Chapter 15 Twentieth-Century Economic Theory Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved. 15-1

Chapter 15

Twentieth-Century Economic Theory

Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.15-1

Objectives

• The equation of exchange

• The quantity theory of money

• Classical economics

• Keynesian economics

• The monetarist school

• Supply-side economics

• The rational expectations theory

15-2Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Equation of Exchange

• Much of the Keynesian-Monetarist debate revolves around the quantity theory of money which itself is based on the equation of exchange– The equation of exchange and the quantity

theory of money are easy to confuse– Perhaps because the equation of exchange is

used to explain the quantity theory of money


The Equation of Exchange

• The equation of exchange is MV = PQ– M is the total dollars in the nation’s money

supply– V is the number of times per year each

dollar is spent [i.e., velocity]– P is the average price of all the goods and

services sold during the year– Q is the quantity of goods and services sold

during the year



The Equation of ExchangeM times V (MV) would be total spending. Total spending by a nation during a given year is GDP. Therefore,

MV = GDP

P times Q (PQ) is the total amount of money received by sellers of all final goods and services produced by a nation during a given year. This also is GDP. Therefore,

PQ = GDPThings equal to the same thing are equal to each other, therefore,

MV = PQ


The Equation of ExchangeThe following example will be in billions of dollars without the dollar signs

MV = PQ

900 X 9 = PQ

8,100 = PQ

8,100 = 81 X Q

8,100 = 81 X 100

8,100 = 8,100

The equation of exchange must always balance, as must all equations.

The Quantity Theory of Money

15-7

The Crude version of the Quantity Theory of Money

This version holds that when the money supply (M) changes by a certain percentage, the price level (P) changes by that same percentage

MV = PQ

900 X 9 = 81 X 100

1800 X 9 = 162 X 100

16,200 = 16,200

Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.


15-8

The Crude version of the Quantity Theory of Money

This version holds that when the money supply (M) changes by a certain percentage, the price level (P) changes by that same percentage

MV = PQ

900 X 9 = 81 X 100

1800 X 9 = 162 X 100

16,200 = 16,200

If V and Q remain constant, the crude version of the quantity theory of money is correct Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

A Closer Look at Q and V• Since 1950 V has risen fairly steadily from about

three to nearly seven• During recessions, production, and therefore Q

will fall– Q fell at an annual rate of about 4 percent during the

1981-82 recession

• During recoveries, production picks up, so we go from a declining Q to a rising Q

• Obviously, neither V or Q are constant• Therefore, the crude version of the quantity

theory of money is invalid


15-10


The sophisticated version of the “Quantity Theory of Money” assumes any short-term changes in V are either very small or predictable

But what happens next is entirely up to the level of production, Q


The Sophisticated Quantity Theory of Money

15-11

If we are well below full employment, an increase in M will lead mainly to an increase in Q

If we are close to or at full employment, an increase in M will lead mainly to an increase in P


National output (real GDP)

Full-employmentGDP

Hypothetical

Aggregate

Supply

Curve

Classical Economics

• The classical school of economics was mainstream from roughly 1775 to 1930

• The classical school has the following tenets– Say’s law is operating– Savings will be invested– Interest rate mechanism– Quantity theory of money

• Assume V and Q are constant

– Recessions cure themselves• Government can’t cure recessions


Keynesian Economics• The Keynesian school of economics was

mainstream from the early 1930s to about 1970


Keynesian Economics

• The Keynesian school has the following tenets– The problem with recessions is inadequate demand– The only hope is for the government to spend

enough money to raise aggregate demand sufficiently to get people back to work

• The government could print the money or borrow it• If enough (newly created money) was spent, the recession

would end

– No one would invest in new plant and equipment when much of their capacity was idle

– Wages and prices were not downwardly flexible because of institutional barriers

– If M rises, people may not spend the additional money, but just hold it

• So much for the quantity theory of money15-14


The Monetarist School

• The Importance of the Rate of Monetary Growth– Milton Friedman, an economist who did

exhaustive studies of the relationship between the rate of growth of the money supply concluded

• The United States has never had a serious inflation that was not accompanied by rapid monetary growth

• When the money supply has grown slowly, the country has had no inflation



• The Importance of the Rate of Monetary Growth

• Building on the quantity theory of money, the monetarists agree with the classicals that when the money supply grows, the price level rises, albeit not at exactly the same rate

• Recessions are caused when the Federal Reserve increases the money supply at less than the rate needed by business – say, anything less than 3 percent a year

• By and large the facts have borne out the monetarists’ analysis



• The Basic Propositions of Monetarism– The key to stable economic growth is a

constant rate of increase in the money supply– Expansionary monetary policy will only

temporarily depress interest rates– Expansionary monetary policy will only

temporarily reduce the unemployment rate – Expansionary fiscal policy will only

temporarily raise output and employment



• The Monetary Rule– Increase the money supply at a constant rate

• When there is a recession, this steady infusion of monetary growth will pick up the economy

• When there is inflation, a steady rate of monetary growth will slow it down

When the country has a steady diet of money, the economic health will be relatively good – if not always excellent - no very fat years and no very lean years



• The Decline of Monetarism– Monetarism’s popularity started to decline

in the late 1970s and early 1980s– The Fed’s policy on monetary growth, sky

high interest rates, combined with two recessions seemed to cause people to look elsewhere for their economic gurus


Supply-Side Economics• Supply-side economics came into vogue in the

early 1980s• Supply-siders mantra was to cut tax rates,

government spending, and government regulation

• The object of supply-siders is to raise aggregate supply

• Many of the undesirable effects of high marginal tax rates are the work effectwork effect, the the savings and investment effectsavings and investment effect, and the the elimination of productive market exchangeselimination of productive market exchanges


The Work Effect

• Facing high marginal tax rates, many people refuse to work more than a certain number of hours overtime or take on second jobs and other forms of extra work– Instead, they opt for more leisure time– Output is less when people work less– When people work less, their income is less


The Saving and Investment Effect

• High marginal tax rates on interest income will provide a disincentive to save, or at least to make savings available for investment purposes

• People who borrow money for investment purposes hope that this will lead to greater profits– But, if these profits are subject to a high

marginal tax rate, once again there is a disincentive to invest

• The economy will stagnate


The Elimination of Productive Market Exchanges

– A productive market exchange is when you work at what your are good at and hire someone who is working at what they are good at to do something for you

– There is a serious misallocation of labor (perhaps hundreds of millions of dollars) when the productive market exchange is eliminated because of high marginal tax rates

• It will pay you to work less at what you are good at to do another job that you are not so good at (you don’t hire some one is is better at it than you to do it)


The Laffer Curve


Tax revenue (in hundreds of $billions)

100

90

80

70

60

50

40

30

20

10

0

A

B

C

The rationale of the Laffer curve is that when marginal tax rates are too high, we can raise tax revenues by lowering them

Rational Expectation Theory

• Rational expectations theory is based on three assumptions– Individuals and firms learn through experience to

anticipate the consequences of changes in monetary and fiscal policy

– They act instantaneously to protect their economic interest

– All resource and product markets are purely competitive



• Rational expectations theorists say the government should do as little as possible

• Basically, then, the government should figure out the right policies to follow and stick to them

• The right policies are– Steady monetary growth of 3 to 4 percent a year

– A balanced budget



• Criticism of the rational expectations school– Is it reasonable to expect individuals and business

firms to accurately predict the consequences of macroeconomic policy?

– Our economic markets are not purely competitive: some are not competitive at all

– The rigidities imposed by contracts restrict adjustments to changing economic conditions


The Economic Behaviorists

• Economic behaviorists are a hot new group of young economists who are complete new- comers to the economic theory scene

• They maintain that while the mainstream beliefs that rational behavior and economic self-interest are important, they are not the only motivating factors

• Their goal is to apply a wider range of psychological concepts to economic theory


Conclusion• “Each of the major schools of economic

thought can be useful on occasion. The insights of Keynesian economics proved appropriate for Western societies attempting to get out of the depression in the 1930s. The tools of monetarism were powerfully effective in squeezing out the inflationary force of the 1970s. Supply-side economics played an important role in getting the public to understand the high cost of taxation and thus to support tax reform in the 1980s. But sensible public policy cannot long focus on any one objective or be limited to one policy approach”– Murray Weidenbaum


Documents

Chapter 15 Twentieth-Century Economic Theory Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved. 15-1