CH 29

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
P Y
or
or M V P Y
V
V
M
M
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.
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.
Karl Case, Ray Fair
The Velocity of Money, 1960 I 2000 II
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.
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.
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.
Karl Case, Ray Fair

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).
Karl Case, Ray Fair

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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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 aftertax wage, they might have an incentive to
work more, but they may also choose to
work less.
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.
Karl Case, Ray Fair

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Keynesian Economics

In a broad sense, Keynesian economics is

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Principles of Economics, 6/e

Karl Case, Ray Fair

The Quantity Theory of Money

Principles of Economics, 6/e

Karl Case, Ray Fair

The Quantity Theory of Money

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

Principles of Economics, 6/e

Karl Case, Ray Fair

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Keynesian/Monetarist Debate

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Keynesian/Monetarist Debate

Principles of Economics, 6/e

Karl Case, Ray Fair

The Keynesian/Monetarist Debate

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

New Classical Macroeconomics

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

New Classical Macroeconomics

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Rational Expectations and

Principles of Economics, 6/e

Karl Case, Ray Fair

The Lucas Supply Function

Principles of Economics, 6/e

Karl Case, Ray Fair

The Lucas Supply Function

Principles of Economics, 6/e

Karl Case, Ray Fair

Evaluating Rational-Expectations Theory

Principles of Economics, 6/e

Karl Case, Ray Fair