Adam Smith

John M. Keynes

Classicals

Keynesians

Expectations
negate fiscal
and monetary
Policy.

3-5%

G&T

No G

Get the G
off of our
backs.

Robert Lucas

Rational Ex.

Monetary
Rule

Milton Friedman

Monetarists

Keynesian Based
Monetary Policy matters

Fiscal policy matters

Money supply matters
Anticipations matter
Ronald Reagan AS fiscal policy matters
Supply-siders
Mainstreamers

Disputes In Macroeconomics

Lets look at another Keynesian.

Chapter 19

Monetarist

Keynesian

19

C H APT E R

DIFFERENT
MACRO THEROIES

Full employment is the norm.

Laissez-faire Let it be
Vertical Aggregate Supply Curve
Stable Aggregate Demand
Real Output Depends Upon
1.. Says Law
2. Responsive, Flexible, Prices and
Wages

Classical Theory

Price Level

AS

P1
AD1
Qf

Real Domestic Output

Classical Theory

Price Level

AS

P1
P2

AD1
AD2
Qf

Real Domestic Output

 Their hero and leader was John Maynard

Keynes

 Active government policy is needed to

stabilize the economy.
Laissez-Faire is subject to recessions
and widespread unemployment
AD is Unstable (Investment fluctuates)
Prices and Wages Downwardly Inflexible
Horizontal AS Curve to Full-Employment

Free gifts to every kid in

the world? Are you a
Keynesian or something?

Keynesian View

Price Level

AS
Prices are downwardly

P1

Inflexible, or Sticky

AD1
AD2
Qu

Qf

Real Domestic Output

Keynesian View
AS

Price Level

P1
AD1
Q1
Real Domestic Output

Keynesian View
The economy has fallen and cant get up.
Prices and wages are
downwardly inflexible
Active government policy required
to stabilize the economy
Horizontal AS to Full-Employment
Unstable AD [because of investment]
G is needed to move the economy
out of recession

Businesses dont let

prices fall so easily
Workers dont let
wages fall so easily.

AS
AD
AD2
1

PL1

Y2

Y1

Real Domestic Output

Keynesian View

Price Level

AS

P1
AD1
Qf

Real Domestic Output

The Equation of Exchange

or Quantity Theory of Money

MV x PQ was the cornerstone of Classical theory.
$ spent

$ received

MxV=PxQ
1. Velocity is stable.
2. The amount of goods/services that can be produced
is fixed in the short run.
3. If the Fed increases the MS by 15%, we will
see a proportional 15% increase in prices.
4. V and Q arent in the equation & a change in MS
will result in a change in P.

Lets Take A Look At Milton Friedmans License Plate

Fiscal Policy

Monetary Rule

The Keynesian Monetarist Debate

Monetarist View

Keynesian View

Velocity is not stable or predictable. Velocity is stable and

So an increase in M or V could increase P. predictable.

V =

Thus, no monetary rule policy.

MS needs to be adjusted.

The Fed cannot predict

short-run variations in V.
Adjustments to M will be
wrong and destabilizing.

Monetarists
Monetary Rule 3-5%
Motto:
Increase the MS 3-5% year
MXV=PXQ
Friedman

Quantity theory of Money

Equation of Exchange

Robert Lucas Wins Nobel Prize in Economics

Dr. Lucas teachings suggest that
consumers and businesses will
adjust their behavior and doom
Fed policies aimed at stimulating
or cooling off the economy.
Ex: If a government attempts to lower
unemployment through expansionary
monetary policy economic agents will
anticipate the effects of the change of
policy and raise their expectations of future
inflation accordingly. This in turn will
counteract the expansionary effect of the
increased money supply. All that the
government can do is raise the
inflation rate, not employment.

RATIONAL EXPECTATIONS

The notion that G policies may prove self-defeating in a world

of RATEX gives rise to the idea of policy impotence, in which
the G is seen as virtually powerless to effect long-term change.
8 University of Chicago profs have won the Nobel prize in economics.

Prize-Winning Foresight
by an Ex-Wife
Robert Lucas,
Lucas the Nobel prize winner
of $1.1 million dollars,
dollars will have to split
his money with his ex-wife,
ex-wife who seven
years ago had her divorce lawyer insert
a clause to cover just such a possibility.
Robert Lucas $1.1 million
The clause in the settlement reads: Wife shall receive 50%
of any Nobel Prize if it occurs within seven years.
Lucas said, A deal is a deal. Its hard to be unpleasant after
a prize like that.
Rita Lucas had more than just foresight;
foresight she had luck.
luck If the
announcement, which came on Oct. 10,
10 had come after Oct.
31,
31 she would have gotten nothing.
nothing 8 University of Chicago
professors have won and he was the 5th in the last 6 years.
years
*Rita Lucas knew who had won in the past and she was thinking
in a rational manner on who she expected to win in the future.

MAINSTREAM ECONOMISTS

[New Keynesian] Keynesian based

The economy is stable but potentially unstable
[supply shocks or booms and busts impact investment].
investment
Many prices/wages are inflexible downward,
downward particularly
wages [contracts and efficiency wages].
wages
Velocity is unstable [direct with the interest rate and
inverse with the money supply]
Inflation can be caused by excess MS,
MS but it may also be
caused by investment booms,
booms or adverse supply shocks.
The Fed targets the interest rate in the SR but monitors the
MS in the LR.
LR

CAUSES OF MACRO INSTABILITY

Mainstream View (Keynesian)

Changes in Investment

Ca + Ig + Xn + G = GDP
Adverse Aggregate Supply
Shocks

Monetarist View (Classical)

Equation of Exchange

M V = P Q (Nom. GDP)
Stable Velocity

CAUSES OF MACRO INSTABILITY

Summary
Mainstream View (Keyensian)
Instability of Investment is the
Main Cause of Output Changes
Monetary Policy is a
Stabilizing Factor

Monetarist View (Classical)

With a Stable Velocity,
Nominal GDP Depends Upon
the Money Supply

DOES THE ECONOMY SELF-CORRECT?

Mainstream View
Downward Wage Inflexibility
Efficiency Wage Theory
Greater Work Effort
Lower Supervision Costs
Reduced Job Turnover
Insider-Outsider Theory and
Relationships

RATIONALE FOR A MONETARY RULE

Federal Reserve Increases Money Supply at
the Long-Run Growth Rate of GDP

Price Level

ASLR1 ASLR2
Fed Increases
The Money
Supply
Resulting in

P1
P2

AD1
Q1 Q2

Real Domestic Output, GDP

RATIONALE FOR A MONETARY RULE

Federal Reserve Increases Money Supply at
the Long-Run Growth Rate of GDP

Price Level

ASLR1 ASLR2

Growth
Without
Inflation or
Deflation

P1
P2

AD2
AD1
Q1 Q2

Real Domestic Output, GDP

Next:

International Trade

Chapter 20