principles of economics chapter 18

8/13/2019 principles of economics chapter 18

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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

CHA

PT

E

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18

Prepared by: Fernando Quijano

and Yvonn Quijano

Debates in Macroeconomics:

Monetarism, New Classical

Theory, and Supply Side

Economics


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Keynesian Economics

In a broad sense, Keynesian economics is

the foundation of modern macroeconomics.

In a narrower sense, Keynesianrefers to

economists who advocate activegovernment intervention in the economy.

Two major schools decidedly against

government intervention have developed:

monetarism and new classical economics.


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The Quantity Theory of Money

Recent data on the U.S. economy showsthat the demand for money does notappear to depend only on nominal income,but also on the interest rate.

Also, the velocity of money is far fromconstant. There is a rising long-term trendin velocity, but fluctuations around this

trend have been quite large. However, whether velocity is constant or

not may depend partly on how wemeasure the money supply.


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The Velocity of Money, 1960 I2000 II


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10/24 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 goodtimes.

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).



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 timebelieve the best possible policy

is basically noninterventionist.



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.


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Rational Expectations

The rat ional-expectat ions 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 averagecorrect, even though

predictions are not exactly right all the

time.


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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, onaverage, 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.



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 expectedprice level (Pe):

Y f P P e ( )

The difference between the actual pricelevel and the expected price level is the

pr ice surp r ise.



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.


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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.


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Real Business Cycle Theory

The real business cycle theoryis an

attempt to explain business cycle

fluctuations under assumptions of

complete price and wage flexibility andrational expectations. It emphasizes

shocks to technology and other shocks.

If theAScurve is vertical, shifts inAD

cannot account for real output fluctuations.


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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 thereal 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.


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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 taxrate could cause tax

revenues to fall. Similarly,

under the same

circumstances, a cut in the

tax rate could generateenough additional

economic activity to cause

revenues to rise.


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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 after-

tax wage, they might have an incentive to

work more, but they may also choose to

work less.


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2002 P ti H ll B i P bli hi P i i l f E i 6/ K l C R F i

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 noway to know what model is in fact the true

one.

There is only a small amount of dataavailable to test macroeconomic

hypothesesonly seven business cycles

since 1950.

principles of economics chapter 18

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