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Chapter 15

Chapter 15

A CENTURY OF ECONOMIC THEORY

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Learning Objectives

After this chapter, you should be able to: 1. Discuss the equation of exchange.2. Explain the quantity theory of money.3. Analyze Classical economics.4. Analyze Keynesian economics.5. Apply the policy prescription of the Monetarist school.6. Describe Supply-Side economics.7. Judge the Rational Expectations theory.8. Apply behavioral economics.9. Assess the use of conventional macropolicy to fight

recessions and inflation.

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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)

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Five Schools of Macroeconomic Theory

1. Classical economics (1776-1930)2. Keynesian economics (1930s - present) 3. Monetarist school (1960s - present)4. Supply-side economics (1970s – present)5. 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.

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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.

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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.

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Both Sides of the Equation are Ways of Describing GDP

Left Side of Equation:

M multiplied by V (MV) would be total spending (dollars in circulation times the number of times they circulate).

Total spending by a nation during a given year is GDP.

Therefore, MV = GDP

Right Side of Equation:

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.

This also is GDP.

Therefore, PQ = GDPThings equal to the same thing are equal to each

other.

MV = PQ

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Example of the Equation of Exchange

The following example is in billions of dollars (without $ signs):

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.

Suppose M = 900; V = 9; and P = 81.

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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

16,200 = 16,200Conclusion: Increasing M leads to

inflation.

If M doubles, then Pwill also double.

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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.

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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.

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Hypothetical Aggregate Supply Curve

If we are well below full employment, an increase in M will lead mainly to an increase in Q.

If we are close to or at full employment, an increase in M will lead mainly to an increase in P.

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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.

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The Interest Rate Mechanism (that leads to S = I)

An interest rate of 10% is found at the intersection.

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Keynesian Economics

The Keynesian school has the following tenets: 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.

Keynesians disagree with using the equation of exchange to conclude that monetary policy is inflationary:

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.

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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.

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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.

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The Basic Tenets of Monetarism

The key to stable economic growth is constant rate of increase in the money supply.

Fed is to blame for economic instability, including the Great Depression.

Expansionary monetary policy will only temporarily depress interest rates.

Eventually, banks will raise them, anticipating inflation.

Expansionary monetary policy will only temporarily reduce the unemployment rate.

Labor unions will bargain up wages, leading to job losses.

Expansionary fiscal policy will only temporarily raise output and employment.

Borrowing leads to crowding out of private investment.

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The Decline of Monetarism

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.

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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.

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Undesirable Effects of High Marginal Tax Rates

Key theorist, Arthur Laffer, focused on undesirable effects of high marginal tax rates.

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.

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The Laffer Curve

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.

If you lower the marginal tax rate frompoint A to point B, you would actuallyincrease tax revenue.

Point C is the tax rate thatmaximizes tax revenue.

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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.

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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?

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Rational Expectations Theory

Key theorist is Robert Lucas.Rational expectations theory is based on three

assumptions: 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.

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Criticisms of Rational Expectations School

Is it reasonable to expect individuals and business firms to accurately predict the consequences of macroeconomic policy?

Our economic markets are not purely competitive, some are not competitive at all.

The rigidities imposed by contracts restrict adjustments to changing economic conditions.

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Macroeconomic Policy in the Real World: Summary

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.

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Behavioral Economics

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.

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Conventional Macropolicy to Fight Recessions

Fiscal Policy: Run a budget deficit by cutting taxes or increasing G or both.

Gradually reduce the deficit as economy recovers to avoid driving up interest rates.

Monetary Policy: Speed up growth of money supply. 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.

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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.

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Fighting Inflationary Recessions (Stagflation) and the Limits of Macropolicy

What if we have a combination of recession and inflation?

Two options: 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)

Conventional policies are not ideal for fighting inflationary recessions.

This was a concern in 2008-2010.

Macropolicy is also less effective as economy globalizes.

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Economics in Action: True Believers

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.