CHAPTER 29

Debates in Macroeconomics:
Monetarism, New Classical
Theory, and Supply Side
Economics

Prepared by: Fernando

Quijano and Yvonn Quijano

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, 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.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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):
G D P
or
P Y or M V P Y
V V
M M
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Quantity Theory of Money

The quantity theory of money is a theory based

on the identity M V P Y , which assumes
that the velocity of money (V) is constant. Then,
the theory can be written as the following equality:
M V P Y
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.

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 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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 The Velocity of Money, 1960 I 2000 II

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Inflation is Purely a
Monetary 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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 Inflation is Purely a
Monetary 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.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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 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).
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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 time believe the best possible policy
is basically noninterventionist.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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, 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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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):
Y f (P P e)
The difference between the actual price
level and the expected price level is the
price surprise.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

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 opportunities
most 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.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.

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 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.

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.
2002 Prentice Hall Business Publishing
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.
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.

2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
 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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair