Transcript Bajada, Economic Principles 3e

Extension Chapter 6
The development of
macroeconomic debates
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Learning objectives
1. Review the classical and Keynesian views of the
economy and then present them within a
simplified aggregate demand–aggregate supply
framework.
2. Examine the monetarist position, and its emphasis
on the money supply through a development of
the equation of exchange.
3. Briefly describe rational expectations theory (RET)
and its implications for policy makers.
4. Review supply-side economics and its
implications.
5. 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 was highly
unlikely, and prices and wages adjust very rapidly
to ensure full employment at all times.
• Two basic assumptions of the classical theory are:
– 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.
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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: a complicating factor
– 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.
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Problems with Say’s law (cont.)
• 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.
– The interest rate will ensure that the leakage from the
income–expenditure stream will reappear as
investment dollars.
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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
Increase
in Investment
I
q q’
Dollars saved and invested
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
– 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.
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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.
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
Qf
Real gross 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
Qu
Qf
Real gross domestic output
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Monetarism
• Monetarism is built on classical foundations
– Assumes price and wage flexibility
• Markets are competitive with a high degree of
macroeconomic stability.
• Monetarists argue that government policies
interfere with competition and promote
downwards price-wage inflexibility.
– 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 prices 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.
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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.
• Involves a 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 of money (V)
• Defined as 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
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The money supply and the level of
GDP 1959–60 to 2009–10
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The velocity of money and interest
rate 1959–60 to 2009–10
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Fiscal policy debate
• The monetarists believe that:
– fiscal policy is weak due to crowding-out effects
– financing deficits by selling securities crowds out
private investment
– there is a relatively inelastic demand-for-money
curve
– there is a relatively elastic investment demand
curve
– they should argue for the use of monetary rules.
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Fiscal policy debate (cont.)
• Keynesians believe that:
– the crowding-out of investment is insubstantial
– there is a relatively elastic demand-for-money
curve
– there is a 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 cyclically and in the long run
– 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
AS
Price level
P2
P1
AD2
AD1
GDP1 GDP2
Real gross domestic output
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AD–AS analysis: Keynesians vs
monetarists (cont.)
• 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 gross 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 on the
future state of the economy in order to further
their own self-interest.
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Rational expectations theory
(cont.)
• Basic concepts:
– Expectations about the future trigger economic
decisions and therefore determine outcomes.
– 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
(cont.)
• 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
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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
the growth in the 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
– 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.
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