Macro Policy Debates

1. Macro Policy Debates neoclassical monetarists, Keynesians, and supply-side economics

2. Quantity Equation MV = PY (sometimes MV = PQ or MV = PT) M = money supply V = velocity of circulation of money (how many times a dollar changes hands per year) P = price level Y = real output

3. Quantity Equation MV = aggregate spending PY = total value of sales Since every purchase is a sale, must be true by definition

4. Quantity Equation MV = PY It is actually an “identity”—meaning it is true by definition. Therefore, differences must come from the way the variables are interpreted, and the conclusions derived from the interpretations.

5. Quantity Equation Suppose there is $20 in the economy. So M = 20. And I have it. I use it to buy some milk from you. I buy 5 gallons at $4 per gallon. Then, in the same time period, you buy one economics textbook from me for $20.

6. Quantity Equation First Round Second Round M = 20 same M V = 1 V = 1 P = $4 P = $20 Y = 5 Y = 1

7. Quantity Equation M = $20 and there was a total of 2 transactions, so MV = $40. P in the first round was $4 and Y in the first round was 5, so PY in the first round was $20. In the second round, PY is 20 x 1 = $20. $20 + $20 = $40.

8. Monetarists Monetarists claim that V is constant or stable (predictable). Therefore, if M increases PY increases, if M decreases PY decreases. But monetarists are neoclassicals, so they believe that output is at full employment in the long run, so Y is also fixed (natural rate of growth and self-adjusting to full-employment). Thus there is a direct relation between the money supply and the price level. And causality goes from M to P. So: If M increases, P increases. If M decreases, P decreases.

9. Monetarism Since monetarists view V as constant, they hold the position that fiscal policy cannot result in any change in aggregate spending. Increases in government spending are offset by corresponding decreases in private expenditure. If the increase in government spending is financed by taxes, they argue that this will decrease disposable income and thus reduce spending. The drop in Yd will be divided between a drop in C and a drop in S. The drop in S will result in less I, so that the fall in C + I will exactly offset the rise in G—crowding out.

10. Monetarism If the government expenditure is financed by borrowing, then this decreases the loanable funds available for private borrowing for investment and the purchase of consumer durables. This increased competition for a fixed pool of savings bids up the interest rate. So, for the monetarists, increased government expenditure necessarily means decreased private expenditure. ‘Crowding-out'.

11. Monetarism • So monetarist policy is for minimal government expenditures (police, military, etc.). Increase the money supply at 3% per year, since that is what they believe the natural rate of growth is- 3%. So if Y is growing at 3% per year, we increase the money supply by 3% per year so there will be just enough aggregate demand to buy the national output, but not out of control inflation. Velocity is supposed to be growing at a constant rate of 3% per year, so P will also be constant at 3% per year.

12. Keynesians For Keynesians, things are much more variable. First, Y does not tend to Yf, so it is likely to be below Yf. There are two versions of the Keynesian story, with exogenous Ms and endogenous Ms. With exogenous Ms, fiscal policy either depends on V being variable, or must be accompanied by complementary monetary policy. As far as V, we can think about the multiplier. Keynesians believe that V is variable. The multiplier affect is not the result of an increase in the money supply; rather it depends on the changeability of V. The same dollar, so to speak, turns over more times in a given time period. The monetarists are right when they say that if V were constant, there could be no increase in aggregate spending without an increase in the money supply. It's just that the monetarists have been unable to prove that V is constant. They have conceded, in the face of empirical evidence, that V is variable in the short run.

13. Keynesians • Keynesians also disagree in their interpretation of Y. They of course say that Y will likely be at a below full-employment equilibrium. Therefore fiscal and monetary policy may affect Y, unless at Yf, then P will be affected. Obviously if we are at full-employment, then P will rise if aggregate spending rises. • With an endogenous Ms, the increase in G increases Y, if Y is less than Yf, and the Ms increases endogenously.

14. Keynesians But if we are at less than full employment, then an increase in G will not crowd out private expenditures, because the increased expenditure is in effect utilizing unused resources, not taking them away from the private sector. Same with an increase in M- it can result in an increase in Y.

15. Keynesians If the increase in G is financed by taxes, the monetarists say that it will be crowded out due to the decrease in disposable income. But this misses the whole point of the balanced budget multiplier. If it is financed by borrowing, the monetarists argue that this reduces the loanable funds available for borrowing. But Keynesians don't believe that investment is financed out of a pool of savings, nor that the interest rate is determined by S and I (modern forms of credit, etc.). So i won't be bid up, either.

16. Keynesians Fiscal policy works because either: 1) Y increases by V increasing; 2) Y increases leading to M increasing, either: a) because coordinated with monetary policy; b) M increases by fiscal policy; c) causality runs from Y to M (endogenous money)

17. Stagflation simultaneous recession and inflation 1970s Keynesians criticized because they were accused of not being able to explain stagflation, supposed to be a trade-off between unemployment and inflation; not supposed to be able to have both

18. stagflation • The reason that Keynesians were supposedly unable to explain stagflation is because, traditionally, unemployment was due to insufficient aggregate demand and inflation was due to excess aggregate demand. How can you have too much and too little of something at the same time?

19. stagflation We can use the aggregate supply-aggregate demand (AS-AD) analysis to look at the stagflation issue. We will assume for now a textbook aggregate demand curve (with real balance effects and so downward sloping to the right). The aggregate supply curve in the following graph is a Keynesian one, horizontal up to full employment and then vertical.

20. AD-AS Analysis P AS P*3 P*1 AD3 AD1 AD2 0 Y Ye*2 Yf

21. stagflation Start at Yf, with the price level at P*1. Insufficient aggregate demand would shift the AD curve in from AS1 to AS2, and output, income, and employment would drop to Ye*2. Excess aggregate demand would shift the AD curve out from AD1 to AD3, causing prices to rise from P*1 to P*3. So there can be either unemployment or inflation, but not both.

22. Stagflation • The Keynesian reply was simple. If the inflation was due, not to excess demand but to supply-side factors, in other words if it was cost-push rather than demand-pull inflation, then stagflation is easy to explain. In that case, rising costs, such as due to the OPEC oil crisis, shifts the AS curve up, causing a recession with rising prices.

23. AD-AS Analysis P AS2 P*2 P*1 AS1 0 Y Ye*2 Ye*1

24. The Decline of Keynesianism and the Rise of Supply-Side Economics But it was too late for Keynesian economics. Stagflation was just the straw that broke the paradigm’s back. With the election of Ronald Reagan as President in 1980, supply-side economics would be given a chance.