Transcript Chapter 18 Alternate Macro Theories

Chapter 18
Debates in Macroeconomics:
Monetarism, and Supply-Side
Economics
Keynesian Economics
• In a broad sense, Keynesian
economics is the foundation of modern
macroeconomics.
• In a narrower sense, Keynesian refers
to economists who advocate active
government intervention in the
economy. (“Activist” or “Activist Policy”)
• An old debate in Macro - between
Keynesians and monetarists.
Keynesian Economics
• Keynesians favor government
intervention
• Monetarist argue against.
Monetarism
• The monetarist analysis of the economy
places emphasis on the velocity of money, or
the number of times a dollar bill changes
hands, on average, during a year; the ratio of
nominal GDP to the stock of money (M):
GDP
V
M
or V 
P Y
M
since
then,
GDP  P  Y
M V  P Y
The Quantity Theory of Money
• The quantity theory of money is a theory based
on the identity M  V  P  Y , which assumes
that the velocity of money (V) is constant. Then,
the theory can be written as the following equality:
M V  P Y
• Rewrite As
• M = (1 / V) x ( P x Y), a demand for money
equation: Md = (1 / V) x ( P x Y).
• If V is constant, the demand for money depends on
nominal income, but NOT the interest rate.
The Quantity Theory of Money
• %ΔM+%Δ V=%Δ P+%Δ Y
• If velocity is constant , a 10 %
increase in the money supply causes
a 10 % increase in nominal income.
• Money Matters
• If at full employment , a 10 %
increase in the money supply causes
a 10 % increase in the price level.
The Quantity Theory of Money
• %ΔM+%Δ V=%Δ P+%Δ Y
• If: % Δ V = 1%, % Δ Y = 3% and % Δ M = 5%
% Δ P = 3%.
In general: % Δ P = % Δ M + % Δ V - % Δ Y
If Δ V = 0: % Δ P = % Δ M - % Δ Y
Testing the Quantity Theory of Money
• The demand for money may depend
not only on nominal income, but also
on the interest rate.
Testing the Quantity Theory of Money
Substitutes for M1
introduced in the 1970’s
 FIGURE 18.1 The Velocity of Money, 1960 I–2010 I
Velocity has not been constant over the period from 1960 to 2012.
There was a long-term positive trend, which has now reversed.
© 2014 Pearson Education, Inc.
9 of 21
© 2014 Pearson Education, Inc.
10 of 21
Factors Affecting Velocity
• Introduction of Money market
accounts
• Interest rate
• As r => Md => V 
• As Y => r => Md => V 
• V is pro-cyclical
Inflation as a Purely
Monetary Phenomenon
• Inflation is always a monetary
phenomenon. If the money supply
does not change, the price level will
not change.
• The view that changes in the money
supply affect only the price level,
without a change in the level of
output, is called the “strict
monetarist” view.
Inflation as a Purely
Monetary Phenomenon
• The “strict monetarist” view is not
compatible with a nonvertical AS
curve.
• Almost all economists agree that
sustained inflation is purely a
monetary phenomenon.
• Inflation cannot continue indefinitely
without increases in the money
supply.
Money and Inflation
Money and Inflation
• An increase in G with
the money supply
constant shifts the AD
curve from AD0 to
AD1. This leads to an
increase in the interest
rate and crowding out
of planned investment.
Money and Inflation
• If the Fed tries to prevent
crowding, it will increase
the money supply and
the AD curve will shift
farther and farther to the
right to AD2 and AD 3.
The result is a sustained
inflation, perhaps
hyperinflation.
The Keynesian/Monetarist Debate
• Milton Friedman has been the
leading spokesman for monetarism
over the last few decades.
• Most monetarists argue that inflation
in the United States could have been
avoided if only the Fed had not
expanded the money supply so
rapidly.
The Keynesian/Monetarist Debate
• %ΔM+%Δ V=%Δ P+%Δ Y
• With constant velocity:% Δ P = % Δ M - % ΔY
• Policy for zero inflation: % Δ M = (%) ΔY
• Most monetarists do not advocate an activist
monetary stabilization policy - expanding the
money supply during bad times and slowing
its growth during good times.
The Keynesian/Monetarist Debate
• Time lags are the most common
argument against such
management.
• Monetarists advocate a policy of
steady and slow money growth, at a
rate equal to the average growth of
real output (Y).
The Keynesian/Monetarist Debate
• Many Keynesians advocate the
application of coordinated monetary
and fiscal policy tools to reduce
instability in the economy—to fight
inflation and unemployment.
• Skip to Topic: Supply Side
Economics
The Keynesian/Monetarist Debate
• The debate between Keynesians and monetarists was the central
controversy in macroeconomics in the 1960s.
• Monetarists were skeptical of the Fed’s ability to “manage” the
economy—to expand the money supply during bad times and
contract it during good times.
• The leading spokesman for monetarism, Milton Friedman, advocated
a policy of steady and slow money growth—specifically, that the
money supply should grow at a rate equal to the average growth of
real output (income) (Y).
• While not all Keynesians advocated an activist federal government,
many advocated the application of coordinated monetary and fiscal
policy tools to reduce instability in the economy—to fight inflation and
unemployment.
© 2014 Pearson Education, Inc.
21 of 21
Supply-Side Economics
• The theories we have discussed are “demand-oriented.” Supply-side
economics, as the name suggests, focuses on the supply side.
• In the late 1970s and early 1980s, supply-siders argued that the real
problem with the economy was not demand, but high rates of taxation and
heavy regulation that reduced the incentive to work, to save, and to invest.
What was needed was not a demand stimulus, but better incentives to
stimulate supply. (reduce government interference in the economy)
• At their most extreme, supply-siders argued that the incentive effects of
supply-side policies were likely to be so great that a major cut in tax rates
would actually increase tax revenues.
• Even though tax rates would be lower, more people would be working and
earning income and firms would earn more profits, so that the increases in
the tax base (profits, sales, and income) would then outweigh the decreases
in rates, resulting in increased government revenues.
© 2014 Pearson Education, Inc.
22 of 21
The Laffer Curve
 FIGURE 18.2 The Laffer Curve
The Laffer curve shows
that the amount of revenue
the government collects is
a function of the tax rate.
It shows that when tax
rates are very high, an
increase in the tax rate
could cause tax revenues
to fall.
Similarly, under the same
circumstances, a cut in the
tax rate could generate
enough additional
economic activity to cause
revenues to rise.
Laffer curve With the tax rate measured on the vertical axis and tax revenue
measured on the horizontal axis, the Laffer curve shows that there is some tax
rate beyond which the supply response is large enough to lead to a decrease in
tax revenue for further increases in the tax rate.
© 2014 Pearson Education, Inc.
23 of 21
Evaluating Supply-Side Economics
• Among the criticisms of supply-side economics is that it is unlikely a tax cut
would substantially increase the supply of labor.
• In theory, a tax cut could even lead to a reduction in labor supply – hang out
at the pool.
• Research done during the 1980s suggests that tax cuts seem to increase
the supply of labor somewhat but that the increases are very modest.
• Traditional theory suggests that a huge tax cut will lead to an increase in
disposable income and, in turn, an increase in consumption spending (a
component of aggregate expenditure).
• Although an increase in planned investment (brought about by a lower
interest rate) leads to added productive capacity and added supply in the
long run, it also increases expenditures on capital goods (new plant and
equipment investment) in the short run.
© 2014 Pearson Education, Inc.
24 of 21
New Classical Macroeconomics
• On the theoretical level, new
classical macroeconomists argue
that traditional models have
assumed that expectations are
formed in naive ways.
• Naive expectations are inconsistent
with the assumptions of
microeconomics. If people are out to
maximize utility and profits, they
should form their expectations in a
smarter way.
New Classical Macroeconomics
• On the empirical level, new classical
theories were an attempt to explain
the apparent breakdown in the
1970s of the simple inflationunemployment trade-off predicted by
the Phillips Curve. We did this!
Rational Expectations
• People are said to have rational
expectations if they use “all available
information” in forming their
expectations.
Rational Expectations
and Market Clearing
• When expectations are rational,
disequilibrium exists only temporarily
as a result of random, unpredictable
shocks.
• On average, all markets clear and
there is full employment. There is no
need for government stabilization.
Evaluating
Rational-Expectations Theory
• If expectations are not rational, there
are likely to be unexploited profit
opportunities—most economists
believe such opportunities are rare
and short-lived.
Evaluating
Rational-Expectations Theory
• The argument against rational
expectations is that it required
households and firms to know too
much. People must know the true
model, or at least a good
approximation of it, and this is a lot
to expect.