Transcript CHAPTER 19: Debates in Macroeconomics: Monetarism, New

Chapter
19
Debates in Macroeconomics:
Monetarism, New Classical
Theory, and Supply-Side
Economics
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
Debates in Macroeconomics:
Monetarism, New Classical Theory,
and Supply-Side Economics
19
Chapter Outline
Keynesian Economics
Monetarism
The Velocity of Money
The Quantity Theory of Money
Inflation as a Purely Monetary
Phenomenon
The Keynesian/Monetarist Debate
New Classical Macroeconomics
The Development of New Classical
Macroeconomics
Rational Expectations
Evaluating Rational-Expectations
Theory
Real Business Cycle Theory
Supply-Side Economics
Evaluating Supply-Side Economics
Testing Alternative Macroeconomic
Models
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, 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.
Two major schools decidedly against
government intervention developed:
monetarism and new classical economics.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
MONETARISM
The main message of monetarists is that
money matters.
Monetarism, however, is usually considered to
go beyond the notion that money matters.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
In the model of aggregate supply and aggregate
demand, money matters because:
a. Changes in the money supply affect the AD
curve.
b. Changes in the money supply shifts affect the AS
curve in the short run.
c. Changes in the money supply shifts affect the AS
curve in the long run.
d. All of the above.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
In the model of aggregate supply and aggregate
demand, money matters because:
a. Changes in the money supply affect the AD
curve.
b. Changes in the money supply shifts affect the AS
curve in the short run.
c. Changes in the money supply shifts affect the AS
curve in the long run.
d. All of the above.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
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.
The income velocity of money (V) is the ratio of
nominal GDP to the stock of money (M):
GDP
V
M
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
MONETARISM
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 x Y
Through substitution:
P xY
V
M
or
M xV  P xY
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
MONETARISM
quantity theory of money The theory
based on the identity M x V  P x Y and
the assumption that the velocity of
money (V) is constant (or virtually
constant).
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
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:
M xV  P xY
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
MONETARISM
Testing the Quantity Theory of Money
FIGURE 19.1 The Velocity of Money, 1960 I–2005 II
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
MONETARISM
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.
Almost all economists agree that sustained
inflation is purely a monetary phenomenon.
Inflation cannot continue indefinitely without increases in the money supply.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
The “strict monetarist” view states that:
a. Changes in aggregate demand cause an
increase in both aggregate income and the price
level.
b. Inflation is a real phenomenon, not a purely
monetary phenomenon.
c. Changes in the money supply affect only the price
level (P), not real output (Y).
d. Since velocity is constant, a change in M affects
both P and Y.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
The “strict monetarist” view states that:
a. Changes in aggregate demand cause an
increase in both aggregate income and the price
level.
b. Inflation is a real phenomenon, not a purely
monetary phenomenon.
c. Changes in the money supply affect only the
price level (P), not real output (Y).
d. Since velocity is constant, a change in M affects
both P and Y.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
MONETARISM
THE KEYNESIAN/MONETARIST DEBATE
Milton Friedman has been the leading
spokesman for monetarism over the last few
decades.
Most monetarists do not advocate an activist
monetary policy stabilization.
Monetarists advocate a policy of steady and
slow money growth, at a rate equal to the
average growth of real output (Y).
Keynesianism and monetarism are at odds with
each other.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
NEW CLASSICAL MACROECONOMICS
The challenge to Keynesian and related
theories has come from a school sometimes
referred to as the new classical
macroeconomics. Like monetarism and
Keynesianism, this term is vague. No two new
classical macroeconomists think exactly alike,
and no single model completely represents this
school.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
Most monetarists, including Milton Friedman, blame
most of the instability in the economy on:
a. The volatility of investment spending.
b. Changes in aggregate demand.
c. Changes in aggregate supply.
d. The federal government.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
Most monetarists, including Milton Friedman, blame
most of the instability in the economy on:
a. The volatility of investment spending.
b. Changes in aggregate demand.
c. Changes in aggregate supply.
d. The federal government.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
NEW CLASSICAL MACROECONOMICS
THE DEVELOPMENT OF 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 theories were an attempt to explain the
apparent breakdown in the 1970s of the simple
inflation-unemployment trade-off predicted by the
Phillips Curve.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
Which of the following events helped motivate the
formulation of new classical economics?
a. The Great Depression.
b. The mercantilist revolution and the birth of laissez
faire.
c. The stagflation of the 1970s.
d. The turnaround from federal budget deficits to
surpluses during the Clinton administration.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
Which of the following events helped motivate the
formulation of new classical economics?
a. The Great Depression.
b. The mercantilist revolution and the birth of laissez
faire.
c. The stagflation of the 1970s.
d. The turnaround from federal budget deficits to
surpluses during the Clinton administration.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
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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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
NEW CLASSICAL MACROECONOMICS
Even though uncertainty exists, if you
know the “model” generating the
uncertainty, it is possible to have
expectations about the future that are
“on average” correct. You do not
know whether a random coin toss will
come up heads or tails. You do know
that if you toss a fair coin 100 times, it
will come up heads about 50 times.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
NEW CLASSICAL MACROECONOMICS
Rational Expectations and Market Clearing
If firms have rational expectations and if they
set prices and wages on this basis, then, on
average, prices and wages will be set at
levels that ensure equilibrium in the goods
and labor markets.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
When expectations are rational, which of the following
stabilization policies is more desirable?
a. Fiscal policy tools as the preferred means of
stabilization.
b. Monetary policy tools as the preferred means of
stabilization.
c. Intervention only when unpredictable shocks
affect the economy.
d. No need for government stabilization policies of
any kind.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
When expectations are rational, which of the following
stabilization policies is more desirable?
a. Fiscal policy tools as the preferred means of
stabilization.
b. Monetary policy tools as the preferred means of
stabilization.
c. Intervention only when unpredictable shocks
affect the economy.
d. No need for government stabilization policies
of any kind.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
NEW CLASSICAL MACROECONOMICS
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.
Y  f (P  Pe )
price surprise Actual price level minus
expected price level.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
NEW CLASSICAL MACROECONOMICS
Policy Implications of the Lucas Supply
Function
Rational-expectations theory combined with
the Lucas supply function proposes a very
small role for government policy in the
economy.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
To derive his supply function, Lucas starts with the
idea that:
a. People and firms are specialists in production but
generalists in consumption.
b. People and firms are specialists in consumption
but generalists in production.
c People are generalists in both consumption and
production.
d Firms are specialists in production, and
households are specialists in consumption.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
To derive his supply function, Lucas starts with the
idea that:
a. People and firms are specialists in production
but generalists in consumption.
b. People and firms are specialists in consumption
but generalists in production.
c People are generalists in both consumption and
production.
d Firms are specialists in production, and
households are specialists in consumption.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
NEW CLASSICAL MACROECONOMICS
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.
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
the true model) to form rational expectations,
and this knowledge is a lot to expect.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
NEW CLASSICAL MACROECONOMICS
REAL BUSINESS CYCLE THEORY
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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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
In the context of the AS/AD model, if prices and
wages are perfectly flexible, then:
a. The AS curve is vertical in the long run but not in
the short run.
b. Events that shift the AD curve have a strong
impact on real output.
c. The AS curve is vertical, even in the short run.
d. Nominal wages are always ahead of real wages.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
In the context of the AS/AD model, if prices and
wages are perfectly flexible, then:
a. The AS curve is vertical in the long run but not in
the short run.
b. Events that shift the AD curve have a strong
impact on real output.
c. The AS curve is vertical, even in the short run.
d. Nominal wages are always ahead of real wages.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
SUPPLY-SIDE ECONOMICS
Orthodox macro theory consists of demandoriented theories that failed to explain the
stagflation of the 1970s.
Supply-side economists believe that the real
problem was that high rates of taxation and
heavy regulation had 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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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
SUPPLY-SIDE ECONOMICS
The Laffer Curve
FIGURE 19.2 The Laffer Curve
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
Refer to the figure below. At which point should tax
rates be cut?
a.
b.
c.
d.
At point A.
At point B.
At both points A and B.
At neither point A nor B.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
Refer to the figure below. At which point should tax
rates be cut?
a.
b.
c.
d.
At point A.
At point B.
At both points A and B.
At neither point A nor B.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
SUPPLY-SIDE ECONOMICS
Laffer Curve With the tax rate
measured on the vertical axis and tax
revenue measured on the horizontal
axis, the Laffer Curve shows 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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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
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.
When households receive a higher after-tax
wage, they might have an incentive to work
more, but they may also choose to work less.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
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TESTING ALTERNATIVE MACROECONOMIC
MODELS
Models differ in ways that are hard to
standardize.
If people have rational expectations, they are
using the true model, but there is no way to
know what model is in fact the true one.
There is only a small amount of data
available to test macroeconomic
hypotheses—only eight business cycles
since 1950.
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CHAPTER 19: Debates in Macroeconomics: Monetarism, New
Classical Theory, and Supply-Side Economics
REVIEW TERMS AND CONCEPTS
Laffer Curve
Lucas supply function
price surprise
quantity theory of money
rational-expectations
hypothesis
real business cycle theory
velocity of money (V)
GDP
V
M
M xV  P xY
M xV  P xY
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