Disputes In MacroeconomicsDisputes In Macroeconomics Rational Ex.Rational Ex. Supply-sidersSupply-siders MainstreamersMainstreamers

Keynesian BasedKeynesian BasedMonetary Policy Monetary Policy mattersmatters

Fiscal policyFiscal policy mattersmattersMoneyMoney supply matters supply mattersAnticipations matterAnticipations matterAS fAS fiscal iscal ppolicy olicy mattersmatters

G G && T TNo “G”No “G”

ClassicalsClassicals KeynesiansKeynesians MonetaristsMonetarists

3-5%3-5%Monetary Monetary

RuleRule

ExpectationsExpectationsnegate fiscalnegate fiscaland monetaryand monetary

Policy.Policy.

Get Get thethe G Goff of our off of our

backs.backs.

Adam SmithAdam Smith John M. KeynesJohn M. Keynes Milton FriedmanMilton Friedman

Robert LucasRobert Lucas Ronald ReaganRonald Reagan

MonetaristMonetarist KeynesianKeynesian

Chapter 19

Let’s look at another Keynesian.Let’s look at another Keynesian.

DIFFERENT MACRO THEROIES

19C H A P T E R

• Full employment is the norm. • Laissez-faire “Let it be” • Vertical Aggregate Supply Curve• Stable Aggregate Demand• Real Output Depends Upon…

1.. Say’s Law2. Responsive, Flexible, Prices and

Wages

Classical Theory

P1

Qf

Pri

ce L

evel

Real Domestic Output

AS

AD1

Classical Theory

P1

Qf

P2

Pri

ce L

evel

Real Domestic Output

AS

AD1

AD2

• Their hero and leader was John Maynard Keynes

• Active government policy is needed to stabilize the economy.

• “Laissez-Faire” is subject to recessions and widespread unemployment

• AD is Unstable (Investment fluctuates)

• Prices and Wages Downwardly Inflexible

• Horizontal AS Curve to Full-Employment

.

Free gifts to every kid in Free gifts to every kid in the world? Are you a the world? Are you a Keynesian or something?Keynesian or something?

Keynesian View

P1

Qf

Pri

ce L

evel

Real Domestic Output

AS

AD1

AD2

Qu

Prices are downwardly Inflexible, or “Sticky”

Keynesian ViewKeynesian View

PP11

QQ11

Pri

ce L

evel

Pri

ce L

evel

Real Domestic OutputReal Domestic Output

ASAS

ADAD11

YY11Real Domestic Output

ASASADAD11ADAD22

YY22

““Businesses don’t let Businesses don’t let prices fall so easily”prices fall so easily”

PLPL11

““Workers don’t letWorkers don’t letwages fall so easily.”wages fall so easily.”

Keynesian ViewKeynesian View““The economy has fallen and can’t get up.”The economy has fallen and can’t get up.”

Prices and wages are downwardly inflexibleActive government policy required to stabilize the economyHorizontal AS to Full-EmploymentUnstable AD [because of investment]G is needed to move the economy out of recessionrecession

Keynesian View

P1

Qf

Pri

ce L

evel

Real Domestic Output

AS

AD1

The The Equation of ExchangeEquation of Exchangeor Quantity Theory of Moneyor Quantity Theory of MoneyMV x PQMV x PQ was the cornerstonecornerstone of of Classical theoryClassical theory..

MM x x VV = = PP x x QQ 1. 1. VVelocity is stable. elocity is stable. 2. The amount of goods/services 2. The amount of goods/services that can bethat can be produced produced is is fixed in the short run. in the short run.3. If the 3. If the Fed increases the MS by 15%,Fed increases the MS by 15%, we will we will see a see a proportional 15% increase in prices.proportional 15% increase in prices.4. V 4. V andand Q aren’t Q aren’t in thein the equation equation & a& a change in MSchange in MS will result in a change in P. change in P.

$ spent $ received

LLet’s et’s TTake ake AA LookLook At At Milton Friedman’s License PlateMilton Friedman’s License Plate

M V = P YM V = P Y

The Keynesian - Monetarist DebateThe Keynesian -

Monetarist Debate

Keynesian ViewKeynesian View Monetarist ViewMonetarist View

Velocity is not stable or predictable. Velocity is not stable or predictable. So So an increase inan increase in M or V could M or V could increase P. increase P.

Thus, no monetary rule policy.Thus, no monetary rule policy.

MS needs to be adjusted.MS needs to be adjusted.

Velocity is stable and Velocity is stable and predictable.predictable.

The Fed cannot predict The Fed cannot predict short-run variations in V.short-run variations in V.

Adjustments to M will be Adjustments to M will be wrong and destabilizingwrong and destabilizing..

Fiscal PolicyFiscal PolicyFiscal PolicyFiscal Policy Monetary RuleMonetary RuleMonetary RuleMonetary Rule

MonetaristsMonetarists

FriedmanFriedman

Monetary RuleMonetary RuleMotto: ““IncreaseIncrease the the MS 3-5MS 3-5% % year”year”

MM X X VV = = PP X X QQ

3-53-5%%

Quantity theory of MoneyQuantity theory of Money

Equation of ExchangeEquation of Exchange

Robert Lucas Wins Nobel Prize in EconomicsRobert Lucas Wins Nobel Prize in EconomicsDr. Lucas’ teachings suggest thatconsumers and businesses will adjust their behavior and doom doom Fed policiesFed policies aimed at stimulating or cooling off the economy. Ex:Ex: If a government attempts to lower unemployment through expansionary monetary policy economic agents will anticipate the effects of the change of policy and raise their expectations of future inflation accordingly. This in turn will counteract the expansionary effect of the increased money supply. All that the government can do is raise the inflation rate, not employment.

The notion that G policies may prove self-defeating in a worldof RATEX gives rise to the idea of “policy impotence,”“policy impotence,” in whichthe G is seen as virtually powerlessG is seen as virtually powerless to effect long-term change. 8 University of Chicago profs have won the Nobel prize in economics.

RATIONAL EXPECTATIONS

Prize-Winning Foresight Prize-Winning Foresight by an Ex-Wifeby an Ex-WifeRobert LucasRobert Lucas, the Nobel prize winnerof $1.1 million dollars$1.1 million dollars, will have to splitsplithis money with his ex-wifehis money with his ex-wife, who sevensevenyears agoyears ago had her divorce lawyer insert a clause to cover just such a possibility.

The clauseclause in the settlement reads: “Wife shall receive 50% “Wife shall receive 50% of any Nobel Prize if it occurs within seven years.”of any Nobel Prize if it occurs within seven years.”Lucas said, “A deal is a deal. It’s hard to be unpleasant after “A deal is a deal. It’s hard to be unpleasant after a prize like that.” a prize like that.” Rita LucasRita Lucas had more than just foresightforesight; she had luckluck. If the announcement, which came on Oct. 10Oct. 10, had come after Oct. after Oct. 3131, she would have gotten nothinggotten nothing. 8 University of Chicago 8 University of Chicago professors have wonprofessors have won and he was the 55thth in the last 6 years in the last 6 years.

**Rita LucasRita Lucas knew who had won in the pastwon in the past and she was thinking thinking in a rational mannerin a rational manner on who she expected expected to winto win in the futurefuture.

Robert Lucas $1.1 Robert Lucas $1.1 millionmillion

MAINSTREAM ECONOMISTSMAINSTREAM ECONOMISTS [[New KeynesianNew Keynesian] – ] – Keynesian basedKeynesian based

• The economy is stable but potentially unstablestable but potentially unstable [supply shockssupply shocks or booms and busts impact investmentinvestment].

• Many prices/wages are inflexible downwardprices/wages are inflexible downward, particularly wages [contractscontracts and efficiency wagesefficiency wages].

• Velocity is unstableVelocity is unstable [directdirect with the interest rateinterest rate and iinnvveerrssee with the mmoonneey sy suuppppllyy]

• InflationInflation can be caused by excess MSexcess MS, but it may also be caused by “investment booms”“investment booms”, or “adverse supply shocks.”“adverse supply shocks.”

• The Fed targets the interest ratetargets the interest rate in the SRin the SR but monitors the monitors the MSMS in the LRin the LR.

CAUSES OF MACRO INSTABILITY

Ca + Ig + Xn + G = GDP

Equation of Exchange

M V = P Q (Nom. GDP)

Changes in InvestmentMainstream View (Keynesian)

Monetarist View (Classical)

Adverse Aggregate Supply Shocks

Stable Velocity

CAUSES OF MACRO INSTABILITY

Instability of Investment is the Main Cause of Output ChangesMonetary Policy is a Stabilizing Factor

Mainstream View (Keyensian)

Monetarist View (Classical)With a Stable Velocity, Nominal GDP Depends Upon the Money Supply

Summary

Mainstream View

Downward Wage InflexibilityEfficiency Wage Theory•Greater Work Effort•Lower Supervision Costs•Reduced Job Turnover

Insider-Outsider Theory and Relationships

DOES THE ECONOMY SELF-CORRECT?

RATIONALE FOR A MONETARY RULEFederal Reserve Increases Money Supply at the Long-Run Growth Rate of GDP

P1

Q1

Pri

ce L

evel

Real Domestic Output, GDP

AD1

Q2

ASLR1

Fed IncreasesThe Money

SupplyResulting in…

ASLR2

P2

RATIONALE FOR A MONETARY RULEFederal Reserve Increases Money Supply at the Long-Run Growth Rate of GDP

P1

Q1

Pri

ce L

evel

Real Domestic Output, GDP

ASLR2

AD2

AD1

Q2

ASLR1

GrowthWithout

Inflation orDeflation

P2

Next:

International Trade

Chapter 20