Chapter 19 Classical vs. Keynesian

Disputes In Macroeconomics Rational Ex. Supply-siders Mainstreamers Keynesian Based Monetary Policy matters Fiscal policy matters Money supply matters Anticipations matter AS f iscal p olicy matters G & T No “G” Classicals Keynesians Monetarists 3-5% Monetary Rule Expectations negate fiscal and monetary Policy. Get the G off of our backs. Adam Smith John M. Keynes Milton Friedman Robert Lucas Ronald Reagan

Monetarist Keynesian Chapter 19 Let’s look at another Keynesian.

DIFFERENT MACRO THEROIES 19 C H A P T E R

Once apon a time, In a land far, far, away There were a group of people called the Classical Economists

Full employment is the norm .

Laissez-faire “Let it be”

Vertical Aggregate Supply Curve

Stable Aggregate Demand

Real Output Depends Upon…

1.. Say’s Law

2. Responsive, Flexible, Prices and Wages

IN CLASSICAL LAND THEY BELIEVED...

Classical Theory P 1 Q f Price Level Real Domestic Output AS AD 1

Classical Theory P 1 Q f P 2 Price Level Real Domestic Output AS AD 1 AD 2

In another land Far, Far, Away The were a group of people called the Keyensians

Their hero and leader was John Maynard Keynes

In Keynesian Land...

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

The Keynesians believed...

. Free gifts to every kid in the world? Are you a Keynesian or something?

Keynesian View P 1 Q f Price Level Real Domestic Output AS AD 1 AD 2 Q u Prices are downwardly Inflexible, or “Sticky”

Keynesian View P 1 Q 1 Price Level Real Domestic Output AS AD 1

Y 1 Real Domestic Output AS AD 1 AD 2 Y 2 “ Businesses don’t let prices fall so easily” PL 1 “ Workers don’t let wages fall so easily.” Keynesian View “ The economy has fallen and can’t 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

Keynesian View P 1 Q f Price Level Real Domestic Output AS AD 1

The Equation of Exchange or Quantity Theory of Money MV x PQ was the cornerstone of Classical theory . M x V = P x Q 1. V elocity 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 aren’t in the equation & a change in MS will result in a change in P. $ spent $ received

L et’s T ake A Look At Milton Friedman’s License Plate

M V = P Y Keynesian View Monetarist View Velocity is not stable or predictable. So an increase in M or V could increase P. Thus, no monetary rule policy. MS needs to be adjusted. Velocity is stable and predictable. The Fed cannot predict short-run variations in V. Adjustments to M will be wrong and destabilizing . The Keynesian - Monetarist Debate Fiscal Policy Monetary Rule

Monetarists Friedman Monetary Rule Motto: “ Increase the MS 3-5 % year” M X V = P X Q 3-5 % 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. 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. RATIONAL EXPECTATIONS

Prize-Winning Foresight by an Ex-Wife Robert Lucas , the Nobel prize winner of $1.1 million dollars , will have to split his money with his ex-wife , who seven years ago had her divorce lawyer insert a clause to cover just such a possibility. 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. It’s hard to be unpleasant after a prize like that.” Rita Lucas had more than just foresight ; she had luck . If the announcement, which came on Oct. 10 , had come after Oct. 31 , she would have gotten nothing . 8 University of Chicago professors have won and he was the 5 th in the last 6 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 . Robert Lucas $1.1 million

MAINSTREAM ECONOMISTS [ New Keynesian ] – Keynesian based

The economy is stable but potentially unstable [ supply shocks or booms and busts impact investment ].

Many prices/wages are inflexible downward , particularly wages [ contracts and efficiency wages ].

Velocity is unstable [ direct with the interest rate and i n v e r s e with the m o n e y s u p p l y ]

Inflation can be caused by excess MS , but it may also be caused by “investment booms” , or “adverse supply shocks.”

The Fed targets the interest rate in the SR but monitors the MS in the LR .

CAUSES OF MACRO INSTABILITY C a + I g + X n + G = GDP Equation of Exchange M V = P Q (Nom. GDP) Changes in Investment Mainstream View (Keynesian) Monetarist View (Classical) Adverse Aggregate Supply Shocks Stable Velocity

CAUSES OF MACRO INSTABILITY Instability of Investment is the Main Cause of Output Changes Monetary Policy is a Stabilizing Factor Mainstream View (Keyensian) Monetarist View (Classical) With a Stable Velocity, Nominal GDP Depends Upon the Money Supply Summary

Mainstream View

Downward Wage Inflexibility

Efficiency Wage Theory

Greater Work Effort

Lower Supervision Costs

Reduced Job Turnover

Insider-Outsider Theory and Relationships

DOES THE ECONOMY SELF-CORRECT?

RATIONALE FOR A MONETARY RULE Federal Reserve Increases Money Supply at the Long-Run Growth Rate of GDP P 1 Q 1 Price Level Real Domestic Output, GDP AD 1 Q 2 AS LR1 Fed Increases The Money Supply Resulting in… AS LR2 P 2

RATIONALE FOR A MONETARY RULE Federal Reserve Increases Money Supply at the Long-Run Growth Rate of GDP P 1 Q 1 Price Level Real Domestic Output, GDP AS LR2 AD 2 AD 1 Q 2 AS LR1 Growth Without Inflation or Deflation P 2

Next: International Trade Chapter 20