CHAPTER

18
Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply Side Economics
Prepared by: Fernando Quijano and Yvonn Quijano

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

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 have developed: monetarism and new classical economics.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Monetarism
The main message of monetarism is 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): GDP or P Y or M V P Y V V M M
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Quantity Theory of Money

The quantity theory of money is a theory based on the identity M V P Y , which assumes that the velocity of money (V) is constant. Then, the theory can be written as the following equality:

M V P Y
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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Quantity Theory of Money

Recent data on the U.S. economy shows that the demand for money does not appear to depend only on nominal income, but also on the interest rate. Also, the velocity of money is far from constant. There is a rising long-term trend in velocity, but fluctuations around this trend have been quite large.

However, whether velocity is constant or not may depend partly on how we measure the money supply.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Velocity of Money, 1960 I 2000 II

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Inflation is Purely a Monetary Phenomenon

Inflation (an increase in P) is always a purely 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. This view is not compatible with a nonvertical AS curve in the AS/AD model. However, almost all economists agree that sustained inflation is purely a monetary phenomenon.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

Inflation is Purely a Monetary Phenomenon

The strict monetarist view is not compatible with a nonvertical AS curve because, if the AS curve is nonvertical, an increase in M, which shifts the AD curve to the right, increases both P and Y.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Keynesian/Monetarist Debate

Milton Friedman has been the leading spokesman for monetarism over the last few decades. Most monetarists argue that inflation in the United States could have been avoided if only the Fed had not expanded the money supply so rapidly.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Keynesian/Monetarist Debate

Most monetarists do not advocate an activist monetary policy stabilization expanding the money supply during bad times and slowing its growth during good times. Time lags are the most common argument against such management.

Monetarists advocate a policy of steady and slow money growth, at a rate equal to the average growth of real output (Y).
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Keynesian/Monetarist Debate

Many Keynesians advocate the application of coordinated monetary and fiscal policy tools to reduce instability in the economy to fight inflation and unemployment.

Others reject the strict monetarist position in favor of the view that both monetary and fiscal policies make a difference and at the same time believe the best possible policy is basically noninterventionist.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

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.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

New Classical Macroeconomics

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.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

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, even though predictions are not exactly right all the time.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Rational Expectations
People are said to have rational expectations if they use all available information in forming their expectations. Because there are costs associated with making a wrong forecast, it is not rational to overlook information, as long as the costs of acquiring that information do not outweigh the benefits of improving its accuracy.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Rational Expectations and Market Clearing

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. When expectations are rational, disequilibrium exists only temporarily as a result of random, unpredictable shocks. On average, all markets clear and there is full employment. There is no need for government stabilization.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Lucas Supply Function

The Lucas supply function is the supply function that embodies the idea that output (Y) depends on the difference between the actual price level (P) and the expected price level (Pe):
Y f ( P Pe )

The difference between the actual price level and the expected price level is the price surprise.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Lucas Supply Function

The rationale for the Lucas supply function is that unexpected increases in the price level can fool workers and firms into thinking that relative prices have changed, causing them to alter the amount of labor or goods they choose to supply. Rational-expectations theory, combined with the Lucas supply function, proposes a very small role for government policy in the economy.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

Evaluating Rational-Expectations Theory

If expectations are not rational, there are likely to be unexploited profit opportunitiesmost 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 it, and this is a lot to expect.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

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. If the AS curve is vertical, shifts in AD cannot account for real output fluctuations.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Supply-Side Economics
Orthodox macro theory consists of demand-oriented 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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Laffer Curve

The Laffer Curve shows the amount of revenue the government collects is a function of the tax rate. When tax rates are very high, an increase in the tax rate could cause tax revenues to fall. Similarly, under the same circumstances, a cut in the tax rate could generate enough additional economic activity to cause revenues to rise.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

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 aftertax wage, they might have an incentive to work more, but they may also choose to work less.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Testing Alternative Macro 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 hypothesesonly seven business cycles since 1950.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair