THE CURRENT POSITION: AN EMERGING CONSENSUS?

WEBSITES RELEVANT TO CHAPTERS 14 AND 15

16.5 THE CURRENT POSITION: AN EMERGING CONSENSUS?

New classical schoolA body of economists who believe that markets are highly competitive and clear very rapidly;

any expansion of demand will feed through virtually instantaneously into higher prices, giving a vertical short-run as well as a vertical long-run Phillips curve.

Real business cycle theory The new classical theory which explains cyclical fluctuations in terms of shifts in aggregate supply, rather than aggregate demand.

Definitions

This school favours laissez-faire (i.e. free-market) pol- icies and is part of what is often called the ‘radical right’.

Moderate monetarists/centre-right analysis

Many economists reject the new classical notion of a verti- cal short-run aggregate supply curve and vertical short-run Phillips curve, but still maintain that markets adjust fairly quickly – perhaps within one or two years.

A rise in money supply and hence aggregate demand will lead to a temporary reduction in unemployment, but as expectations of inflation (and hence of wage increases) adjust upwards, so eventually the whole of the rise in aggre- gate demand will be swallowed up in higher prices. Real aggregate demand falls back to its original level and hence the level of unemployment rises back to its original level too. Thus the short-run Phillips curve is downward sloping, but the long-run curve is vertical.

If the economy is faced with high inflation, a sudden tight monetary policy may temporarily lead to a recession.

Thus sudden extreme policies should be avoided. Instead there should be a gradual reduction in the growth of the money supply.

Any temporary demand-deficient unemployment will be reduced if workers can be encouraged to take reductions in real wages. Ultimately, though, any policies to make long-term reductions in unemployment must be aimed at the supply side of the economy: reducing the natural rate of unemployment by increasing labour mobility and get- ting markets to work better.

This analysis has resulted in the modern approach by governments and central banks of targeting the rate of inflation as the core focus of monetary policy. Adhering to this policy rule, it is argued, creates the stable environment necessary for the market to flourish: expectations will adjust to the target rate of inflation (assuming central banks are successful in sticking to the target) and firms will be able to plan with more confidence. Investment is thereby encour- aged and this, in turn, encourages a growth in potential output. In other words, sticking to the targets creates the best environment for the expansion of aggregate supply.

Moderate Keynesians

Moderate Keynesians argue that economies will probably eventually pull out of recession even if governments do not boost demand. There will be a natural upturn in the business cycle. Firms’ confidence will begin to return and investment will start to increase. Nevertheless a recession can be deep and long-lived and the recovery slow and faltering. Thus moderate Keynesians argue for active inter- vention by government to boost demand.

As the world plunged into recession in 2008, so govern- ments in many countries adopted Keynesian policy recom- mendations. Both monetary and fiscal policies were used to boost flagging aggregate demand. Central banks cut interest rates to nearly zero in an attempt to encourage borrowing and therefore spending. Alongside this, huge fiscal stimulus

packages were adopted by governments, involving substan- tial tax cuts and large increases in public expenditure. The US fiscal package adopted by President Obama in 2009 was

$787 billion – a massive 5.7 per cent of GDP.

Once an economy has recovered from recession and is back to near full employment, the government must still continue to control aggregate demand to prevent fluctu- ations in output and employment. Keynesians generally advocate the use of anti-cyclical demand management policy.

Most moderate Keynesians blame the persistence of recessions on the reluctance of real wages to fall so as to clear the labour market and eliminate demand-deficient unemployment. In recent years new Keynesians, as they are called, have attempted to discover the reasons for the downward stickiness in real wages during a recession.

These include the following:

• The worry of employers about demotivating their work- force, and thus causing efficiency to suffer. This is known as the efficiency wage theory.

• The power of insidersto resist real wage cuts.

• The power of firms under imperfect competitionto main- tain their prices. Firms may prefer to respond to a fall in demand by cutting output rather than cutting (real) prices, especially if they believe that their rivals will do the same. In such cases, they are not under the same pressure to cut real wage rates. Instead, they prefer to cut employment.

Extreme Keynesians

Extreme Keynesians argue that there is no automatic mech- anism to eliminate demand-deficient unemployment even in the long run.

Not only are real wage rates sticky downwards, but also any reductions in real wage rates that do take place will further reduce consumer demand. The amount of money circulating will automatically fall as banks lend out less and less in response to falling demand. Firms are unlikely to borrow for investment, since they have no confidence in their market. Expectations are likely to remain pessimistic.

Under these circumstances, the government must inter- vene to expand demand. By raising government expendi- ture and cutting taxes, the nation must spend its way out of recession. It may be necessary to use import controls to pre- vent any resulting balance of payments problems.

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New KeynesiansEconomists who seek to explain the downward stickiness of real wages and the resulting persistence of unemployment. They argue that governments may have to expand aggregate demand when demand-deficient unemployment is persistent.

Definition

After the economy has pulled out of recession, it is still important for the government to maintain a high level of demand. Not only will this maintain low unemployment and keep actual national income close to potential national income, it will also provide the most favourable environ- ment for research and development, innovations and investment generally. Thus potentialnational income will grow more rapidly.

Some Keynesians in this group are known as post- Keynesians. They highlight some of the key features of Keynes’ General Theoryto explain why economies are not self-correcting. In particular, they stress the importance of what Keynes called ‘animal spirits’, or what is today known as business expectations or business confidence.

The mood of the country’s business community is funda- mental in determining investment and output. Without appropriate demand-management policy, this mood can remain depressed into the long term.

Post-Keynesians and other ‘heterodox economists’ also challenge most of the microeconomic assumptions on which other more ‘mainstream’ macroeconomic theories are based.

Firms are not cold, rational profit maximisers, making calm calculations based on marginal analysis. Instead, firms make output decisions largely in response to anticipated demand, again based on their confidencein their market.

The result is that anticipated demand changes are likely to lead to outputand employmentchanges, not price changes.

Finally, post-Keynesians tend to focus on a country’s institutionsand cultureto explain how firms and consumers respond to economic stimuli. In other words, they try to base their explanations and policies on real-world institu- tional and behavioural information rather than on abstract models.

The radical left

Some economists make a far more fundamental attack on the market economy. Most Keynesians, although they see a free market as leading to serious problems, nevertheless argue that government intervention can rectify these prob- lems. Those on the radical left disagree. They see the mar- ket economy as so flawed that mere intervention will not solve its problems. Instead the market economy needs to be replaced by an alternative system such as state planning and/or worker control of industry. Marxist economists see the problem of capitalism to be so severe that ultimately there will be a revolution and it will be overthrown.

The fact that there are so many different views as to how the macroeconomy functions makes it impossible to do justice to them all in an introductory book. Nevertheless it is hoped that you will get some insight into the major schools of thought and why they advocate the policies they do.

Two economists disagree over the best way of tackling the problem of unemployment. For what reasons might they disagree? Are these reasons positive or normative?

A mainstream consensus?

Although there are many areas of disagreement in macro- economics, some general points of agreement have emerged in recent years, at least among the majority of economists.

• In the short run, changes in aggregate demand will have a major effect on output and employment. If there is a collapse in demand, as in 2008, governments and/or central banks should intervene through expansionary fiscal and/or monetary policies. Only a few extreme new classical economists would disagree with this proposition.

• In the long run, changes in aggregate demand will have much less effect on output and employment and much more effect on prices. In fact, many economists say that there will be noeffect at all on output and employment, and that the whole effect will be on prices. There is still a substantial body of Keynesians, however, especially post-Keynesians, who argue that changes in aggregate demand willhave substantial effects on long-term out- put and employment via changes in investment and hence in potential output.

• There is no simple long-run trade-off between inflation and unemployment. There is still disagreement, how- ever, as to whether there is no relationship between them at all (i.e. the long-run Phillips curve is vertical), or whether they are connected indirectly via the long- term effects of changes in aggregate demand on invest- ment, etc.

• Expectations have an important effect on the economy.

There is still disagreement, however, as to whether it is people’s expectations of price changes or of output changes that are more important.

• Excessive growth in the money supply will lead to inflation. Some economists argue that the quantity the- ory of money holds in the long run (i.e. that inflation is entirelydue to increases in the money supply). Others argue that the relationship is more general. Neverthe- less, the consensus is that governments should avoid allowing the money supply to grow too rapidly.

• Controlling inflation through control of the money supply, however, is difficult, since money supply itself is not easy to control. Even if it were possible to control money supply, there is a time lag between changes in money supply and the resulting changes in inflation.

This makes a precise control of inflation by this means

?

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Post-Keynesians Economists who stress the importance of institutional and behavioural factors, and the role of business confidence in explaining the state of the economy. They argue that firms are more likely to respond to changes in demand by changing output rather than prices.

Definition

very difficult. Most economists, therefore, argue that it is easier to control inflation by controlling interest rates, since this directly affects aggregate demand. Most cen- tral banks around the world today therefore use interest rate changes to achieve a target rate of inflation.

• Macroeconomic policy should not focus exclusively on the demand side. Long-term growth depends primarily on changes in supply (i.e. in potential output). It is important, therefore, for governments to develop an effective supply-side policy if they want to achieve faster economic growth. There is still disagreement, however, over the forms that supply-side policy should take: should it focus on freeing up the market, or should it focus on various forms of government intervention to compen- sate for market deficiencies?

• Governments’ ability to control their country’s macro- economic destiny is being increasingly eroded by the process of globalisation. As countries become more and

more interdependent, and as capital moves more and more freely around the globe, so there is a growing need for co-ordinated policies between governments to tackle problems of global recessions or excessive exchange rate fluctuations. This lesson was brought home in 2008, when it became obvious that most countries were ex- periencing a collapse in aggregate demand following the banking crisis and the credit crunch. Leaders discussed common policy approaches at several international summits, including both bank rescue packages and expansionary fiscal and monetary policies.

It is perhaps too soon to say that there is now a macroeco- nomic consensus, but at least the areas of disagreement have been refined.

As the book progresses, we will be looking at the various areas of agreement and disagreement in more detail. We shall pull most of the arguments together in Chapter 21.

Section summary

1. There are many shades of opinion among the different groups of economists, from extreme new classical economists who advocate almost complete laissez- faire to the extreme left where economists advocate the virtual abandonment of markets. In between comes a whole spectrum of opinions and theories about the relative effectiveness of markets and the government in achieving the various macroeconomic goals.

2. Despite these disagreements, most economists would agree on the following points: changes in aggregate demand have a direct effect on output and

employment in the short run, but either no effect or a far less certain effect in the long run; there is no simple long-run trade-off between inflation and unemployment; expectations have an important effect on the economy; excessive growth in the money supply causes inflation; it is easier to achieve inflation targets by controlling interest rates than by controlling money supply; changes on the supply side of the economy are the major determinant of long-term growth; globalisation reduces individual countries’

ability to control their economies.

END OF CHAPTER QUESTIONS

1. In a given economy, the supply of money is £10 billion;

the velocity of circulation of money (spent on final goods and services) is 3; and the price index is 2.00.

(a) What is the level of real national income?

(b) How much have prices risen (in percentage terms) since the base year?

(c) Assume that money supply increases by 10 per cent and that the velocity of circulation remains constant. By what percentage will prices rise if (i) there is no increase in real national income;

(ii) real national income increases by 10 per cent;

(iii) real national income increases by 5 per cent?

2. In what way will the nature of aggregate supply influence the effect of a change in aggregate demand on prices and real national income?

3. Criticise the classical theory that higher government spending will necessarily crowd out private spending.

4. Criticise the use of increasing government expenditure as a means of reducing unemployment.

5. In what way may short-term demand-management policies help to stabilise the economy? What problems occur in the use of such policies?

6. What explanations can you give for the increase in both unemployment and inflation in the 1970s?

7. What is meant by hysteresis when applied to unemployment? How do you account for this phenomenon in the 1980s?

8. What will cause people to expect higher rates of inflation? How will expectations of inflation affect the actual rate of inflation?

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Online resources

Additional case studies in MyEconLab

16.1 The equation of exchange. This examines two more versions that are commonly used: the Fisher version and the Cambridge version.

16.2 Money and inflation in ancient Rome. A very early case study of the quantity theory of money: how the minting of extra coins by the Romans caused prices to rise.

16.3 The Great Depression and the return to the gold standard. A time of great hardship and sacrifice.

16.4 Classical ‘remedies’ for unemployment. How the policies advocated by the classical economists to cure unemployment would, according to Keynes, make the problem worse.

16.5 A little bit less of this and a little bit more of that. Fine tuning in 1959 and 1960.

16.6 ‘ You’ve never had it so good.’ The claim in 1957 by Harold Macmillan, the British Conservative Prime Minister, that governments were now able to manage the economy so as to give growing prosperity.

Websites relevant to this chapter

See sites listed at the end of Chapter 17 on page 501.

17 Ch apt er

Short-run Macroeconomic Equilibrium