Chapter 2 : School of Thoughts

1. Chapter 2 : School of Thoughts Kornkarun Kungpanidchakul, Ph.D. Macroeconomics MS Finance Chulalongkorn University, Spring 2008

2. School of thoughts • Classical Economics • Keynesian Economics • Monetarist • New Classical Economics • Real Business Cycle • New Keynesian Economics

3. Classical Economics • Inspired by • David Hume • Adam Smith • Thomas Malthus • David Ricardo • Etc. • The main idea is “invisible hand”. The most effective market system is the market without government intervention. The outcome will be efficient.

4. Classical Economics • Aggregate supply • Prices and wages can adjust quickly and fully. • Households and firms learn reasonably and quickly about economic environment. • The economy is always fully-employed. • The position of AS changes because of capital stock, technology, or skill of labor.

5. Classical Economics • Aggregate demand • The classical theory centers on the quantity theory of money MV = PT (1) With M = the quantity of Money in the circulation V = the transaction velocity of money P = price level T = volume of transaction

6. Classical Economics • Aggregate demand - Assume that T = Q (real output), with Q is fixed at the fully employed level. Also, the short run V is fixed. - Therefore, (1) becomes: A change in money supply only affects the price level.

7. Classical Economics • Implications of Classical Economics • Money supply changes has not effect on current output, only affect price. • Changes in government expenditure has no effect on current output. • Changes in the overall level of taxation do not affect current output. • Changes in marginal tax rates can cause current output to change. • Policy tools will not affect output and employment but add instability. • Let market work properly is the best thing the government can do.

8. Neoclassical Economics • The main decision problem is resource allocation, not economic growth. • Price is determined by preference of consumers, not purely on production cost (which is claimed by traditional classical economists). • “Marginalism”, use marginal value to analyze economic problems.

9. Keynesian Economics • Motivated by the great depression • Keynes published “The General theory of Employment, Income, and Money” in 1936. • The classical economics cannot explain the great depression since it considers only LR equilibrium and expects a temporary disequilibrium to be adjust quickly.

10. Keynesian Economics • Keynesians believed that the cause of the great depression was due to a combination of events that led to great uncertainty, huge decreases in investment, and economies being stuck in an unemployment trap. • “In the long run, we are all dead” • Government intervention is needed to help an economy to go back to the steady state.

11. Keynesian Economics • Aggregate supply • Wages and quantities do not adjust immediately (wage/price rigidities in the short run). • Involuntary unemployment could occur. • When prices are rigid, all necessary information are not transmitted to market participants; hence, market might not work well.

12. Keynesian Economics • Aggregate demand • The main tool used by Keynesian economists is IS-LM model. • LM is flat and IS is steep; therefore, • Liquidity trap, the change in money stock would have little effect or no effect at all on the interest rate.

13. Keynesian Economics • Implications of the Keynesian model • The economy is unstable. • The economy takes a long time to adjust to shocks and go back to the steady state. • AD is the main determinant of output and employment. • Fiscal policy is preferred to monetary policy.

14. Monetarist • Inspired by • Friedman (1912) • Brunner (1916) • Meltzer (1928) • Friedman did not believe the Keynesian view that money had little or no impact.

15. Monetarist • The important of money • The only times that major economic contractions occurred were when the absolute value of the money stock fell. • From evidences, changes in money cause changes in money income. • Monetarists believe that money is a substitute for a wide range of real and financial assets, but not single asset could be a close substitute for money. So interest rate affect money demand.

16. Monetarist • Monetarists thought that LM is flatter and IS is steeper than in Keynesians. • Fiscal policy would lead to a large amount of “crowding out” of investment and have little impact on total output. • There is no liquidity trap.

17. Monetarist • Philips curve • The second wave of monetarism deal with Philip curve. • Philip curve is published in 1958 using UK data. It shows the inverse relationship between money wage and the rate of unemployment. • The Keynesians draw the conclusion of this finding to support their idea of a permanent trade-off between inflation and unemployment.

18. Monetarist • Philips curve (cont’) • To justify Keynesian policy, the workers must have “money illusion”. • Friedman argued that money illusion occurs in the short run only. In the long run, there is no trade-off between unemployment and inflation and the evidences seem to confirm this point of view.

19. Monetarist • Implications of monetarist • Monetary policy is more effective than fiscal policy. • No long-run trade-off between inflation and unemployment. • The market system was not perfect, the government would only make things worse. • Fiscal policy could only influence the distribution of income and the allocation of resources (crowding out effect). • The only way to increase output permanently is to make market work better. • Adaptive expectation.

20. New Classical Economics • Initiated by • Lucas • Wallace • Sargent • Barro • Initiated because of: • Theoretical : introduce microeconomic foundation in macroeconomics instead of AD-AS model. • Empirical: inconsistencies between Keynesian and Monetarist and what actually happened in 1970s from oil price shocks, “Stagflation”.

21. New Classical Economics • Rational Expectation • Stagflation is inconsistent with adaptive expectation (backward-looking). • John Muth developed “rational expectation”, which is forward looking expectation. • It features: - people would look to the future. - people use information wisely. - people would not make systematic errors.

22. New Classical Economics • Incorporating rational expectations in the AS-AD model 1. Imperfect information : Household may not know the price level at the time they make decision. 2. Parameterization of AS, Ls and Ld curve: The curves are parameterized by expectations of the values of the exogenous variable.

23. New Classical Economics • Implications of new classical economics • Expectations are formed normally. They may form wrong expectations, but once they have learnt their mistake, they will no longer make mistakes. • Only unanticipated policies have an effect on the output and employment. • SR AS is upward sloping from imperfect information. • LR AS is vertical. • Self-correcting economy.

24. Real Business cycle • New classical fails to explain the important empirical fact, deviations from capacity output tended to be prolonged and correlated.

25. Real Business cycle • Important summary 1. Random walks : shocks to US output is random walk so it did not revert back to its trend. 2. Intertemporal substition : Instead of AS-AD model, RBC tried to use intertemporal substitution to explain how shocks are transmitted into the economy. 3. RBC still uses rational expectation.

26. Real Business cycle • Important summary (cont’) 4. Market are always clearing. 5. Money is neutral. 6. Economic fluctuations are due to supply side such as technological changes, natural disaster, tax, input prices, etc.

27. New Keynesian Economics • There are 3 main problems with new classical 1. Unhappy / involuntary workers. 2. 1982 US recession. 3. Intertemporal substitution of labor does not seem to be as large as RBC suggested. 4. Hysteresis of unemployment.

28. New Keynesian Economics • New Keynesian uses the new classical model but introduces: • Union models • Contracts and staggering of price and wage changes • Menu cost and imperfect competition

29. New Keynesian Economics • Implications of New Keynesian Economics • Market may not adjust quickly even with rational expectation. • Strong recession warrants government intervention. • Government should ensure that market works smoothly as possible via microeconomic policies.