The Roots of Modern Macroeconomics

The Roots of ModernThe Roots of ModernMacroeconomicsMacroeconomics

The Roots of Modern MacroeconomicsThe Roots of Modern Macroeconomics

Setting the Scene: Three Key Issues

Setting the Scene: Three Key Issues

THREE KEY ISSUESTHREE KEY ISSUES

Issue 1: Flexibility of prices and wages

the right: flexible prices and wages

the left: price and wage rigidities

Issue 2: Flexibility of aggregate supply

the right: aggregate supply determined independently of aggregate demand

Issue 1: Flexibility of prices and wages

the right: flexible prices and wages

the left: price and wage rigidities

Issue 2: Flexibility of aggregate supply

the right: aggregate supply determined independently of aggregate demand

Different aggregate supply curves: (a)Different aggregate supply curves: (a)

O

AS

Pric

e le

vel

National output

Y

O

P1

Pric

e le

vel

National output

AD1

Y

AS

Different aggregate supply curves: (a)Different aggregate supply curves: (a)

O

P1

Pric

e le

vel

National output

AD2

P2

Y

AS

AD1

Different aggregate supply curves: (a)Different aggregate supply curves: (a)

THREE KEY ISSUESTHREE KEY ISSUES

Issue 1: Flexibility of prices and wages

the right: flexible prices and wages

the left: price and wage rigidities

Issue 2: Flexibility of aggregate supply

the right: aggregate supply determined independently of aggregate demand

the left: aggregate supply responsive to changes in aggregate demand

Issue 1: Flexibility of prices and wages

the right: flexible prices and wages

the left: price and wage rigidities

Issue 2: Flexibility of aggregate supply

the right: aggregate supply determined independently of aggregate demand

the left: aggregate supply responsive to changes in aggregate demand

Different aggregate supply curves: (b)Different aggregate supply curves: (b)

O

ASPric

e le

vel

National output

P

O

ASPric

e le

vel

National output

Y1

P

AD1

Different aggregate supply curves: (b)Different aggregate supply curves: (b)

O

AS

Y1

Pric

e le

vel

National output

Y2

P

AD2

AD1

Different aggregate supply curves: (b)Different aggregate supply curves: (b)

THREE KEY ISSUESTHREE KEY ISSUES

Issue 1: Flexibility of prices and wages the right: flexible prices and wages

the left: price and wage rigidities

Issue 2: Flexibility of aggregate supply the right: aggregate supply determined

independently of aggregate demand

the left: aggregate supply responsive to changes in aggregate demand

some consensus on nature of short-run AS curve

Issue 1: Flexibility of prices and wages the right: flexible prices and wages

the left: price and wage rigidities

Issue 2: Flexibility of aggregate supply the right: aggregate supply determined

independently of aggregate demand

the left: aggregate supply responsive to changes in aggregate demand

some consensus on nature of short-run AS curve

Different aggregate supply curves: (c)Different aggregate supply curves: (c)

O

Pric

e le

vel

National output

AS

O

AS

Pric

e le

vel

National output

Y1

P1

AD1

Different aggregate supply curves: (c)Different aggregate supply curves: (c)

O

AS

Y1

Pric

e le

vel

National output

Y2

P1

P2

AD2

AD1

Different aggregate supply curves: (c)Different aggregate supply curves: (c)

Issue 3: The role of expectations in the working of the market

the right: expectations adjust rapidly to changes in prices

the left: expectations of prices depend on expectations of output and employment

Issue 3: The role of expectations in the working of the market

the right: expectations adjust rapidly to changes in prices

the left: expectations of prices depend on expectations of output and employment

THREE KEY ISSUESTHREE KEY ISSUES

The Roots of Modern MacroeconomicsThe Roots of Modern Macroeconomics

Classical Macroeconomics

Classical Macroeconomics

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

Classical analysis of output and employment markets clear

labour marketmarket for loanable funds

Classical analysis of output and employment markets clear

labour marketmarket for loanable funds

O

Saving (supply)

Investment (demand)

Rat

e of

inte

rest

Quantity of loanable funds

The market for loanable fundsThe market for loanable funds

O

Saving (supply)

Investment (demand)

Rat

e of

inte

rest

Quantity of loanable funds

r1

The market for loanable fundsThe market for loanable funds

O

Saving (supply)

Investment (demand)

Rat

e of

inte

rest

Quantity of loanable funds

r1

The market for loanable fundsThe market for loanable funds

O

Saving (supply)

Investment (demand)

Rat

e of

inte

rest

Quantity of loanable funds

r2

The market for loanable fundsThe market for loanable funds

O

Saving (supply)

Investment (demand)

Rat

e of

inte

rest

Quantity of loanable funds

r2

The market for loanable fundsThe market for loanable funds

O

Saving (supply)

Investment (demand)

Rat

e of

inte

rest

Quantity of loanable funds

re

The market for loanable fundsThe market for loanable funds

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

Classical analysis of output and employment markets clear

labour marketmarket for loanable fundsmarket for imports and exports:

the gold standard

Classical analysis of output and employment markets clear

labour marketmarket for loanable fundsmarket for imports and exports:

the gold standard

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

Classical analysis of output and employment markets clear

labour marketmarket for loanable fundsmarket for imports and exports:

the gold standard Say’s law

Classical analysis of output and employment markets clear

labour marketmarket for loanable fundsmarket for imports and exports:

the gold standard Say’s law

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

Classical analysis of output and employment markets clear

labour marketmarket for loanable fundsmarket for imports and exports:

the gold standard Say’s law

Classical analysis of prices and inflation

Classical analysis of output and employment markets clear

labour marketmarket for loanable fundsmarket for imports and exports:

the gold standard Say’s law

Classical analysis of prices and inflation

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

Classical analysis of output and employment markets clear

labour marketmarket for loanable fundsmarket for imports and exports:

the gold standard Say’s law

Classical analysis of prices and inflation the quantity theory of money

Classical analysis of output and employment markets clear

labour marketmarket for loanable fundsmarket for imports and exports:

the gold standard Say’s law

Classical analysis of prices and inflation the quantity theory of money

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

Classical analysis of output and employment markets clear

labour marketmarket for loanable fundsmarket for imports and exports:

the gold standard Say’s law

Classical analysis of prices and inflation the quantity theory of money the equation of exchange: MV = PY

Classical analysis of output and employment markets clear

labour marketmarket for loanable fundsmarket for imports and exports:

the gold standard Say’s law

Classical analysis of prices and inflation the quantity theory of money the equation of exchange: MV = PY

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

Classical analysis of output and employment markets clear

labour marketmarket for loanable fundsmarket for imports and exports:

the gold standard Say’s law

Classical analysis of prices and inflation the quantity theory of money the equation of exchange: MV = PY implications for monetary policy

Classical analysis of output and employment markets clear

labour marketmarket for loanable fundsmarket for imports and exports:

the gold standard Say’s law

Classical analysis of prices and inflation the quantity theory of money the equation of exchange: MV = PY implications for monetary policy

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

The Great Depression and the return to the gold standard the depression of the 1920s

The Great Depression and the return to the gold standard the depression of the 1920s

0

2

4

6

8

10

12

14

16

18

20

22

24

1919 1921 1923 1925 1927 1929 1931 1933 1935 1937

Une

mpl

oym

ent (

% o

f wor

kfor

ce)

-25

-20

-15

-10

-5

0

5

10

15

Inflatio

n (%

)UK unemployment and inflation: 1919 38UK unemployment and inflation: 1919 38

Unemployment

0

2

4

6

8

10

12

14

16

18

20

22

24

1919 1921 1923 1925 1927 1929 1931 1933 1935 1937

Une

mpl

oym

ent (

% o

f wor

kfor

ce)

-25

-20

-15

-10

-5

0

5

10

15

Inflatio

n (%

)

Unemployment

Inflation

UK unemployment and inflation: 1919 38UK unemployment and inflation: 1919 38

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

The Great Depression and the return to the gold standard the depression of the 1920s

return to the gold standard

The Great Depression and the return to the gold standard the depression of the 1920s

return to the gold standard

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

The Great Depression and the return to the gold standard the depression of the 1920s

return to the gold standard

effects on the economy

The Great Depression and the return to the gold standard the depression of the 1920s

return to the gold standard

effects on the economy

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

The Great Depression and the return to the gold standard the depression of the 1920s

return to the gold standard

effects on the economy

the policy response

The Great Depression and the return to the gold standard the depression of the 1920s

return to the gold standard

effects on the economy

the policy response

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

The Great Depression and the return to the gold standard the depression of the 1920s

return to the gold standard

effects on the economy

the policy response

classical rejection of public works

The Great Depression and the return to the gold standard the depression of the 1920s

return to the gold standard

effects on the economy

the policy response

classical rejection of public works

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

The Great Depression and the return to the gold standard the depression of the 1920s

return to the gold standard

effects on the economy

the policy response

classical rejection of public works the fear of inflation

The Great Depression and the return to the gold standard the depression of the 1920s

return to the gold standard

effects on the economy

the policy response

classical rejection of public works the fear of inflation

CLASSICAL MACROECONOMICSCLASSICAL MACROECONOMICS

The Great Depression and the return to the gold standard the depression of the 1920s

return to the gold standard

effects on the economy

the policy response

classical rejection of public works the fear of inflation

the problem of crowding out

The Great Depression and the return to the gold standard the depression of the 1920s

return to the gold standard

effects on the economy

the policy response

classical rejection of public works the fear of inflation

the problem of crowding out

AD2

AD1

O

AS

P1

Pric

e le

vel

National output

P2

Q1

The effect of printing extra money: the classical analysisThe effect of printing extra money: the classical analysis

The Roots of Modern MacroeconomicsThe Roots of Modern Macroeconomics

The Keynesian Revolution

The Keynesian Revolution

THE KEYNESIAN REVOLUTIONTHE KEYNESIAN REVOLUTION

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand

O

ADL1

Rea

l wag

e ra

te (

W /

P)

Quantity of labour

W1

ADL2

ASL

The problem of demand deficiency in the labour marketThe problem of demand deficiency in the labour market

THE KEYNESIAN REVOLUTIONTHE KEYNESIAN REVOLUTION

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means

of increasing investment

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means

of increasing investment

O

Savings 1

Investment

Rat

e of

inte

rest

Quantity of loanable funds

r1

Savings 2

r2

Disequilibrium in the market for loanable fundsDisequilibrium in the market for loanable funds

THE KEYNESIAN REVOLUTIONTHE KEYNESIAN REVOLUTION

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means

of increasing investment rejection of simple quantity theory

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means

of increasing investment rejection of simple quantity theory

THE KEYNESIAN REVOLUTIONTHE KEYNESIAN REVOLUTION

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means

of increasing investment rejection of simple quantity theory rejection of a balanced budget

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means

of increasing investment rejection of simple quantity theory rejection of a balanced budget

THE KEYNESIAN REVOLUTIONTHE KEYNESIAN REVOLUTION

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means

of increasing investment rejection of simple quantity theory rejection of a balanced budget

Keynes’ analysis of employment and inflation

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means

of increasing investment rejection of simple quantity theory rejection of a balanced budget

Keynes’ analysis of employment and inflation

THE KEYNESIAN REVOLUTIONTHE KEYNESIAN REVOLUTION

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means

of increasing investment rejection of simple quantity theory rejection of a balanced budget

Keynes’ analysis of employment and inflation the importance of aggregate demand

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means

of increasing investment rejection of simple quantity theory rejection of a balanced budget

Keynes’ analysis of employment and inflation the importance of aggregate demand

O

Pric

e le

vel

National output

YP

The effects of increases in aggregate demand on national outputThe effects of increases in aggregate demand on national output

AS

O Y1

Pric

e le

vel

National output

Y2

AS

Y3 Y4 YP

The effects of increases in aggregate demand on national outputThe effects of increases in aggregate demand on national output

AD3AD2AD1

AD4

THE KEYNESIAN REVOLUTIONTHE KEYNESIAN REVOLUTION

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means

of increasing investment rejection of simple quantity theory rejection of a balanced budget

Keynes’ analysis of employment and inflation the importance of aggregate demand the multiplier process

Keynes’ rejection of classical theory rigidities in the labour market the problem of deficiency of demand rejection of increased saving as a means

of increasing investment rejection of simple quantity theory rejection of a balanced budget

Keynes’ analysis of employment and inflation the importance of aggregate demand the multiplier process

The circular flow of incomeThe circular flow of income

Cd

The circular flow of incomeThe circular flow of income

CdIncomes

The circular flow of incomeThe circular flow of income

Cd

W = S + T + M

Incomes

The circular flow of incomeThe circular flow of income

Cd

W = S + T + M

J = I + G + X

Incomes

The circular flow of incomeThe circular flow of income

Cd

W = S + T + M

J = I + G + X

Incomes

The circular flow of incomeThe circular flow of income

Cd

W = S + T + M

J = I + G + X

Incomes

The circular flow of incomeThe circular flow of income

Cd

W = S + T + M

J = I + G + X

Incomes

The circular flow of incomeThe circular flow of income

THE KEYNESIAN REVOLUTIONTHE KEYNESIAN REVOLUTION

Keynes’ policy recommendations

demand management by fiscal and monetary policies

Keynesian policies in 1950s and 60s

stop–go policies

criticisms of short-term demand management

the breakdown of the Phillips curve

Keynes’ policy recommendations

demand management by fiscal and monetary policies

Keynesian policies in 1950s and 60s

stop–go policies

criticisms of short-term demand management

the breakdown of the Phillips curve

The Roots of Modern MacroeconomicsThe Roots of Modern Macroeconomics

The Monetarist– Keynesian DebateThe Monetarist–

Keynesian Debate

THE MONETARIST–KEYNESIAN DEBATETHE MONETARIST–KEYNESIAN DEBATE

The monetarist counter-revolution the restatement of the quantity theory rejection of Keynesian demand

management policies the problem of inflationary expectations reappraisal of the Phillips curve

unemployment inflation

The monetarist counter-revolution the restatement of the quantity theory rejection of Keynesian demand

management policies the problem of inflationary expectations reappraisal of the Phillips curve

unemployment inflation

The monetarist version of the long-run Phillips curveThe monetarist version of the long-run Phillips curve

O

Unemployment

Infla

tion

(%)

Un

(a) Keynesian aggregate supply curve(a) Keynesian aggregate supply curve

O

Pric

e le

vel

National output

AS

YPYmax

(b) Keynesian Phillips curve(b) Keynesian Phillips curve

O

Unemployment

Infla

tion

(%)

Umin

THE MONETARIST–KEYNESIAN DEBATETHE MONETARIST–KEYNESIAN DEBATE

The monetarist counter-revolution the restatement of the quantity theory rejection of Keynesian demand

management policies the problem of inflationary expectations reappraisal of the Phillips curve

unemployment inflation

monetarist policies

The monetarist counter-revolution the restatement of the quantity theory rejection of Keynesian demand

management policies the problem of inflationary expectations reappraisal of the Phillips curve

unemployment inflation

monetarist policies

THE MONETARIST–KEYNESIAN DEBATETHE MONETARIST–KEYNESIAN DEBATE

The monetarist counter-revolution the restatement of the quantity theory rejection of Keynesian demand

management policies the problem of inflationary expectations reappraisal of the Phillips curve

unemployment inflation

monetarist policies attempts at such policies in the 1980s

The monetarist counter-revolution the restatement of the quantity theory rejection of Keynesian demand

management policies the problem of inflationary expectations reappraisal of the Phillips curve

unemployment inflation

monetarist policies attempts at such policies in the 1980s

Modern-day Keynesians inflation unemployment structural problems hysteresis

low capital stockdeskilling insiders and outsiders

criticisms of monetarism Keynesian policy proposals

Modern-day Keynesians inflation unemployment structural problems hysteresis

low capital stockdeskilling insiders and outsiders

criticisms of monetarism Keynesian policy proposals

THE MONETARIST–KEYNESIAN DEBATETHE MONETARIST–KEYNESIAN DEBATE

The Roots of Modern MacroeconomicsThe Roots of Modern Macroeconomics

The Current PositionThe Current Position

THE CURRENT POSITIONTHE CURRENT POSITION

The current range of views

new classical / rational expectations school

moderate monetarists

moderate Keynesians (new Keynesians)

extreme Keynesians

the radical left

eclectic economists

The current range of views

new classical / rational expectations school

moderate monetarists

moderate Keynesians (new Keynesians)

extreme Keynesians

the radical left

eclectic economists

A mainstream consensus? short-run effects of changes in AD long-run effects of changes in AD no simple trade-off between inflation and

unemployment role of expectations effects of excessive growth in the money

supply importance of supply-side policies erosion of governments' power by the

process of globalisation

A mainstream consensus? short-run effects of changes in AD long-run effects of changes in AD no simple trade-off between inflation and

unemployment role of expectations effects of excessive growth in the money

supply importance of supply-side policies erosion of governments' power by the

process of globalisation

THE CURRENT POSITIONTHE CURRENT POSITION