Monetarism in Macroeconomics: Money Matters and Inflation Trends

P R I N C I P L E S O F MACROECONOMICS T E N T H E D I T I O N CASE FAIR OSTER Prepared by: Fernando Quijano & Shelly Tefft

18 Alternative Views in Macroeconomics CHAPTER OUTLINE Keynesian Economics Monetarism The Velocity of Money The Quantity Theory of Money Inflation as a Purely Monetary Phenomenon The Keynesian/Monetarist Debate Supply-Side Economics The Laffer Curve Evaluating Supply-Side Economics New Classical Macroeconomics The Development of New Classical Macroeconomics Rational Expectations Real Business Cycle Theory and New Keynesian Economics Evaluating the Rational Expectations Assumption Testing Alternative Macroeconomic Models

Keynesian Economics In one sense, Keynesian economics is the foundation of all of macroeconomics. Now used more narrowly, Keynesian sometimes refers to economists who advocate active government intervention in the macroeconomy. We begin with an old debate—that between Keynesians and monetarists.

Monetarism The debate between monetarist and Keynesian economics is complicated because it means different things to different people. If we consider the main monetarist message to be that “money matters,” then almost all economists would agree. Monetarism, however, is usually considered to go beyond the notion that money matters.

In the model of aggregate supply and aggregate demand, money matters because: a. Changes in the money supply affect the AD curve. b. Changes in the money supply shifts affect the AS curve in the short run. c. Changes in the money supply shifts affect the AS curve in the long run. d. All of the above.

Monetarism The Velocity of Money velocity of money The number of times a dollar bill changes hands, on average, during a year; the ratio of nominal GDP to the stock of money. The income velocity of money (V) is the ratio of nominal GDP to the stock of money (M):

Monetarism The Velocity of Money We can expand this definition slightly by noting that nominal income (GDP) is equal to real output (income) (Y) times the overall price level (P): Through substitution: or quantity theory of money The theory based on the identity M × V ≡P × Y and the assumption that the velocity of money (V) is constant (or virtually constant).

The key assumption of the quantity theory of money is that the velocity of money is constant (or virtually constant) over time. If we let V denote the constant value of V, the equation for the quantity theory can be written as follows: Monetarism The Quantity Theory of Money

Monetarism The Quantity Theory of Money Testing the Quantity Theory of Money  FIGURE 18.1The Velocity of Money, 1960 I–2010 I Velocity has not been constant over the period from 1960 to 2010. There is a long-term trend—velocity has been rising. There are also fluctuations, some of them quite large.

Monetarism Inflation as a Purely Monetary Phenomenon In the “strict monetarist” view, changes in M affect only P and not Y, so inflation (an increase in P) is always a purely monetary phenomenon. The price level will not change if the money supply does not change. There is considerable disagreement as to whether the strict monetarist view is a good approximation of reality. Almost all economists agree, however, that sustained inflation—inflation that continues over many periods—is a purely monetary phenomenon. Inflation cannot continue indefinitely without increases in the money supply.

The “strict monetarist” view states that: a. Changes in aggregate demand cause an increase in both aggregate income and the price level. b. Inflation is a real phenomenon, not a purely monetary phenomenon. c. Changes in the money supply affect only the price level (P), not real output (Y). d. Since velocity is constant, a change in M affects both P and Y.

Monetarism The Keynesian/Monetarist Debate Monetarists were skeptical of the Fed’s ability to “manage” the economy—to expand the money supply during bad times and contract it during good times. The leading spokesman for monetarism, Milton Friedman, advocated a policy of steady and slow money growth—specifically, that the money supply should grow at a rate equal to the average growth of real output (income) (Y). While not all Keynesians advocated an activist federal government, many advocated the application of coordinated monetary and fiscal policy tools to reduce instability in the economy—to fight inflation and unemployment. The debate between Keynesians and monetarists subsided with the advent of what we will call “new classical macroeconomics.”

Most monetarists, including Milton Friedman, blame most of the instability in the economy on: a. The volatility of investment spending. b. Changes in aggregate demand. c. Changes in aggregate supply. d. The federal government.

Supply-Side Economics The theories we have been discussing are “demand-oriented.” Supply-side economics, as the name suggests, focuses on the supply side. In the late 1970s and early 1980s, supply-siders argued that the real problem with the economy was not demand, but high rates of taxation and heavy regulation that reduced the incentive to work, to save, and to invest. What was needed was not a demand stimulus, but better incentives to stimulate supply. At their most extreme, supply-siders argued that the incentive effects of supply-side policies were likely to be so great that a major cut in tax rates would actually increase tax revenues. Even though tax rates would be lower, more people would be working and earning income and firms would earn more profits, so that the increases in the tax bases (profits, sales, and income) would then outweigh the decreases in rates, resulting in increased government revenues.

Supply-Side Economics The Laffer Curve  FIGURE 18.2The Laffer Curve The Laffer curve shows that the amount of revenue the government collects is a function of the tax rate. It shows that 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. Laffer curve With the tax rate measured on the vertical axis and tax revenue measured on the horizontal axis, the Laffer curve shows that 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.

Refer to the figure below. At which point should tax rates be cut? a. At point A. b. At point B. c. At both points A and B. d. At neither point A nor B.

Supply-Side Economics 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. In theory, a tax cut could even lead to a reduction in labor supply. Research done during the 1980s suggests that tax cuts seem to increase the supply of labor somewhat but that the increases are very modest. Traditional theory suggests that a huge tax cut will lead to an increase in disposable income and, in turn, an increase in consumption spending (a component of aggregate expenditure). Although an increase in planned investment (brought about by a lower interest rate) leads to added productive capacity and added supply in the long run, it also increases expenditures on capital goods (new plant and equipment investment) in the short run.

New Classical Macroeconomics The challenge to Keynesian and related theories has come from a school sometimes referred to as the new classical macroeconomics. No two new classical macroeconomists think exactly alike, and no single model completely represents this school. The Development of New Classical Macroeconomics Keynes recognized that expectations (in the form of “animal spirits”) play a big part in economic behavior. The problem is that traditional models assume that expectations are formed in naïve ways, which is inconsistent with the assumptions of microeconomics. If, as microeconomic theory assumes, people are out to maximize their satisfaction and firms are out to maximize their profits, they should form their expectations in a smarter way. In this view, forward-looking, rational people compose households and firms.

Which of the following is true about new classical economics? a. It is derived from Keynesian economics. b. It builds forecasts based on naïve expectations. c. No two new classical macroeconomists think alike. d. It is based on a widely accepted simple economic model.

New Classical Macroeconomics Rational Expectations rational-expectations hypothesis The hypothesis that people know the “true model” of the economy and that they use this model to form their expectations of the future. Rational Expectations and Market Clearing If firms have rational expectations and if they set prices and wages on this basis, disequilibrium in any market is only temporary. In this world, all markets clear (on average) and there is full employment thus no need for government stabilization policies.

When expectations are rational, which of the following stabilization policies is more desirable? a. Fiscal policy tools as the preferred means of stabilization. b. Monetary policy tools as the preferred means of stabilization. c. Intervention only when unpredictable shocks affect the economy. d. No need for government stabilization policies of any kind.

E C O N O M I C S I N P R A C T I C E How Are Expectations Formed? A current debate among macroeconomists and policy makers is how people form expectations about the future state of the economy. In 2010, a number of economists began to worry about the possibility of inflationary expectations heating up in the United States in the next few years because of the large federal government deficit. Do expectations reflect an accurate understanding of how the economy works or are they formed in simpler, more mechanical ways? A study in England suggests a less sophisticated process, finding British consumers more influenced by their own experience than by actual government numbers and mostly expecting the future to look the way they perceive the past to have looked.

New Classical Macroeconomics Rational Expectations The Lucas Supply Function Lucas supply function The supply function embodies the idea that output (Y) depends on the difference between the actual price level and the expected price level. price surprise Actual price level minus expected price level.

New Classical Macroeconomics Rational Expectations Policy Implications of the Lucas Supply Function The Lucas supply function in combination with the assumption that expectations are rational implies that anticipated policy changes have no effect on real output. The general conclusion is that any announced policy change—in fiscal policy or any other policy—has no effect on real output because the policy change affects both actual and expected price levels in the same way. Rational-expectations theory combined with the Lucas supply function proposes a very small role for government policy in the economy.

The Lucas Supply Function in combination with the assumption that expectations are rational implies that announced policy changes: a. Will have no affect on real output. b. Will have no affect on the actual price level. c. Will have no affect on the expected price level. d. Will have no affect on nominal output.

New Classical Macroeconomics Real Business Cycle Theory and New Keynesian Economics real business cycle theory An attempt to explain business cycle fluctuations under the assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks. new Keynesian economics A field in which models are developed under the assumptions of rational expectations and sticky prices and wages.

In the context of the AS/AD model, if prices and wages are perfectly flexible, then: a. The AS curve is vertical in the long run but not in the short run. b. Events that shift the AD curve have a strong impact on real output. c. The AS curve is vertical, even in the short run. d. Nominal wages are always ahead of real wages.

New Classical Macroeconomics Evaluating the Rational Expectations Assumption When expectations are not rational, there are likely to be unexploited profit opportunities, and most economists believe such opportunities are rare and short-lived. The argument against rational expectations is that it requires households and firms to know too much while the gain from learning the true model (or a good approximation of it) may not be worth the cost. Although the assumption that expectations are rational seems consistent with the satisfaction-maximizing and profit-maximizing postulates of microeconomics, such an assumption is more extreme and demanding because it requires more information on the part of households and firms. In the final analysis, the issue is empirical.

Testing Alternative Macroeconomic Models • Macroeconomists cannot test their models against one another to see which performs best because: • Macroeconomic models differ in ways that are hard to standardize. • The rational expectations hypothesis assumes (1) that expectations are formed rationally and (2) that the model being used is the true one. • The small amount of data available leaves considerable room for disagreement, a range needing more time to narrow.

Laffer curve Lucas supply function new Keynesian economics price surprise quantity theory of money rational expectations hypothesis real business cycle theory velocity of money R E V I E W T E R M S A N D C O N C E P T S

Monetarism in Macroeconomics: Money Matters and Inflation Trends