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

CHAPTER 19
Debates in Macroeconomics:
Monetarism, New Classical
Theory, and Supply-Side
Economics
Prepared by: Fernando Quijano

and Yvonn Quijano
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair
Keynesian Economics
New Classical Theory, and Supply-Side Economics
Debates in Macroeconomics: Monetarism,
• 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.
C H A P T E R 19:
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 38
Keynesian Economics
• Two major schools decidedly against

government intervention have
developed: monetarism and new
classical economics.
C H A P T E R 19:
Monetarism
• The main message of monetarists is

that money matters.
• Monetarism, however, is usually

considered to go beyond the notion
that money matters.
C H A P T E R 19:
Monetarism
• 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):
C H A P T E R 19:
GDP or V 
P Y since GDP  P Y
V 
M M then, M V  P  Y
The Quantity Theory of Money
• The quantity theory of money is a

theory based on the identity
M x V = P x Y and the assumption
that the velocity of money (V) is
constant (or virtually constant).
Then, the theory can be written as
the following equality:
C H A P T E R 19:
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
C H A P T E R 19:
the interest rate.
• The demand for money may depend

not only on nominal income, but also
on the interest rate.
• Whether velocity is constant or not

may depend partly on how we
measure the money supply.
C H A P T E R 19:
The Velocity of Money,
1960 I – 2003 II
C H A P T E R 19:
• The velocity of money is far from constant. There is

a rising long-term trend, but fluctuations around this
trend have been quite large.
Inflation as a Purely
Monetary Phenomenon
• Inflation is always a 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
C H A P T E R 19:
output, is called the “strict

monetarist” view.
Inflation as a Purely
Monetary Phenomenon
• The “strict monetarist” view is not

compatible with a nonvertical AS
curve.
• Almost all economists agree that
sustained inflation is purely a
monetary phenomenon.
• Inflation cannot continue indefinitely
C H A P T E R 19:
without increases in the money

supply.
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
C H A P T E R 19:
rapidly.
• Most monetarists do not advocate an

activist monetary policy stabilization
—expanding the money supply
during bad times and slowing its
growth during good times.
C H A P T E R 19:
• 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).
C H A P T E R 19:
• Many Keynesians advocate the

application of coordinated monetary
and fiscal policy tools to reduce
instability in the economy—to fight
inflation and unemployment.
C H A P T E R 19:
• 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.
C H A P T E R 19:
New Classical Macroeconomics
• On the theoretical level, new

classical macroeconomists argue
that traditional models have
assumed that expectations are
formed in naive ways.
C H A P T E R 19:
• 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.
C H A P T E R 19:
• 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.
C H A P T E R 19:
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 in
C H A P T E R 19:
forecasting inflation.
• People are said to have rational

expectations if they use “all available
information” in forming their
expectations.
C H A P T E R 19:
• 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.
C H A P T E R 19:
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.
C H A P T E R 19:
and Market Clearing
• 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.
C H A P T E R 19:
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):
e
Y  f (P  P )
C H A P T E R 19:
• The difference between the actual

price level and the expected price
level is the price surprise.
e
(P P )
C H A P T E R 19:
• 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.
C H A P T E R 19:
• Rational-expectations theory,
combined with the Lucas supply
function, proposes a very small role
for government policy in the
economy.
C H A P T E R 19:
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.
C H A P T E R 19:
Evaluating
Rational-Expectations Theory
• 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.
C H A P T E R 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.
C H A P T E R 19:
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
C H A P T E R 19:
stimulus but better incentives to stimulate

supply.
The Laffer Curve
• With the tax rate measured on the

vertical axis and tax revenue
measured on the horizontal axis, the
Laffer curve shows there is some
tax rate beyond which the supply
response is large enough to lead to a
decrease in tax revenue for further
increases in the tax rate.
C H A P T E R 19:
The Laffer Curve
• The Laffer curve shows

the amount of revenue
the government collects
is a function of the tax
rate.
C H A P T E R 19:
The Laffer Curve
• When tax rates are very

high, an increase in the
tax rate could cause tax
revenues to fall.
Similarly, a cut in the
tax rate could generate
enough additional
economic activity to
C H A P T E R 19:
cause revenues to rise.
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
C H A P T E R 19:
also choose to work less.
Testing Alternative
Macroeconomic 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
C H A P T E R 19:
available to test macroeconomic

hypotheses—only eight business
cycles since 1950.
Review Terms and Concepts
Laffer curve
Lucas supply function
price surprise
quantity theory of money
rational expectations hypothesis
real business cycle theory
velocity of money
C H A P T E R 19:

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CHAPTER 19

Prepared by: Fernando Quijano

• In a broad sense, Keynesian

• Two major schools decidedly against

• The main message of monetarists is

• Monetarism, however, is usually

• The monetarist analysis of the

• The quantity theory of money is a

• If there is equilibrium in the money

the interest rate.

• The demand for money may depend

• Whether velocity is constant or not

• The velocity of money is far from constant. There is

• Inflation is always a monetary

• The view that changes in the money

output, is called the “strict

• The “strict monetarist” view is not

without increases in the money

• Milton Friedman has been the

• Most monetarists argue that inflation

• Most monetarists do not advocate an

• Time lags are the most common

• Monetarists advocate a policy of

• Many Keynesians advocate the

• Others reject the strict monetarist

• On the theoretical level, new

• Naive expectations are inconsistent

• On the empirical level, new classical

• By “true” model we mean a model

• People are said to have rational

• Because there are costs associated

• If firms have rational expectations,

• When expectations are rational,

• The Lucas supply function is the

• The difference between the actual

• The rationale for the Lucas supply

• If expectations are not rational, there

• The argument against rational

• The real business cycle theory is

• Orthodox macro theory consists of

• Supply-side economists believe that the

stimulus but better incentives to stimulate

• With the tax rate measured on the

• The Laffer curve shows

• When tax rates are very

cause revenues to rise.

• Among the criticisms of supply-side

• When households receive a higher

also choose to work less.

• Models differ in ways that are hard to

available to test macroeconomic

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