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8/13/2019 principles of economics chapter 18
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
CHA
PT
E
R
18
Prepared by: Fernando Quijano
and Yvonn Quijano
Debates in Macroeconomics:
Monetarism, New Classical
Theory, and Supply Side
Economics
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Keynesian Economics
In a broad sense, Keynesian economics is
the foundation of modern macroeconomics.
In a narrower sense, Keynesianrefers to
economists who advocate activegovernment intervention in the economy.
Two major schools decidedly against
government intervention have developed:
monetarism and new classical economics.
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Quantity Theory of Money
Recent data on the U.S. economy showsthat the demand for money does notappear to depend only on nominal income,but also on the interest rate.
Also, the velocity of money is far fromconstant. There is a rising long-term trendin velocity, but fluctuations around this
trend have been quite large. However, whether velocity is constant or
not may depend partly on how wemeasure the money supply.
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Velocity of Money, 1960 I2000 II
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The Keynesian/Monetarist Debate
Most monetarists do not advocate an
activist monetary policy stabilization
expanding the money supply during bad
times and slowing its growth during goodtimes.
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 economy
to 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 timebelieve 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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Rational Expectations
The rat ional-expectat ions 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 averagecorrect, even though
predictions are not exactly right all the
time.
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Rational Expectations and
Market 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, onaverage, 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 expectedprice level (Pe):
Y f P P e ( )
The difference between the actual pricelevel and the expected price level is the
pr ice surp r ise.
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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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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
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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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Real Business Cycle Theory
The real business cycle theoryis an
attempt to explain business cycle
fluctuations under assumptions of
complete price and wage flexibility andrational expectations. It emphasizes
shocks to technology and other shocks.
If theAScurve is vertical, shifts inAD
cannot account for real output fluctuations.
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
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 thereal 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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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
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 taxrate could cause tax
revenues to fall. Similarly,
under the same
circumstances, a cut in the
tax rate could generateenough additional
economic activity to cause
revenues to rise.
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2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
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 noway to know what model is in fact the true
one.
There is only a small amount of dataavailable to test macroeconomic
hypothesesonly seven business cycles
since 1950.