Principles of macroeconomics 10e by case fair oster ch18

The Velocity of Money The Quantity Theory of Money Inflation as a Purely Monetary Phenomenon The Keynesian/Monetarist DebateSupply-Side Economics The Laffer Curve Evaluating Supply-Side

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

The Velocity of Money The Quantity Theory of Money Inflation as a Purely Monetary Phenomenon The 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

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 debate—that between Keynesians and monetarists

Keynesian Economics

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 that

money matters

Monetarism

a Changes in the money supply affect the AD curve.

velocity of money The number of times a dollar

bill changes hands, on average, during a year;

the ratio of nominal GDP to the stock of money

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   

Monetarism

The Velocity of Money

Y P

quantity theory of money The theory based on the identity M × V ≡ P × Y and the assumption that the velocity of money (V) is constant (or virtually constant)

let V denote the constant value of V, the equation for the quantity

theory can be written as follows:

Y P

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

There is a long-term trend—velocity has been rising

There are also fluctuations, some of them quite large.

 FIGURE 18.1 The Velocity of Money, 1960 I–2010 I

Monetarism

The Quantity Theory of Money

Testing the Quantity Theory of Money

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

There is considerable disagreement as to whether the strict monetarist view is a good approximation of reality

Almost all economists agree, however, that sustained inflation—

inflation that continues over many periods—is a purely monetary phenomenon

Inflation cannot continue indefinitely without increases in the money supply

Monetarism

Inflation as a Purely Monetary Phenomenon

The “strict monetarist” view states that:

aggregate income and the price level

phenomenon

c Changes in the money supply affect only the price level (P), not

real output (Y).

d Since velocity is constant, a change in M affects both P and Y.

The “strict monetarist” view states that:

aggregate income and the price level

phenomenon

c Changes in the money supply affect only the price level (P),

not real output (Y).

d Since velocity is constant, a change in M affects both P and Y.

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

The debate between Keynesians and monetarists subsided with the advent of what we will call “new classical macroeconomics.”

Monetarism

The Keynesian/Monetarist Debate

d The federal government.

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, 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 bases (profits, sales, and income) would then outweigh the decreases in

rates, resulting in increased government revenues

Supply-Side Economics

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

 FIGURE 18.2 The Laffer Curve

Supply-Side Economics

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

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

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

Supply-Side Economics

Evaluating Supply-Side Economics

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

New Classical Macroeconomics

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 nạve 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

Which of the following is true about new classical economics?

Which of the following is true about new classical economics?

c No two new classical macroeconomists think alike.

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

New Classical Macroeconomics

Rational Expectations

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

economy.

d No need for government stabilization policies of any kind.

A current debate among

macroeconomists and policy

makers is how people form

expectations about the future state

of the economy

In 2010, a number of economists

began 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 works

or 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

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

) ( P Pef

price surprise Actual price level minus expected price level

New Classical Macroeconomics

Rational Expectations

The Lucas Supply Function

The general conclusion is that any announced policy change

—in fiscal policy or any other policy—has 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

New Classical Macroeconomics

Rational Expectations

Policy Implications of the Lucas Supply Function

a Will have no affect on real output

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

New Classical Macroeconomics

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

output.

c The AS curve is vertical, even in the short run.

The argument against rational expectations is that it requires

households and firms to know too much while the gain from learning the true 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

New Classical Macroeconomics

Evaluating the Rational Expectations Assumption

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

quantity theory of moneyrational expectations hypothesisreal business cycle theory

M   

Y P V

M   

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