment. Stagflation of the 1970s and 1980s contributed to the growth in the public sector due to the growing tax wedge between production costs and product prices.

38. Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada Slides prepared by George Bredon E6- 38 Supply-side economics (cont.) Tax-transfer disincentive –Incentives to work –Transfer disincentives –Incentives to save and invest Resource misallocation –Resources of large numbers of lawyers and accountants discovering ways to avoid taxes, could be more effectively used elsewhere. Overregulation –Government involvement in the economy has adverse effects on productivity and costs.