Keynesian%20Economics

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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.
• Two major schools decidedly against government
  intervention have developed monetarism and new
  classical economics.

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Monetarism

• The main message of monetarism is that money
  matters.
• 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)

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The Quantity Theory of Money

• The quantity theory of money is a theory based on
  the identity , which
  assumes that the velocity of money (V) is
  constant. Then, the theory can be written as the
  following equality

• If there is equilibrium in the money market, then
  the quantity of money supplied is equal to the
  quantity of money demanded. When M is taken to
  be the quantity of money demanded, this equality
  would make the quantity of money demanded
  dependent on nominal GDP, but not the interest
  rate.

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The Quantity Theory of Money

• Recent data on the U.S. economy shows that the
  demand for money does not appear to depend only
  on nominal income, but also on the interest rate.
• Also, the velocity of money is far from constant.
  There is a rising long-term trend in velocity,
  but fluctuations around this trend have been
  quite large.
• However, whether velocity is constant or not may
  depend partly on how we measure the money supply.

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The Velocity of Money, 1960 I 2000 II
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Inflation is Purely aMonetary Phenomenon

• Inflation (an increase in P) is always a purely
  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.
• This view is not compatible with a nonvertical AS
  curve in the AS/AD model. However, almost all
  economists agree that sustained inflation is
  purely a monetary phenomenon.

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Inflation is Purely aMonetary Phenomenon

• The strict monetarist view is not compatible
  with a nonvertical AS curve because, if the AS
  curve is nonvertical, an increase in M, which
  shifts the AD curve to the right, increases both
  P and Y.

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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.

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The Keynesian/Monetarist Debate

• Most monetarists do not advocate an activist
  monetary policy stabilizationexpanding the money
  supply during bad times and slowing its growth
  during good times.
• 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).

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The Keynesian/Monetarist Debate

• Many Keynesians advocate the application of
  coordinated monetary and fiscal policy tools to
  reduce instability in the economyto fight
  inflation and unemployment.
• Others reject the strict monetarist position in
  favor of the view that both monetary and fiscal
  policies make a difference and at the same time
  believe the best possible policy is basically
  noninterventionist.

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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.

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New Classical Macroeconomics

• On the empirical level, new classical theories
  were an attempt to explain the apparent breakdown
  in the 1970s of the simple inflation-unemployment
  trade-off predicted by the Phillips Curve.

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Rational Expectations

• The rational-expectations hypothesis assumes
  people know the true model of the economy and
  that they use this model to form their
  expectations of the future.
• By true model we mean a model that is on
  average correct, even though predictions are not
  exactly right all the time.

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Rational Expectations

• People are said to have rational expectations if
  they use all available information in forming
  their expectations.
• Because there are costs associated with making a
  wrong forecast, it is not rational to overlook
  information, as long as the costs of acquiring
  that information do not outweigh the benefits of
  improving its accuracy.

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Rational Expectations andMarket Clearing

• If firms have rational expectations, on average,
  prices and wages will be set at levels that
  ensure equilibrium in the goods and labor
  markets. In other words, on average, there will
  be no unemployment.
• 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.

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The Lucas Supply Function

• The Lucas supply function is the supply function
  that embodies the idea that output (Y) depends on
  the difference between the actual price level (P)
  and the expected price level (Pe)

• The difference between the actual price level and
  the expected price level is the price surprise.

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The Lucas Supply Function

• The rationale for the Lucas supply function is
  that unexpected increases in the price level can
  fool workers and firms into thinking that
  relative prices have changed, causing them to
  alter the amount of labor or goods they choose to
  supply.
• Rational-expectations theory, combined with the
  Lucas supply function, proposes a very small role
  for government policy in the economy.

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Evaluating Rational-Expectations Theory

• If expectations are not rational, there are
  likely to be unexploited profit
  opportunitiesmost economists believe such
  opportunities are rare and short-lived.
• 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.

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Real Business Cycle Theory

• The real business cycle theory is an attempt to
  explain business cycle fluctuations under
  assumptions of complete price and wage
  flexibility and rational expectations. It
  emphasizes shocks to technology and other shocks.
• If the AS curve is vertical, shifts in AD cannot
  account for real output fluctuations.

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Supply-Side Economics

• Orthodox macro theory consists of demand-oriented
  theories that failed to explain the stagflation
  of the 1970s.
• Supply-side economists believe that the real
  problem was that high rates of taxation and heavy
  regulation had reduced the incentive to work, to
  save, and to invest. What was needed was not a
  demand stimulus but better incentives to
  stimulate supply.

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The Laffer Curve

• The Laffer Curve shows the amount of revenue the
  government collects is a function of the tax rate.

• 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.

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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.
• When households receive a higher after-tax wage,
  they might have an incentive to work more, but
  they may also choose to work less.

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Testing Alternative Macro Models

• Models differ in ways that are hard to
  standardize.
• If people have rational expectations, they are
  using the true model, but there is no way to know
  what model is in fact the true one.
• There is only a small amount of data available to
  test macroeconomic hypothesesonly seven business
  cycles since 1950.