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Keynesian%20Economics

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Title: Keynesian%20Economics


1
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.

2
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)

3
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.

4
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.

5
The Velocity of Money, 1960 I 2000 II
6
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.

7
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.

8
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.

9
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).

10
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.

11
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.

12
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.

13
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.

14
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.

15
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.

16
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.

17
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.

18
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.

19
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.

20
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.

21
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.

22
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.

23
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.
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