Title: Keynesian%20Economics
1Keynesian 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.
2Monetarism
- 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)
3The 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.
4The 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.
5The Velocity of Money, 1960 I 2000 II
6Inflation 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.
7Inflation 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.
8The 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.
9The 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).
10The 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.
11New 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.
12New 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.
13Rational 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.
14Rational 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.
15Rational 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.
16The 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.
17The 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.
18Evaluating 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.
19Real 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.
20Supply-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.
21The 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.
22Evaluating 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.
23Testing 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.