Transcript Principles of Macroeconomics, Case/Fair/Oster, 10e

PRINCIPLES OF
MACROECONOMICS
PART IV Further Macroeconomics Issues
TENTH EDITION
CASE FAIR OSTER
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Prepared by: Fernando Quijano & Shelly
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PART IV Further Macroeconomics Issues
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Alternative Views in
Macroeconomics
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CHAPTER OUTLINE
Keynesian Economics
Monetarism
The Velocity of Money
The Quantity Theory of Money
Inflation as a Purely Monetary Phenomenon
The Keynesian/Monetarist Debate
PART IV Further Macroeconomics Issues
Supply-Side Economics
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The Laffer Curve
Evaluating Supply-Side Economics
New Classical Macroeconomics
The Development of New Classical Macroeconomics
Rational Expectations
Real Business Cycle Theory and New Keynesian Economics
Evaluating the Rational Expectations Assumption
Testing Alternative Macroeconomic Models
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Keynesian Economics
In one sense, Keynesian economics is the foundation of all of macroeconomics.
Now used more narrowly, Keynesian sometimes refers to economists who
advocate active government intervention in the macroeconomy.
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We begin with an old debate—that between Keynesians and monetarists.
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Monetarism
The debate between monetarist and Keynesian economics is complicated
because it means different things to different people.
If we consider the main monetarist message to be that “money matters,” then
almost all economists would agree.
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Monetarism, however, is usually considered to go beyond the notion that
money matters.
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Monetarism
The Velocity of Money
velocity of money The number of times a dollar
bill changes hands, on average, during a year;
the ratio of nominal GDP to the stock of money.
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The income velocity of money (V) is the ratio of nominal GDP to the
stock of money (M):
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V
GDP
M
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Monetarism
The Velocity of Money
We can expand this definition slightly by noting that nominal income
(GDP) is equal to real output (income) (Y) times the overall price level (P):
GDP  P  Y
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Through substitution:
P Y
V
M
or
M V  P  Y
quantity theory of money The theory based on the identity M × V ≡ P × Y and
the assumption that the velocity of money (V) is constant (or virtually constant).
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Monetarism
The Quantity Theory of Money
The key assumption of the quantity theory of money is that the
velocity of money is constant (or virtually constant) over time. If we
let V denote the constant value of V, the equation for the quantity
theory can be written as follows:
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M V  P  Y
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Monetarism
The Quantity Theory of Money
PART IV Further Macroeconomics Issues
Testing the Quantity Theory of Money
 FIGURE 18.1 The Velocity of Money, 1960 I–2010 I
Velocity has not been constant over the period from 1960 to 2010.
There is a long-term trend—velocity has been rising.
There are also fluctuations, some of them quite large.
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Monetarism
Inflation as a Purely Monetary Phenomenon
In the “strict monetarist” view, changes in M affect only P and not Y, so
inflation (an increase in P) is always a purely monetary phenomenon.
The price level will not change if the money supply does not change.
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There is considerable disagreement as to whether the strict monetarist
view is a good approximation of reality.
Almost all economists agree, however, that sustained inflation—
inflation that continues over many periods—is a purely monetary
phenomenon.
Inflation cannot continue indefinitely without increases in the money
supply.
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Monetarism
The Keynesian/Monetarist Debate
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.
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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.
The debate between Keynesians and monetarists subsided with the
advent of what we will call “new classical macroeconomics.”
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Supply-Side Economics
The theories we have been discussing 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.
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At their most extreme, supply-siders argued that the incentive effects of supplyside 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 bases (profits, sales, and income) would then outweigh the decreases in
rates, resulting in increased government revenues.
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Supply-Side Economics
The Laffer Curve
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 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.
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Supply-Side Economics
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.
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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.
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New Classical Macroeconomics
The challenge to Keynesian and related theories has come from a school
sometimes referred to as the new classical macroeconomics.
No two new classical macroeconomists think exactly alike, and no single model
completely represents this school.
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The Development of New Classical Macroeconomics
Keynes recognized that expectations (in the form of “animal spirits”) play a
big part in economic behavior. The problem is that traditional models
assume that expectations are formed in naive ways, which is inconsistent
with the assumptions of microeconomics.
If, as microeconomic theory assumes, people are out to maximize their
satisfaction and firms are out to maximize their profits, they should form their
expectations in a smarter way.
In this view, forward-looking, rational people compose households and firms.
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New Classical Macroeconomics
Rational Expectations
rational-expectations hypothesis The hypothesis that
people know the “true model” of the economy and that they
use this model to form their expectations of the future.
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Rational Expectations and Market Clearing
If firms have rational expectations and if they set prices and
wages on this basis, disequilibrium in any market is only
temporary.
In this world, all markets clear (on average) and there is full
employment thus no need for government stabilization
policies.
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EC ON OMIC S IN PRACTICE
How Are Expectations Formed?
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A current debate among
macroeconomists and policy
makers is how people form
expectations about the future state
of the economy.
In 2010, a number of economists
began to worry about the possibility
of inflationary expectations heating
up in the United States in the next
few years because of the large
federal government deficit.
Do expectations reflect an accurate understanding of how the economy works
or are they formed in simpler, more mechanical ways?
A study in England suggests a less sophisticated process, finding British
consumers more influenced by their own experience than by actual
government numbers and mostly expecting the future to look the way they
perceive the past to have looked.
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New Classical Macroeconomics
Rational Expectations
The Lucas Supply Function
Lucas supply function The supply function embodies the
idea that output (Y) depends on the difference between the
actual price level and the expected price level.
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Y  f (P  Pe )
price surprise Actual price level minus expected price level.
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New Classical Macroeconomics
Rational Expectations
Policy Implications of the Lucas Supply Function
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The Lucas supply function in combination with the
assumption that expectations are rational implies that
anticipated policy changes have no effect on real output.
The general conclusion is that any announced policy
change—in fiscal policy or any other policy—has no effect on
real output because the policy change affects both actual and
expected price levels in the same way.
Rational-expectations theory combined with the Lucas supply
function proposes a very small role for government policy in
the economy.
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New Classical Macroeconomics
Real Business Cycle Theory and New Keynesian Economics
real business cycle theory An attempt to explain
business cycle fluctuations under the assumptions of
complete price and wage flexibility and rational expectations.
It emphasizes shocks to technology and other shocks.
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new Keynesian economics A field in which models are
developed under the assumptions of rational expectations
and sticky prices and wages.
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New Classical Macroeconomics
Evaluating the Rational Expectations Assumption
When expectations are not rational, there are likely to be unexploited
profit opportunities, and most economists believe such opportunities are
rare and short-lived.
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The argument against rational expectations is that it requires
households and firms to know too much while the gain from learning the
true model (or a good approximation of it) may not be worth the cost.
Although the assumption that expectations are rational seems
consistent with the satisfaction-maximizing and profit-maximizing
postulates of microeconomics, such an assumption is more extreme
and demanding because it requires more information on the part of
households and firms.
In the final analysis, the issue is empirical.
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Testing Alternative Macroeconomic Models
Macroeconomists cannot test their models against one another to see which
performs best because:
 Macroeconomic models differ in ways that are hard to standardize.
 The rational expectations hypothesis assumes (1) that expectations are
formed rationally and (2) that the model being used is the true one.
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 The small amount of data available leaves considerable room for
disagreement, a range needing more time to narrow.
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REVIEW TERMS AND CONCEPTS
Laffer curve
Lucas supply function
new Keynesian economics
price surprise
quantity theory of money
rational expectations hypothesis
real business cycle theory
PART IV Further Macroeconomics Issues
velocity of money
GDP
V
M
M V  P  Y
M V  P  Y
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