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2012 Pearson Education, Inc. Publishing as Prentice Hall

Prepared by: Fernando Quijano & Shelly TefftCASE FAIR OSTER

P R I N C I P L E S O F

MACROECONOMICST E N T H E D I T I O N

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FurtherMacroeconom

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CHAPTER OUTLINE18

Alternative Views in

Macroeconomics

Keynesian Economics

Monetarism

The Velocity of Money

The Quantity Theory of Money

Inflation as a Purely Monetary PhenomenonThe Keynesian/Monetarist Debate

Supply-Side Economics

The Laffer Curve

Evaluating Supply-Side Economics

New Classical Macroeconomics

The Development of New Classical Macroeconomics

Rational Expectations

Real Business Cycle Theory and New Keynesian Economics

Evaluating the Rational Expectations Assumption

Testing Alternative Macroeconomic Models

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In one sense, Keynesian economics is the foundation of all of macroeconomics.

Now used more narrowly, Keynesian sometimes refers to economists who

advocate active government intervention in the macroeconomy.

We begin with an old debatethat between Keynesians and monetarists.

Keynesian Economics

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The debate between monetarist and Keynesian economics is complicated

because it means different things to different people.

If we consider the main monetarist message to be that money matters, then

almost all economists would agree.

Monetarism, however, is usually considered to go beyond the notion thatmoney matters.

Monetarism

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velocity of money The number of times a dollar

bill changes hands, on average, during a year;

the ratio of nominal GDPto the stock of money.

M

GDPV

The income velocity of money (V) is the ratio of nominal GDP to thestock of money (M):

Monetarism


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We can expand this definition slightly by noting that nominal income

(GDP) is equal to real output (income) (Y) times the overall price level (P):

M

YPV

Through substitution:

or

YPVM

Monetarism


YPGDP

quantity theory of money The theory based on the identity M VP Yand

the assumption that the velocity of money (V) is constant (or virtually constant).

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The key assumption of the quantity theory of money is that the

velocity of money is constant (or virtually constant) over time. If we

let Vdenote the constant value ofV, the equation for the quantity

theory can be written as follows:

YPVM

Monetarism


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Velocity has not been constant over the period from 1960 to 2010.

There is a long-term trendvelocity has been rising.

There are also fluctuations, some of them quite large.

FIGURE 18.1 The Velocity of Money, 1960 I2010 I

Monetarism


Testing the Quantity Theory of Money

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In the strict monetarist view, changes in Maffect only Pand not Y, so

inflation (an increase in P) is always a purely monetary phenomenon.

The price level will not change if the money supply does not change.

There is considerable disagreement as to whether the strict monetaristview is a good approximation of reality.

Almost all economists agree, however, that sustainedinflation

inflation that continues over many periodsis a purely monetary

phenomenon.

Inflation cannot continue indefinitely without increases in the money

supply.

Monetarism

Inflation as a Purely Monetary Phenomenon

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Monetarists were skeptical of the Feds ability to manage the

economyto expand the money supply during bad times and contract

it during good times.

The leading spokesman for monetarism, Milton Friedman, advocated a

policy of steady and slow money growthspecifically, that the moneysupply should grow at a rate equal to the average growth of real output

(income) (Y).

While not all Keynesians advocated an activist federal government,

many advocated the application of coordinated monetary and fiscal

policy tools to reduce instability in the economyto fight inflation and

unemployment.

The debate between Keynesians and monetarists subsided with the

advent of what we will call new classical macroeconomics.

Monetarism

The Keynesian/Monetarist Debate

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The theories we have been discussing are demand-oriented. Supply-side

economics, as the name suggests, focuses on the supply side.

In the late 1970s and early 1980s, supply-siders argued that the real problem

with the economy was not demand, but high rates of taxation and heavy

regulation that reduced the incentive to work, to save, and to invest. What was

needed was not a demand stimulus, but better incentives to stimulate supply.

At their most extreme, supply-siders argued that the incentive effects of supply-

side policies were likely to be so great that a major cut in tax rates would

actually increase tax revenues.

Even though tax rates would be lower, more people would be working and

earning income and firms would earn more profits, so that the increases in thetax bases (profits, sales, and income) would then outweigh the decreases in

rates, resulting in increased government revenues.


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The Laffer curve shows that the

amount of revenue the

government collects is a

function of the tax rate.

It shows that when tax rates

are very high, an increase inthe 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.

FIGURE 18.2 The Laffer Curve


The Laffer Curve

Laffer curve With the tax rate measured on the vertical axis and tax

revenue measured on the horizontal axis, the Laffer curve shows that

there is some tax rate beyond which the supply response is large enough

to lead to a decrease in tax revenue for further increases in the tax rate.

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Among the criticisms of supply-side economics is that it is unlikely a tax

cut would substantially increase the supply of labor.

In theory, a tax cut could even lead to a reduction in labor supply.

Research done during the 1980s suggests that tax cuts seem toincrease the supply of labor somewhat but that the increases are very

modest.

Traditional theory suggests that a huge tax cut will lead to an increase

in disposable income and, in turn, an increase in consumption

spending (a component of aggregate expenditure).

Although an increase in planned investment (brought about by a lower

interest rate) leads to added productive capacity and added supply in

the long run, it also increases expenditures on capital goods (new plant

and equipment investment) in the short run.


Evaluating Supply-Side Economics

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The challenge to Keynesian and related theories has come from a school

sometimes referred to as the new classical macroeconomics.

No two new classical macroeconomists think exactly alike, and no single model

completely represents this school.


Keynes recognized that expectations (in the form of animal spirits) play a

big part in economic behavior. The problem is that traditional models

assume that expectations are formed in naive ways, which is inconsistent

with the assumptions of microeconomics.

If, as microeconomic theory assumes, people are out to maximize their

satisfaction and firms are out to maximize their profits, they should form their

expectations in a smarter way.

In this view, forward-looking, rational people compose households and firms.

The Development of New Classical Macroeconomics

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rational-expectations hypothesis The hypothesis that

people know the true model of the economy and that they

use this model to form their expectations of the future.



If firms have rational expectations and if they set prices and

wages on this basis, disequilibrium in any market is only

temporary.

In this world, all markets clear (on average) and there is full

employment thus no need for government stabilization

policies.

Rational Expectations and Market Clearing

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A current debate amongmacroeconomists and policy

makers is how people form

expectations about the future state

of the economy.

In 2010, a number of economistsbegan to worry about the possibility

of inflationary expectations heating

up in the United States in the next

few years because of the large

federal government deficit.

Do expectations reflect an accurate understanding of how the economy worksor are they formed in simpler, more mechanical ways?

A study in England suggests a less sophisticated process, finding British

consumers more influenced by their own experience than by actual

government numbers and mostly expecting the future to look the way they

perceive the past to have looked.

How Are Expectations Formed?

E C O N O M I C S I N P R A C T I C E

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Lucas supply function The supply function embodies the

idea that output (Y) depends on the difference between the

actual price level and the expected price level.

)( ePPfY

price surprise Actual price level minus expected price level.



The Lucas Supply Function

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The Lucas supply function in combination with the

assumption that expectations are rational implies that

anticipated policy changes have no effect on real output.

The general conclusion is that anyannounced policy

changein fiscal policy or any other policyhas no effect on

real output because the policy change affects both actual and

expected price levels in the same way.

Rational-expectations theory combined with the Lucas supply

function proposes a very small role for government policy in

the economy.



Policy Implications of the Lucas Supply Function

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real business cycle theory An attempt to explain

business cycle fluctuations under the assumptions of

complete price and wage flexibility and rational expectations.

It emphasizes shocks to technology and other shocks.


Real Business Cycle Theory and New Keynesian Economics

new Keynesian economics A field in which models are

developed under the assumptions of rational expectations

and sticky prices and wages.

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When expectations are not rational, there are likely to be unexploited

profit opportunities, and most economists believe such opportunities are

rare and short-lived.

The argument againstrational expectations is that it requires

households and firms to know too much while the gain from learning thetrue model (or a good approximation of it) may not be worth the cost.

Although the assumption that expectations are rational seems

consistent with the satisfaction-maximizing and profit-maximizing

postulates of microeconomics, such an assumption is more extreme

and demanding because it requires more information on the part of

households and firms.

In the final analysis, the issue is empirical.


Evaluating the Rational Expectations Assumption

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Macroeconomists cannot test their models against one another to see which

performs best because:

Macroeconomic models differ in ways that are hard to standardize.

The rational expectations hypothesis assumes (1) that expectations are

formed rationally and (2) that the model being used is the true one.

The small amount of data available leaves considerable room for

disagreement, a range needing more time to narrow.

Testing Alternative Macroeconomic Models

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Laffer curve

Lucas supply function

new Keynesian economics

price surprise

quantity theory of money

rational expectations hypothesis

real business cycle theory

velocity of money

M

GDPV

YPVM

YPVM

R E V I E W T E R M S A N D C O N C E P T S

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