SOME HISTORY: CLASSICAL ECONOMICS AND KEYNES
- The Classical View
The aggregate supply curve is vertical and is the sole determinant of the level of real output.
· Vertical Aggregate Supply Curve
The economy will operate at its potential output because of (1) Say’s Law, and (2) responsive, flexible prices and wages.
· Stable Aggregate Demand
The amount of real output that can be purchased depends on (1) the quantity of money households and business process and (2) the quantity of purchasing power of that money as determined by the price level.
- The Keynesian View
The macroeconomic generalizations that lead to the conclusion that a capitalistic economy is characterized by the macroeconomic instability and that fiscal policy and monetary policy can be used to promote full employment, price level stability and economic growth.
· Horizontal Aggregate Supply Curve
The downward inflexibility of prices and wages presumed by the Keynesian translates to the horizontal aggregate supply curve.
· Unstable Aggregate Demand
- Keynesian economics view aggregate demand as unstable from one period to the next, even WHAT CAUSES MACRO INSTABILITY?
- Mainstream View
Macro instability is caused by the volatility of investment spending, which shifts the aggregate demand curve. If aggregate demand increases too rapidly, demand-pull inflation may occur, if aggregate demand decreases, recession may occur.
2 main sources:
(1) Significant changes in investment spending, which change aggregate demand and (2) adverse aggregate supply shocks, which change aggregate supply.
· Changes in Investment Spending
Investment spending in particular, is subject to wide “booms” and “busts”. Increases in investment spending are multiplied into even greater increases in aggregate demand and thus can produce demand-pull inflation. In contrast, significant declines in investment spending are multiplied into even greater decreases in aggregate demand and thus can cause recessions.
· Adverse Aggregate Supply Shocks
- Monetary View
(1) Focuses on the money supply, (2) holds that markets are highly competitive, and (3) says that a competitive market gives the economy a high degree of macroeconomic stability.
· Equation of Exchange
MV =PQ
M is the supply of money
V is the velocity of money, that is, the average number of times per year a dollar is spent on final goods and services
P is the price level
Q is the physical volume of goods and services produced
· Stable velocity
When monetarists say that velocity is stable, they mean that the factors altering velocity change gradually and predictably that changes in velocity from one year to the next can be readily anticipated. Moreover, they told that velocity does not change in response to changes in the money supply itself.
- Monetary Causes of Instability
Inappropriate monetary policy – an increase in the money supply directly increases aggregate demand.
- Real-Business Cycle View
Views changes in resource availability and technology, which alter productivity, as the main causes of macroeconomic instability. In this theory, shifts of the economy’s long-run aggregate supply curve change real output. In turn, money demanded and money supply change, changing the aggregate demand curve in the same direction as the initial change in long-run aggregate supply. Real output thus can change without a change in the price level.
- Coordination Failures
Is said to occur when people lack away to coordinate their actions in order to achieve a mutually beneficial equilibrium. Depending on people’s expectations, the economy can come to rest either a good equilibrium or a bad equilibrium.
· Noneconomic Example
· Macroeconomic Example
DOES THE ECONOMY “SELF-CORRECT”?
- New Classical View of Self-Correction
Rational Expectations Theory – the idea that businesses, consumers and workers expect charges in policies or circumstances to have certain effects on the economy, and in pursuing their own self-interest, take actions to make sure those changes affect them as little as possible.
New Classical Economics – holds that when the economy occasionally diverges from its full-employment output, internal mechanisms within the economy will automatically move it back to that output.
- Graphical Analysis
- Speed of Adjustment
RET is based on two assumptions:
· People behave rationally, gathering and intelligently processing information to form expectations about things that an economically important to them.
· Like classical economists, RET economists assume that all product and resource markets are highly competitive and that prices and wages are flexible both upward and downward.
- Unanticipated Price-Level Changes
Price-level surprises – unanticipated changes in the price level cause temporary changes in real output.
- Fully Anticipated Price-Level Changes
Do not change real output, even for shorter periods
- Mainstream View of Self-Correction
- Graphical Analysis
- Downward Wage Inflexibility
- Efficiency Wage Theory
Efficiency Wage – is a wage that minimizes the firm’s labor cost per unit of output.
How can higher wage result in greater efficiency?
· Greater work effect
· Lower supervision costs
· Reduced job turnover
- Insider-Outsider Relationships
Insider-Outsider Theory – outsiders may not be able to underbid existing wages because employers may view the nonwage cost of hiring them to be prohibitive.
RULES OR DISCRETION?
- In Support of Policy Rules
Such rules would prevent government from trying to “manage” aggregate demand. That would be a desirable trend, because in their view, such management is misguided and thus is likely to cause more instability.
- Monetary Rule
One such rule would be a requirement that the Fed expand the money supply each year, at the same annual rate as the typical growth of the economy’s production capacity.
- Balanced Budget
- In Defense of Discretionary Stabilization Policy
· Discretionary Monetary Policy – Annual rate of increase in the money supply might not eliminate fluctuations in aggregate demand.
- · Discretionary Fiscal Policy – Deliberate changes in taxes and government spending by Increased Macro Stability
Moreover, mainstream economists point out several specific policy successes in the past two decades.
· A tight money policy dropped inflation from 13.5% in 1980 to 3.2% in 1983.
· An expansionary fiscal policy reduced the unemployment rate from 9.7% in 1982 to 5.5% in 1988.
· An easy money policy helped the economy recover from the 1990-1991 recession.
· Judicious tightening of monetary policy in the mid-1990s, and then again in the late 1990s, helped the economy remain on a noninflationary, full-employment growth output.
· In late 2001 to 2002, expansionary fiscal and monetary policy helped the economy slowly recover from a series of economic blows, including the collapse of numerous Internet start-up firms, a severe decline in investment spending, the impacts of the terrorist attacks of September 11, 2001, and a precipitous decline in stock values.
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