Transcript Chapter 13

Chapter 13
Macroeconomic Debates
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PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
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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.
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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.
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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 and
employment
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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
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Problems with Say’s Law
• Saving
– If households saved a given portion of their
income, supply would not create its own
demand
• 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
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I1
S (saving)
Rate of interest (%)
Rate of interest (%)
Classical View of the Money Market
I
S1
Increase
in saving
S2
r1
r
r2
I
Dollars saved and invested
I
Dollars saved/invested
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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
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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
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Keynesian Economics (cont.)
• Unlinking of savings and investment
plans
–
Savers and investors are different groups
–
Savers and investors are differently
motivated
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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
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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
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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
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Classical View of the Macroeconomy
Price Level
AS
P1
P2
AD1
AD2
Q1
Real Domestic Output
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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
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Keynesian View of the Macroeconomy
Price Level
AS
P1
AD1
AD2
Q2
Q1
Real Domestic Output
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Monetarism
• Built on Classical foundations
• Markets are competitive
–
government policies interfere with competition:
minimum wages, pro-union legislation, rural
price supports, pro-business monopoly
legislation, etc.
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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
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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
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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)
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Monetarist Equation of
Exchange (cont.)
• Simple and direct transmission
mechanism:
–
change in money supply causes a change in
GDP
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Velocity (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
–
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Velocity (cont.)
• Keynesians: V is unstable
–
Why? Money is held for transactions and as
assets
–
No dependable relationship between M and V
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The Money Supply and the Level
of GDP 1968–69 to 2001–02
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The Velocity of Money and
Interest Rate 1968–69 to 2001–02
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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
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Fiscal Policy Debate (cont.)
• Keynesians:
–
crowding-out of investment is insubstantial
–
relatively elastic demand-for-money curve
–
relatively inelastic investment demand curve
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Monetary Mismanagement
•
According to Monetarists, the
two sources of monetary
mismanagement are:
1.
Irregular time lags
2.
Wrong target: interest rates vs money supply
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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
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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
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Monetarist AD–AS Perspective
Price Level
AS
P2
P1
AD2
AD1
GDP1 GDP2
Real Domestic Output
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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
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Price Level
Keynesian AD–AS Perspective
AS
P2
P1
AD2
AD1
GDP1
GDP2
Real Domestic Output
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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
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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
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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
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RET and the AD–AS Model
Price Level
AS
P2
b
P1
a
AD2
AD1
Q1
Real Domestic Output
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Rational Expectations
Theory
• Further consequences:
–
Pro-cyclical policy: businesses may come to
expect tax relief whenever a recession occurs
and postpone investment purchases
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Rational Expectations
Theory (cont.)
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
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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
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Supply-Side Economics
(cont.)
• Tax transfer disincentive
–
Incentives to work
–
Transfer disincentives
–
Incentives to save and invest
• Resource misallocation
• Overregulation
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Next Chapter:
Inflation
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13-42