Transcript Chapter 15 - McGraw Hill Higher Education

A Century of
Economic Theory
Chapter 15
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
 After this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
9.
Discuss the equation of exchange.
Explain the quantity theory of money.
Analyze classical economics.
Analyze Keynesian economics.
Apply the policy prescription of the monetarist school.
Describe supply-side economics.
Judge the rational expectations theory.
Apply behavioral economics.
Assess the use of conventional macropolicy to fight
recessions and inflation.
15-2
Why Do Economists Disagree?

Policy debates derive from different theories, either consciously
or implicitly.
•

John Maynard Keynes: “Practical men, who believe themselves to
be quite exempt from any intellectual influence, are usually slaves
of some defunct economist.”
Why are there different economic theories?
•
Different assumptions about human behavior and motivations
(e.g., how rational are we?)
• Different assumptions about the behavior of economic variables
(e.g., velocity of money)
• Focus on short run versus long run (e.g., shape of Aggregate
Supply curve)
• Different goals (e.g., fighting unemployment or inflation)
15-3
Five Schools of Macroeconomic Theory
1.
2.
3.
4.
5.


Classical economics (1776-1930)
Keynesian economics (1930s - present)
Monetarist school (1960s - present)
Supply-side economics (1970s – present)
Rational expectations theory 1990s – present)
Only Keynesian economics argues for active
macroeconomic policy.
All of the others are variations on “laissez-faire,” small
government approach.
15-4
Keynesian-Monetarist Debate

Since the mid-20th century, the two major macroeconomic
policy schools have dominated policy debates: Keynesianism
and Monetarism.

Keynesian-Monetarist debate revolves around the quantity
theory of money which itself is based on the equation of
exchange.
•
The equation of exchange and the quantity theory of money are
easy to confuse.
• The equation of exchange is used to explain the quantity theory of
money.
15-5
The Equation of Exchange





The equation of exchange is MV = PQ.
M is the total dollars in the nation’s money supply.
V is the number of times per year each dollar is spent [i.e.,
velocity of money].
P is the average price of all the goods and services sold during
the year.
Q is the quantity of goods and services sold during the year.
15-6
Both Sides of the Equation are Ways of
Describing GDP
Left Side of Equation:
Right Side of Equation:
M multiplied by V (MV)
would be total spending
(dollars in circulation times
the number of times they
circulate).
P multiplied by Q (PQ) is
the total amount of money
received by sellers of all
final goods and services
produced by a nation
during a given year.
Total spending by a nation
during a given year is GDP.
Therefore, MV = GDP
This also is GDP.
Therefore, PQ = GDP
Things equal to the same thing are equal to each other.
Therefore, MV = PQ
15-7
Example of the Equation of Exchange
The following example is in billions of dollars (without $ signs):
Suppose M = 900; V = 9; and P = 81.
MV = PQ
900 X 9 = 81 x Q
8,100 = 81 X Q
Q must = 100
8,100 = 81 X 100
8,100 = 8,100
The equation of exchange must always balance.
15-8
The Quantity Theory of Money:
The Crude Version
This version, espoused by Classical economists, assumes that
V and Q are constant.
So if the money supply (M) changes by a certain percentage,
the price level (P) changes by that same percentage.
MV = PQ
900 X 9 = 81 X 100
1800 X 9 = 162 X 100
If M doubles, then P
will also double.
16,200 = 16,200
Conclusion: Increasing M leads to inflation.
15-9
A Closer Look at V and Q

Keynesian economists looked empirically at V and Q and found
neither is constant in the short run.
•
Since 1950, V has risen fairly steadily from about 3 to over 10.
• Classical economists assumed Q was constant in the long run.
But it isn’t in the short run.
 During recessions, production, and therefore Q will fall.
 Q fell at an annual rate of about 4 percent during the 1981-82
recession.
 During recoveries, production picks up, so we go from a
declining Q to a rising Q.

Therefore, the crude version of the quantity theory of money is
not valid.
15-10
The Quantity Theory of Money:
The Sophisticated Version


Monetarists developed a sophisticated version of the Quantity
Theory of Money to respond to the Keynesians.
Like the Classicals, they emphasize long-run trends:
•
Short-term changes in V are either very small or predicable.
• Q may fall below full-employment in the short run, but is stable in the
long run.


The effect of an increase in M depends on the initial level of
output (Q).
This can be modeled using aggregate supply and demand.
15-11
Hypothetical Aggregate Supply Curve
If we are close to or at
full employment, an
increase in M will lead
mainly to an increase in
P.
If we are well below full
employment, an increase in M will
lead mainly to an increase in Q.
15-12
Classical Economics

The classical school had the following tenets:
•
•
•
•
•

Say’s law implies supply generates its own demand.
Flexible prices mean there are no shortages or surpluses.
Flexible wages mean all unemployment is voluntary.
Interest rates balance Savings and Investment because savings
will be invested.
“Laissez-faire” and wait for recessions to cure themselves.
Classical school relied upon the crude version of the Quantity
theory of money.
•
They assumed Q was constant in the long run, as economy
reached full employment equilibrium.
• For the equation of exchange to balance, V must also be
constant.
• Conclusion: Expansionary monetary policy is inflationary.
15-13
The Interest Rate Mechanism
(that leads to S = I)
An interest rate of
10% is found at
the intersection.
15-14
Keynesian Economics

The Keynesian school has the following tenets:
•
•
•
•
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Keynesians disagree with using the equation of exchange to
conclude that monetary policy is inflationary:
•
•

The problem with recessions is inadequate demand.
No one will invest in new plant and equipment when much of their capacity is
idle.
Wages and prices are not flexible downward due to institutional barriers.
Government must spend enough money to raise aggregate demand to get
people back to work.
Neither Q nor V are constant in the short run.
If M rises, people may not spend the additional money, but just hold it until
interest rates rise.
Keynesian economics enjoyed a revival beginning in 2009 with the
Great Recession and the Obama stimulus package.
15-15
The Monetarist School


Monetarism’s name comes from the theory’s emphasis on
managing the rate of growth in the money supply to control
inflation.
Key theorist was Milton Friedman.
•
Friedman did exhaustive studies of the relationship between the rate
of growth of the money supply and the rate of increase in prices.
• He concluded that the U.S. never had a serious inflation that was not
accompanied by rapid monetary growth.
• When the money supply has grown slowly, the country has had no
inflation.

From these correlations, he concluded increases in the money
supply cause inflation.
15-16
Monetarism and the Sophisticated Quantity
Theory of Money

Monetarists use the sophisticated version of the Quantity
Theory of Money.
•
When the money supply grows, the price level rises, albeit not at
exactly the same rate.
• Recessions are caused when the Federal Reserve increases the
money supply at less than the rate needed by business.

Minimal policy intervention: Fed should target a constant rate of
growth in the money supply to accommodate economic growth.
•
Since real GDP growth has a long-term trend of 3 percent per
year, that’s how much to increase M.
•
This steady policy is called The Monetary Rule.
15-17
The Basic Tenets of Monetarism
The key to stable economic growth is constant rate of increase
in the money supply.
1.
•
Fed is to blame for economic instability, including the Great
Depression.
Expansionary monetary policy will only temporarily depress
interest rates.
2.
•
Eventually, banks will raise them, anticipating inflation.
Expansionary monetary policy will only temporarily reduce the
unemployment rate.
3.
•
Labor unions will bargain up wages, leading to job losses.
Expansionary fiscal policy will only temporarily raise output and
employment.
4.
•
Borrowing leads to crowding out of private I.
15-18
The Decline of Monetarism
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Monetarism’s popularity started to decline in the late 1970s
and early 1980s.
Both Keynesianism and Monetarism had difficulty prescribing
a policy to deal with stagflation (combination of recession
and inflation) caused by high oil prices.
First serious experiment with the Monetary Rule coincided
with economic instability:
•
•
Paul Volker, the first Monetarist Fed Chair, adhered to the
Monetary Rule starting in 1979.
This was followed by double-digit inflation and interest rates, two
recessions, and major unemployment.
15-19
Supply-Side Economics

In response to stagflation and perceived limits of Keynesianism
and Monetarism, Supply-side economics came into vogue in the
early 1980s.
•
Supply-side economics endorsed by President Ronald Reagan.
• Theme was “get government off the backs of the American people.”

The object of supply-siders is to raise aggregate supply (not
AD).
•
If shift AS, can increase real GDP without increasing price level.
• Supply-siders mantra was to cut tax rates, reduce government
spending, and eliminate government regulations to stimulate AS.
15-20
Undesirable Effects of High Marginal Tax
Rates

Key theorist, Arthur Laffer, focused on undesirable effects of
high marginal tax rates.
1.
2.
3.


The Work Effect: People may not work overtime or second jobs if
pushes them into higher tax bracket.
The Savings and Investment Effect: High tax rates on interest
and profits are disincentives.
The Elimination of Productive Market Exchanges: People may
engage in “do it yourself” projects rather than paying someone to
do the work, if they have to pay taxes on the services.
Output is lower because of these disincentives.
Government regulation of businesses also is another
disincentive for investment.
15-21
The Laffer Curve
If you lower the marginal tax rate from
point A to point B, you would actually
increase tax revenue.
Point C is the tax rate that
maximizes tax revenue.
The rationale of the Laffer curve is that when marginal tax rates are too high,
we can raise tax revenues by lowering the tax rate.
15-22
Does Supply-Side Economics Work?

Keynesians use tax cuts to stimulate AD; Supply-siders use tax
cuts to stimulate AS. What’s the difference?
•
•
•


Keynesians expect households to spend their tax cuts. They prefer tax cuts
aimed at working class and middle class.
Supply-siders expect households to save their tax cuts. They prefer tax cuts
aimed at high earners (“trickle-down” economics).
Supply side only works if tax cuts are saved and then invested by businesses.
During the Reagan administration, tax rates were cut, but tax
revenues did not increase enough to avert huge budget deficits.
In 2003, President George W. Bush’s tax cuts were passed in
Congress, but barely.
15-23
Questions for Thought and Discussion

If you received a tax cut or tax rebate, would you be more likely to
spend it or save it?

If income tax rates were reduced, would you increase your hours of
work?
15-24
Rational Expectations Theory
Key theorist is Robert Lucas.
Rational expectations theory is based on three assumptions:


1.
2.
3.
Individuals and businesses learn through experience to anticipate
the consequences of changes in monetary and fiscal policy.
They act instantaneously to protect their economic interest thus
nullifying the intended effects.
All resource and product markets are purely competitive.
Rational expectations theorists, like classical economists, say
the government should do as little as possible.

•
•
Follow the monetary rule (3% annual growth in M).
Balance the budget.
15-25
Criticisms of Rational Expectations School
1.
Is it reasonable to expect individuals and business firms to
accurately predict the consequences of macroeconomic policy?
2.
Our economic markets are not purely competitive: some are not
competitive at all.
3.
The rigidities imposed by contracts restrict adjustments to changing
economic conditions.
15-26
Macroeconomic Policy in the Real World:
Summary

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Three of our schools of economics (Classical, Monetarist, and
Rational Expectations) believe government should do nothing
during recession and little during inflation.
Supply-siders believe in reducing the impact of government to
stimulate the economy.
Only Keynesians believe in active government intervention.
The large majority of economists favor some intervention in the
short run, even if the economy could self-regulate.
15-27
Behavioral Economics

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Relatively new school of thought.
Their goal is to apply a wider range of psychological concepts to
economic theory.
Humans can be short-sighted, emotional, and irrational. But …
The main contention is that while people often do not act in their
own self-interested, they can be nudged to do so.
Behavioral economists are not challenging mainstream beliefs
that rational behavior and economic self-interest motivate
behavior.
They are challenging the belief that these are the only motivating
factors.
15-28
Conventional Macropolicy to Fight
Recessions

Fiscal Policy: Run a budget deficit by cutting taxes or increasing G
or both.
•

Monetary Policy: Speed up growth of money supply.
•

Gradually reduce the deficit as economy recovers to avoid driving up
interest rates.
Gradually reduce growth of M as economy recovers to avoid inflation.
Policy dilemma: Budget deficits require massive borrowing by the
U.S. Treasury, but this drives up interest rates. Higher interest
rates can choke an economic recovery.
•
Is there a way out of this dilemma? Think of the economic conditions
of 2009 – 2010.
15-29
Conventional Macropolicy to Fight Inflation

To Fight Inflation:
•
•
Fiscal Policy: Reduce budget deficits and create surpluses to pay off
federal debt.
Monetary Policy: Slow the rate of growth in M or even contract it.
15-30
Fighting Inflationary Recessions (Stagflation)
and the Limits of Macropolicy
What if we have a combination of recession and inflation?
Two options:


1.
2.
Conventional policies are not ideal for fighting inflationary
recessions.

•

Combine an expansionary fiscal policy and a contractionary
monetary policy (Example: 1981-82).
Fight them in sequence (Example: fighting inflation in 1950s, then
expanding economy in 1960s)
This has been a concern in 2008-2010.
Macropolicy is also less effective as economy globalizes.
15-31
Current Issue: True Believers
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Great Recession of 2008 - ?
Financial crisis, worst since the 1930s.
Keynesian fiscal policy + expansionary monetary policy.
Financial meltdown was prevented.
Politicians and policymakers want to adhere to and believe at
least one school of economic thought.
In the Great Recession, Keynesianism has made a comeback.
Question for thought and discussion: Has there been any
push-back against Keynesianism during the Great recession.
15-32