Transcript The Economic Theories all in one

Keynes v. Hayek-The Battle of Ideas
http://econstories.tv/fight-of-the-century/
Keynesian Theory
• John Maynard Keynes: father of
Macroeconomics
• Developed consensus that the
government should be proactive and
manage the economy
• Created fiscal policy ideas to combat
unemployment and inflation.
What he advocated.
I: John M. Keynes is best known for advocating
a. a policy of annually balancing the budget.
b. deficit spending during some recessions.
c. the fixed-growth-rate monetary rule.
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Answer: deficit spending during recessions.
He believed demand drives the economy
“Animal spirits”
Fiscal policy is more effective than monetary
policy
Before Keynes
• Classical economists –during the 1700’s
and early 1800’s – Adam Smith, David
Riccardo, Jean Baptiste Say, and Frederic
Bastiat believed in no government
involvement, laissez-faire, private property
is absolute-let the free market rein.
• Microeconomics was the study.
What about the curve?
In the classical model- the short run
curve is vertical- meaning prices and
wages are flexible – no need for outside
intervention
Say’s Law
• Classical economist who stated that
supply creates its own demand
Hayek and the Austrian School
• Austrian school of Economics was founded in 1871 by
Carl Menger- created the law of diminishing marginal
utility.
• Ludwig von Mises continued school of though
• Frederick von Hayek-pupil of Mises and rival of Keynes
during the 20th century
• Austrians Believe in unfettered markets
• Price is driven by consumer preference not the supply
and demand( Classical) or the cost of production
(Keynes)
• Private property is absolute-competition works
• No government intervention period• Do not agree with Federal Reserve and monetary policy
Ludwig von Mises
Monetarism and New Classical
• Two major schools decidedly against
government intervention have developed:
monetarism and new classical economics.
• Hayek’s free market ideas begin to
resurface in the 1970’s when the US,
Europe and Great Britain suffered from
stagflation.
Monetarism
• The main message of monetarists is that
money matters.
• Monetarism, however, is usually
considered to go beyond the notion that
money matters.
• 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):
The Quantity Theory of Money
• The quantity theory of money is a 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). Then, the theory can
be written as the following equality:
• If there is equilibrium in the money market, then the
quantity of money supplied is equal to the quantity of
money demanded. When M is taken to be the quantity
of money demanded, this equality would make the
quantity of money demanded dependent on nominal
GDP, but not the interest rate.
• The demand for money may depend not only on nominal
income, but also on the interest rate.
• Whether velocity is constant or not may depend partly on
how we measure the money supply.
The monetarist view of inflation
• 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.
• They want a stable money supply
• But not active monetary policy-some but not a
lot.
Milton Friedman
• Father of monetarism
• Chicago school of Economics
• Came out of the rise of socialism in the wake of
WWII and differed slightly from New
Classical/Hayek/Austrian School
• Majority of monetarists argue that inflation in the
United States during the 1970’s could have been
avoided if only the Fed had not expanded the
money supply so rapidly.
• Advocate for minimal govt. interventionderegulation.
What about the curve?
• The “strict monetarist” view is not
compatible with a nonvertical AS curve.
• Most all economists agree that sustained
inflation is purely a monetary
phenomenon.
• Inflation cannot continue indefinitely
without increases in the money supply.
Stable money leads to stable
prices
• Monetarist believe in the Fed doing
minimal policy making.
• Monetary policy is more effective than
fiscal policy
• Competition is best to keep prices stable
• Too much money in circulation will lead to
inflation.
Last point
• Monetarists believe in a policy of steady
and slow money growth, at a rate equal to
the average growth of real output (Y).
New Classical Macroeconomics
• New classical macroeconomists argue that traditional
models have assumed that expectations are formed in
simple ways.
• People base their expectations on what they see and
feel.
• On the empirical level, 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.
Rational Expectations
• The rational-expectations hypothesis assumes people
know the “true model” of the economy and that they use
this model to form their expectations of the future.
• By “true” model we mean a model that is on average
correct in forecasting inflation.
• Developed by John F. Muth in the sixties.
• The theory holds that people have rational expectations
if they have use all of the available information and
knowledge to make decisions and form their
expectations.
Firms and the theory
• If firms have rational expectations, on
average, prices and wages will be set at
levels that ensure equilibrium in the goods
and labor markets. In other words, on
average, there will be no unemployment.
• The market clears and finds equilibrium
• There is no need for government
stabilization or intervention.
What is the real business cycle
theory?
• The real business cycle theory is an
attempt to explain business cycle
fluctuations under assumptions of
complete price and wage flexibility and
rational expectations. It emphasizes
shocks to technology and other shocks.
Supply Side Economics
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Macro theory consists of demand-oriented theories that
failed to explain the stagflation of the 1970s.
• Reagonomics- Coined term b/c Reagan and Thatcher
adopted many of the ideas.
• Thatcher and Reagan used Hayek’s and Friedman’s
ideas.
• 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.
Supply Side Economics
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Supply-side policies: Government policies that promote economic growth by limiting
government involvement .
Based on Say’s Law: Supply creates demand.
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Measures undertaken by the government aimed at increasing the level of aggregate supply in a
nation, and thereby meant to promote long-run economic growth
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Examples include:
Lower tax rates on income and businesses
No need for minimum wage- eliminate price controls
Limit power of labor unions.
Reduce unemployment benefits and give incentives to work
Deregulate
Free Trade
Investments in human and physical capital
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Supply side polices increase productivity, reduce cost to production so that companies re invest
and hire more workers, pay more to keep workers, and that drives the market.
The Laffer Curve
• 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.
The Laffer Curve
Criticisms of Supply Side
• 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 aftertax wage, they might have an incentive to
work more, but they may also choose to
work less.