Transcript Chapter 12

Chapter 12
Macroeconomic ideas —
evolution and debates
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-1
Learning objectives
• Review the classical and Keynesian views
of the economy and then present them within
a simplified aggregate demand–aggregate
supply framework
• Examine the monetarist position, and its
emphasis on the money supply through
a development of the equation of exchange
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-2
Learning objectives (cont.)
• Briefly describe rational expectations theory
(RET) and its implications for policy makers
• Review supply-side economics and its implications
• Discuss the insights that these alternative
views have provided for us on the operation
of the macroeconomy
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-3
Classical employment theory
• Underspending in a capitalist economy
highly unlikely, and prices and wages adjust
very rapidly to ensure full employment at
all times
• Two basic assumptions of the classical theory
– Underspending is most unlikely to occur
– Prices and wages adjust to ensure that a decline
in spending would not result in a fall in real output,
employment and real incomes
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-4
Say’s law
• The foundation of the classical theory
is Say’s law
– The very act of producing goods generates
an amount of income exactly equal to the value
of the goods produced
– Production of output automatically generates
the incomes required to purchase this output,
i.e. supply creates its own demand
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-5
Problems with Say’s law
• Saving
– If households saved a given portion of their
income, supply would not create its own demand
– Saving would cause a deficiency of consumption,
resulting in unsold goods, unemployment and
falling income
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-6
Problems with Say’s law
• Saving, investment and the interest rate
– The money market will ensure that the interest
rate (the price of money) would adjust to bring
about equilibrium between saving and investment
– Interest rate will ensure that the leakage from
the income–expenditure stream will reappear
as investment dollars
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-7
I
S (saving)
Rate of interest (%)
Rate of interest (%)
Classical view of the money market
S
I
Increase
in saving
S’
r1
r
r2
I
Dollars saved and invested
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
Increase
in Investment
I
Dollars saved/invested
12-8
Classical employment theory
• Price–wage flexibility
– The assumption that all prices, including wages
and interest rates, are flexible and will rapidly
adjust to remove disequilibria
• Classical theory and laissez-faire
– The price system ensured that price–wage flexibility
and fluctuations in the interest rate were capable of
maintaining full employment
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-9
Keynesian economics
• The Great Depression of the 1930s
• Keynes and Keynesian economics
– Keynes (1936), General theory of employment,
interest and money
– The capitalist economy is inherently unstable
and likely to achieve equilibrium with considerable
unemployment or severe inflation, and the possibility
of persistent unemployment
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-10
Keynesian economics (cont.)
Unlinking of savings and investment plans
• Savers and investors are different groups
– Saving and investment decisions are made
by different groups of individuals
– Firms also save in the form undistributed profits
• Savers and investors are differently motivated
– Savings decisions are motivated by diverse
considerations
– Motivations for business investment are complex
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-11
Keynesian economics (cont.)
Money balances and banks
• Savings and investment plans can be at odds
and result in fluctuations in total output, income,
employment and the price level
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-12
Keynesian economics (cont.)
Discrediting price–wage flexibility
• The existence of price–wage flexibility
– Prices and wages are inflexible downwards
– It is doubtful that price–wage declines would
alleviate widespread unemployment
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-13
AD–AS in the classical theory
• Vertical aggregate supply curve
– Exclusively determines level of real domestic output
• Stable down-sloping aggregate demand
– Exclusively determines price level
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-14
Classical view of the macroeconomy
Price level
AS
P1
P2
AD1
AD2
Q1
Real domestic output
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-15
Keynesian view of AD–AS
• Horizontal aggregate supply curve
– SR prices and wages are downwardly inflexible
• Unstable aggregate demand
– Especially investment
– Demand management and stabilisation policies
by the government are required
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-16
Keynesian view of the macroeconomy
Price level
AS
P1
AD1
AD2
Q2
Q1
Real domestic output
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-17
Monetarism
• Built on classical foundations
– Assume price and wage flexibility
• Markets are competitive with a high degree
of macroeconomic stability
• Monetarist argue government policies interfere with
competition and promote downwards
price–wage inflexibility
– Minimum wages, pro-union legislation, rural price
supports, pro-business monopoly legislation etc.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-18
Monetarism (cont.)
• Economy is essentially stable
– Competitive markets cause adjustments to product
and resource price and not output and employment
• Government creates rigidities and weaknesses
in the market
– Government intervention must be avoided
 Inefficient, harmful to incentives and policy mistakes
that destabilise the economy
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-19
Keynesian aggregate expenditure
equation
• C + I + G + NX = GDP
• Aggregate spending by buyers equals total
value of goods and services bought
• Money plays a secondary role
• Lengthy transmission mechanism
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-20
Monetarist equation of exchange
• MV = PQ
Where M is the supply of money
V is the velocity of money
P is the price level
Q is the physical volume of goods and
services produced
• MV refers to actual spending!
(whereas C + I + G + NX refers to planned
expenditure)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-21
Monetarist equation of exchange
(cont.)
• Simple and direct transmission mechanism:
– Change in money supply causes a change in GDP
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-22
Velocity of money (V)
• The number of times per year the average dollar is spent
on final goods and services
• Monetarists: V is stable or on a steady long-term trend
– Why? Money is the primary medium of exchange
– Store-of-money function is inconsequential
– Over time transactions demand increases steadily
• Keynesians: V is unstable
– Why? Money is held for transactions and as assets
– No dependable relationship between M and V
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-23
The money supply and the level of GDP
1968–69 to 2004–05
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-24
The velocity of money and interest rate
1968–69 to 2004–05
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-25
Fiscal policy debate
• Monetarists
– Fiscal policy is weak due to crowding-out effects
– Funding deficits by selling securities crowds out
private investment
– Relatively inelastic demand-for-money curve
– Relatively elastic investment demand curve
– Argue for the use of monetary rules
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-26
Fiscal policy debate (cont.)
• Keynesians
– Crowding-out of investment is insubstantial
– Relatively elastic demand-for-money curve
– Relatively inelastic investment demand curve
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-27
Monetary mismanagement
•
According to monetarists, the two sources
of monetary mismanagement are:
1. Irregular time lags
2. Wrong target — interest rates vs money supply
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-28
Monetary rule
• According to monetarists, monetary authorities
should stabilise the rate of growth of the money
supply, not the interest rate
• Keynesians argue against this
– V is variable both secularly and cyclically
– A money rule could contribute to fluctuations
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-29
AD–AS analysis: Keynesians
vs monetarists
• Monetarists believe that the AS curve is
relatively steep
• Any change in AD through monetary policy
will have little impact on equilibrium real
GDP, but will result in large increases in
the price level
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-30
Monetarist AD–AS perspective
Price level
AS
P2
P1
AD2
AD1
GDP1 GDP2
Real domestic output
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-31
AD–AS analysis: Keynesians
vs monetarists
• Keynesians believe that the AS curve is
relatively flat
• Thus, changes in AD through fiscal or
monetary policy will have a larger impact
on equilibrium real GDP but only a small
impact on the price level
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-32
Price level
Keynesian AD–AS perspective
AS
P2
P1
AD2
AD1
GDP1 GDP2
Real domestic output
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-33
Rational expectations theory
(RET)
• Also known as new-classical economics
• Businesses, consumers and workers understand
the workings of the economy and use this
knowledge to assess the anticipated effects
of current economic policies upon the future
of the economy in order to further their own
self-interest
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-34
Rational expectations theory
(cont.)
• Theoretical underpinnings:
– Expectations about the future
– Assumes all markets are purely competitive
 Prices and wages are highly flexible
– Markets instantly adjust to new changes
– AS curve is vertical
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-35
RET and policy frustration
• Aggregated responses of the public will make
discretionary stabilisation policies ineffective
• Increases in AD will result in an offsetting
increase in the price level, leaving output
and employment unchanged
• Compared to traditional classical theory —
RET does not result in temporary lapses
from full-employment level of output
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-36
RET and the AD–AS model
Price level
AS
P2
b
P1
a
AD2
AD1
Q1
Real domestic output
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-37
Rational expectations theory
• Further consequences
– Pro-cyclical policy: businesses may come to expect
tax relief whenever a recession occurs and
postpone investment purchases
• Evaluation
• Behaviour
– Knowledge and understanding about the workings
of the economy may be overstated by RET
• Sticky prices
– Markets are not purely competitive
• Policy and stability
– Empirical evidence that economic policy does
affect GDP and employment
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-38
Supply-side economics
• Economic disturbance can be generated from
the supply side
• Change in aggregate supply is an active force
in determining the levels of inflation and
unemployment
• Stagflation of the 1970s and 1980s contributed
to by growth in public sector due to the growing
tax wedge between production costs and
product prices
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-39
Supply-side economics (cont.)
• Tax transfer disincentive
– Incentives to work
– Transfer disincentives
– Incentives to save and invest
• Resource misallocation
– Resources of large numbers of lawyers and
accountants discovering ways to avoid taxes,
could be more effectively used elsewhere
• Overregulation
– Government involvement in the economy has
adverse effects on productivity and costs
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
12-40