Chapter 18 Debates in Macroeconomics: Monetarism, and Supply-Side Economics. Keynesian Economics. Keynesian Economics

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1 Chapter 18 Debates in Macroeconomics: Monetarism, and Supply-Side Economics Keynesian Economics In a broad sense, Keynesian economics is the foundation of modern macroeconomics. In a narrower sense, Keynesian refers to economists who advocate active government intervention in the economy. ( Activist or Activist Policy ) An old debate in Macro - between Keynesians and monetarists. Keynesian Economics Keynesians favor government intervention Monetarist argue against. 1

2 Monetarism The monetarist analysis of the economy places emphasis on the velocity of money, or the number of times a dollar bill changes hands, on average, during a year; the ratio of nominal GDP to the stock of money (M): V GDP M or V P Y M since then, GDP P Y M V P Y The Quantity Theory of Money The quantity theory of money is a theory based on the identity M V P Y, which assumes that the velocity of money (V) is constant. Then, the theory can be written as the following equality: Rewrite As M V P Y M = (1 / V) x ( P x Y), a demand for money equation: Md = (1 / V) x ( P x Y). If V is constant, the demand for money depends on nominal income, but NOT the interest rate. The Quantity Theory of Money % Δ M + % Δ V = % Δ P + % Δ Y If velocity is constant, a 10 % increase in the money supply causes a 10 % increase in nominal income. Money Matters If at full employment, a 10 % increase in the money supply causes a 10 % increase in the price level. 2

3 The Quantity Theory of Money % Δ M + % Δ V = % Δ P + % Δ Y If: % Δ V = 1%, % Δ Y = 3% and % Δ M = 5% % Δ P = 3%. In general: % Δ P = % Δ M + % Δ V - % Δ Y If Δ V = 0: % Δ P = % Δ M - % Δ Y Testing the Quantity Theory of Money The demand for money may depend not only on nominal income, but also on the interest rate. Testing the Quantity Theory of Money Substitutes for M1 introduced in the 1970 s FIGURE 18.1 The Velocity of Money, 1960 I 2010 I Velocity has not been constant over the period from 1960 to There was a long-term positive trend, which has now reversed Pearson Education, Inc. 9 of 21 3

4 2014 Pearson Education, Inc. 10 of 21 Factors Affecting Velocity Introduction of Money market accounts Interest rate As r => Md => V As Y => r => Md => V V is pro-cyclical Inflation as a Purely Monetary Phenomenon Inflation is always a monetary phenomenon. If the money supply does not change, the price level will not change. The view that changes in the money supply affect only the price level, without a change in the level of output, is called the strict monetarist view. 4

5 Inflation as a Purely Monetary Phenomenon The strict monetarist view is not compatible with a nonvertical AS curve. Almost all economists agree that sustained inflation is purely a monetary phenomenon. Inflation cannot continue indefinitely without increases in the money supply. Money and Inflation Money and Inflation An increase in G with the money supply constant shifts the AD curve from AD 0 to AD 1. This leads to an increase in the interest rate and crowding out of planned investment. 5

6 Money and Inflation If the Fed tries to prevent crowding, it will increase the money supply and the AD curve will shift farther and farther to the right to AD 2 and AD 3. The result is a sustained inflation, perhaps hyperinflation. The Keynesian/Monetarist Debate Milton Friedman has been the leading spokesman for monetarism over the last few decades. Most monetarists argue that inflation in the United States could have been avoided if only the Fed had not expanded the money supply so rapidly. The Keynesian/Monetarist Debate % Δ M + % Δ V = % Δ P + % Δ Y With constant velocity:% Δ P = % Δ M - % ΔY Policy for zero inflation: % Δ M = (%) ΔY Most monetarists do not advocate an activist monetary stabilization policy - expanding the money supply during bad times and slowing its growth during good times. 6

7 The Keynesian/Monetarist Debate 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. Skip to Topic: Supply Side Economics The Keynesian/Monetarist Debate The debate between Keynesians and monetarists was the central controversy in macroeconomics in the 1960s. Monetarists were skeptical of the Fed s ability to manage the economy to 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 growth specifically, that the money supply 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 economy to fight inflation and unemployment Pearson Education, Inc. 21 of 21 7

8 Supply-Side Economics The theories we have discussed 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. (reduce government interference in the economy) 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 the tax base (profits, sales, and income) would then outweigh the decreases in rates, resulting in increased government revenues Pearson Education, Inc. 22 of 21 The Laffer Curve FIGURE 18.2 The Laffer Curve 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 in the 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. 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 Pearson Education, Inc. 23 of 21 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. In theory, a tax cut could even lead to a reduction in labor supply hang out at the pool. Research done during the 1980s suggests that tax cuts seem to increase 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 Pearson Education, Inc. 24 of 21 8

9 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. New Classical Macroeconomics On the empirical level, new classical theories were an attempt to explain the apparent breakdown in the 1970s of the simple inflationunemployment trade-off predicted by the Phillips Curve. We did this! Rational Expectations People are said to have rational expectations if they use all available information in forming their expectations. 9

10 Rational Expectations and Market Clearing 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. Evaluating Rational-Expectations Theory If expectations are not rational, there are likely to be unexploited profit opportunities most economists believe such opportunities are rare and short-lived. Evaluating Rational-Expectations Theory 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. 10