1. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-1 Chapter 12 Macroeconomic ideas — evolution and debates

2. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-2 Learning objectives Review the classical and Keynesian views of the economy and then present them within a simplified aggregate demand–aggregate supply framework Examine the monetarist position, and its emphasis on the money supply through a development of the equation of exchange

3. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-3 Learning objectives (cont.) Briefly describe rational expectations theory (RET) and its implications for policy makers Review supply-side economics and its implications Discuss the insights that these alternative views have provided for us on the operation of the macroeconomy

4. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-4 Classical employment theory Underspending in a capitalist economy highly unlikely, and prices and wages adjust very rapidly to ensure full employment at all times Two basic assumptions of the classical theory –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

5. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-5 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

6. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-6 Problems with Say’s law Saving –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

7. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-7 Problems with Say’s law 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 –Interest rate will ensure that the leakage from the income–expenditure stream will reappear as investment dollars

8. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-8 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

9. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-9 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

10. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-10 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

11. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-11 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

12. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-12 Keynesian economics (cont.) 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

13. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-13 Keynesian economics (cont.) 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

14. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-14 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

15. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-15 Classical view of the macroeconomy Price level Real domestic output Q1Q1 AS P1P1 AD 1 AD 2 P2P2

16. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-16 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

17. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-17 Keynesian view of the macroeconomy P1P1 Q1Q1 Price level Real domestic output AD 1 Q2Q2 AS AD 2

18. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-18 Monetarism Built on classical foundations –Assume price and wage flexibility Markets are competitive with a high degree of macroeconomic stability Monetarist argue government policies interfere with competition and promote downwards price–wage inflexibility –Minimum wages, pro-union legislation, rural price supports, pro-business monopoly legislation etc.

19. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-19 Monetarism (cont.) Economy is essentially stable –Competitive markets cause adjustments to product and resource price 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

20. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-20 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 Lengthy transmission mechanism

21. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-21 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)

22. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-22 Monetarist equation of exchange (cont.) Simple and direct transmission mechanism: –Change in money supply causes a change in GDP

23. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-23 Velocity of money (V) 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

24. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-24 The money supply and the level of GDP 1968–69 to 2004–05

25. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-25 The velocity of money and interest rate 1968–69 to 2004–05

26. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-26 Fiscal policy debate Monetarists –Fiscal policy is weak due to crowding-out effects –Funding deficits by selling securities crowds out private investment –Relatively inelastic demand-for-money curve –Relatively elastic investment demand curve –Argue for the use of monetary rules

27. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-27 Fiscal policy debate (cont.) Keynesians –Crowding-out of investment is insubstantial –Relatively elastic demand-for-money curve –Relatively inelastic investment demand curve

28. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-28 Monetary mismanagement According to monetarists, the two sources of monetary mismanagement are: 1.Irregular time lags 2.Wrong target — interest rates vs money supply

29. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-29 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 secularly and cyclically –A money rule could contribute to fluctuations

30. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-30 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

31. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-31 Monetarist AD–AS perspective Price level Real domestic output AS AD 1 AD 2 P1P1 GDP 1 GDP 2 P2P2

32. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-32 AD–AS analysis: Keynesians vs monetarists 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

33. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-33 Keynesian AD–AS perspective Price level Real domestic output AS AD 1 AD 2 P1P1 GDP 1 GDP 2 P2P2

34. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-34 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 upon the future of the economy in order to further their own self-interest

35. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-35 Rational expectations theory (cont.) Theoretical underpinnings: –Expectations about the future –Assumes all markets are purely competitive  Prices and wages are highly flexible –Markets instantly adjust to new changes –AS curve is vertical

36. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-36 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

37. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-37 RET and the AD–AS model Q1Q1 Price level Real domestic output AS AD 1 P1P1 a P2P2 AD 2 b

38. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-38 Rational expectations theory 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

39. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-39 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 by growth in public sector due to the growing tax wedge between production costs and product prices

40. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 12-40 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