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1. The Roots of Modern
Macroeconomics
Setting the Scene: Three Key Issues

2. THREE KEY ISSUES
• Issue 1: Flexibility of prices and wages
– the right: flexible prices and wages
– the left: price and wage rigidities
• Issue 2: Flexibility of aggregate supply
– the right: aggregate supply determined
independently of aggregate demand

3. Different aggregate supply curves: (a)
AS
Price level
O Y
National output

4. Different aggregate supply curves: (a)
AS
Price level
P1
AD1
O Y
National output

5. Different aggregate supply curves: (a)
AS
Price level
P2
P1
AD2
AD1
O Y
National output

6. THREE KEY ISSUES
• Issue 1: Flexibility of prices and wages
– the right: flexible prices and wages
– the left: price and wage rigidities
• Issue 2: Flexibility of aggregate supply
– the right: aggregate supply determined
independently of aggregate demand
– the left: aggregate supply responsive to changes
in aggregate demand

7. Price level Different aggregate supply curves: (b)
P AS
O
National output

8. Price level Different aggregate supply curves: (b)
P AS
AD1
O Y1
National output

9. Price level Different aggregate supply curves: (b)
P AS
AD2
AD1
O Y1 Y2
National output

10. THREE KEY ISSUES
• Issue 1: Flexibility of prices and wages
– the right: flexible prices and wages
– the left: price and wage rigidities
• Issue 2: Flexibility of aggregate supply
– the right: aggregate supply determined
independently of aggregate demand
– the left: aggregate supply responsive to changes
in aggregate demand
– some consensus on nature of short-run AS curve

11. Different aggregate supply curves: (c)
AS
Price level
O
National output

12. Different aggregate supply curves: (c)
AS
Price level
P1
AD1
O Y1
National output

13. Different aggregate supply curves: (c)
AS
Price level
P2
P1
AD2
AD1
O Y1 Y2
National output

14. THREE KEY ISSUES
• Issue 3: The role of expectations in the
working of the market
– the right: expectations adjust rapidly to changes
in prices
– the left: expectations of prices depend on
expectations of output and employment

15. The Roots of Modern
Macroeconomics
Classical
Macroeconomics

16. CLASSICAL MACROECONOMICS
• Classical analysis of output and employment
– markets clear
• labour market
• market for loanable funds

17. The market for loanable funds
Saving (supply)
Rate of interest
Investment (demand)
O
Quantity of loanable funds

18. The market for loanable funds
Saving (supply)
Rate of interest
r1
Investment (demand)
O
Quantity of loanable funds

19. The market for loanable funds
Saving (supply)
Rate of interest
r1
Investment (demand)
O
Quantity of loanable funds

20. The market for loanable funds
Saving (supply)
Rate of interest
r2
Investment (demand)
O
Quantity of loanable funds

21. The market for loanable funds
Saving (supply)
Rate of interest
r2
Investment (demand)
O
Quantity of loanable funds

22. The market for loanable funds
Saving (supply)
Rate of interest
re
Investment (demand)
O
Quantity of loanable funds

23. CLASSICAL MACROECONOMICS
• Classical analysis of output and employment
– markets clear
• labour market
• market for loanable funds
• market for imports and exports:
the gold standard

24. CLASSICAL MACROECONOMICS
• Classical analysis of output and employment
– markets clear
• labour market
• market for loanable funds
• market for imports and exports:
the gold standard
– Say’s law

25. CLASSICAL MACROECONOMICS
• Classical analysis of output and employment
– markets clear
• labour market
• market for loanable funds
• market for imports and exports:
the gold standard
– Say’s law
• Classical analysis of prices and inflation

26. CLASSICAL MACROECONOMICS
• Classical analysis of output and employment
– markets clear
• labour market
• market for loanable funds
• market for imports and exports:
the gold standard
– Say’s law
• Classical analysis of prices and inflation
– the quantity theory of money

27. CLASSICAL MACROECONOMICS
• Classical analysis of output and employment
– markets clear
• labour market
• market for loanable funds
• market for imports and exports:
the gold standard
– Say’s law
• Classical analysis of prices and inflation
– the quantity theory of money
– the equation of exchange: MV = PY

28. CLASSICAL MACROECONOMICS
• Classical analysis of output and employment
– markets clear
• labour market
• market for loanable funds
• market for imports and exports:
the gold standard
– Say’s law
• Classical analysis of prices and inflation
– the quantity theory of money
– the equation of exchange: MV = PY
– implications for monetary policy

29. CLASSICAL MACROECONOMICS
• The Great Depression and the return to the
gold standard
– the depression of the 1920s

30. UK unemployment and inflation: 1919 − 38
24 15
Unemployment
22
10
20
Unemployment (% of workforce)
18 5
16
0
Inflation (%)
14
12 -5
10
-10
8
6 -15
4
-20
2
0 -25
1919 1921 1923 1925 1927 1929 1931 1933 1935 1937

31. UK unemployment and inflation: 1919 − 38
24 15
Unemployment
22
10
20
Unemployment (% of workforce)
18 Inflation 5
16
0
Inflation (%)
14
12 -5
10
-10
8
6 -15
4
-20
2
0 -25
1919 1921 1923 1925 1927 1929 1931 1933 1935 1937

32. CLASSICAL MACROECONOMICS
• The Great Depression and the return to the
gold standard
– the depression of the 1920s
– return to the gold standard

33. CLASSICAL MACROECONOMICS
• The Great Depression and the return to the
gold standard
– the depression of the 1920s
– return to the gold standard
– effects on the economy

34. CLASSICAL MACROECONOMICS
• The Great Depression and the return to the
gold standard
– the depression of the 1920s
– return to the gold standard
– effects on the economy
– the policy response

35. CLASSICAL MACROECONOMICS
• The Great Depression and the return to the
gold standard
– the depression of the 1920s
– return to the gold standard
– effects on the economy
– the policy response
– classical rejection of public works

36. CLASSICAL MACROECONOMICS
• The Great Depression and the return to the gold
standard
– the depression of the 1920s
– return to the gold standard
– effects on the economy
– the policy response
– classical rejection of public works
• the fear of inflation

37. CLASSICAL MACROECONOMICS
• The Great Depression and the return to the gold
standard
– the depression of the 1920s
– return to the gold standard
– effects on the economy
– the policy response
– classical rejection of public works
• the fear of inflation
• the problem of crowding out

38. The effect of printing extra money: the classical analysis
AS
Price level
P2
P1
AD2
AD1
O Q1
National output

39. The Roots of Modern
Macroeconomics
The Keynesian
Revolution

40. THE KEYNESIAN REVOLUTION
• Keynes’ rejection of classical theory
– rigidities in the labour market
– the problem of deficiency of demand

41. The problem of demand deficiency in the labour market
ASL
Real wage rate (W / P)
W1
ADL1
ADL2
O
Quantity of labour

42. THE KEYNESIAN REVOLUTION
• Keynes’ rejection of classical theory
– rigidities in the labour market
– the problem of deficiency of demand
– rejection of increased saving as a means of
increasing investment

43. Disequilibrium in the market for loanable funds
Savings 1
Savings 2
Rate of interest
r1
r2
Investment
O
Quantity of loanable funds

44. THE KEYNESIAN REVOLUTION
• Keynes’ rejection of classical theory
– rigidities in the labour market
– the problem of deficiency of demand
– rejection of increased saving as a means of
increasing investment
– rejection of simple quantity theory

45. THE KEYNESIAN REVOLUTION
• Keynes’ rejection of classical theory
– rigidities in the labour market
– the problem of deficiency of demand
– rejection of increased saving as a means of
increasing investment
– rejection of simple quantity theory
– rejection of a balanced budget

46. THE KEYNESIAN REVOLUTION
• Keynes’ rejection of classical theory
– rigidities in the labour market
– the problem of deficiency of demand
– rejection of increased saving as a means of
increasing investment
– rejection of simple quantity theory
– rejection of a balanced budget
• Keynes’ analysis of employment and inflation

47. THE KEYNESIAN REVOLUTION
• Keynes’ rejection of classical theory
– rigidities in the labour market
– the problem of deficiency of demand
– rejection of increased saving as a means of
increasing investment
– rejection of simple quantity theory
– rejection of a balanced budget
• Keynes’ analysis of employment and inflation
– the importance of aggregate demand

48. The effects of increases in aggregate demand on national output
AS
Price level
O YP
National output

49. The effects of increases in aggregate demand on national output
AS
Price level
AD4
AD3
AD1 AD2
O Y1 Y2 Y3 Y4 YP
National output

50. THE KEYNESIAN REVOLUTION
• Keynes’ rejection of classical theory
– rigidities in the labour market
– the problem of deficiency of demand
– rejection of increased saving as a means of increasing
investment
– rejection of simple quantity theory
– rejection of a balanced budget
• Keynes’ analysis of employment and inflation
– the importance of aggregate demand
– the multiplier process

51. The circular flow of income

52. The circular flow of income
Cd

53. The circular flow of income
Incomes Cd

54. The circular flow of income
Incomes Cd
W=S+T+M

55. The circular flow of income
J=I+G+X
Incomes Cd
W=S+T+M

56. The circular flow of income
J=I+G+X
Incomes Cd
W=S+T+M

57. The circular flow of income
J=I+G+X
Incomes Cd
W=S+T+M

58. The circular flow of income
J=I+G+X
Incomes Cd
W=S+T+M

59. THE KEYNESIAN REVOLUTION
• Keynes’ policy recommendations
– demand management by fiscal and monetary
policies
• Keynesian policies in 1950s and 60s
– stop–go policies
– criticisms of short-term demand management
– the breakdown of the Phillips curve

60. The Roots of Modern
Macroeconomics
The Monetarist– Keynesian Debate

61. THE MONETARIST–KEYNESIAN DEBATE
• The monetarist counter-revolution
– the restatement of the quantity theory
– rejection of Keynesian demand management
policies
– the problem of inflationary expectations
– reappraisal of the Phillips curve
• unemployment
• inflation

62. Inflation (%) The monetarist version of the long-run Phillips curve
O Un
Unemployment

63. (a) Keynesian aggregate supply curve
AS
Price level
O Ymax YP
National output

64. Inflation (%) (b) Keynesian Phillips curve
O
Umin
Unemployment

65. THE MONETARIST–KEYNESIAN DEBATE
• The monetarist counter-revolution
– the restatement of the quantity theory
– rejection of Keynesian demand management policies
– the problem of inflationary expectations
– reappraisal of the Phillips curve
• unemployment
• inflation
– monetarist policies

66. THE MONETARIST–KEYNESIAN DEBATE
• The monetarist counter-revolution
– the restatement of the quantity theory
– rejection of Keynesian demand management policies
– the problem of inflationary expectations
– reappraisal of the Phillips curve
• unemployment
• inflation
– monetarist policies
– attempts at such policies in the 1980s

67. THE MONETARIST–KEYNESIAN DEBATE
• Modern-day Keynesians
– inflation
– unemployment
– structural problems
– hysteresis
• low capital stock
• deskilling
• insiders and outsiders
– criticisms of monetarism
– Keynesian policy proposals

68. The Roots of Modern
Macroeconomics
The Current Position

69. THE CURRENT POSITION
• The current range of views
– new classical / rational expectations school
– moderate monetarists
– moderate Keynesians (new Keynesians)
– extreme Keynesians
– the radical left
– eclectic economists

70. THE CURRENT POSITION
• A mainstream consensus?
– short-run effects of changes in AD
– long-run effects of changes in AD
– no simple trade-off between inflation and
unemployment
– role of expectations
– effects of excessive growth in the money supply
– importance of supply-side policies
– erosion of governments' power by the process of
globalisation