Chapter 15

1. Chapter 15 Twentieth-Century Economic Theory 15-1 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Objectives • The equation of exchange • The quantity theory of money • Classical economics • Keynesian economics • The monetarist school • Supply-side economics • The rational expectations theory 15-2 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

3. The Equation of Exchange • Much of the Keynesian-Monetarist debate revolves around the quantity theory of money which itself is based on the equation of exchange • The equation of exchange and the quantity theory of money are easy to confuse • Perhaps because the equation of exchange is used to explain the quantity theory of money 15-3 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

4. The Equation of Exchange • The equation of exchange is MV = PQ • M is the total dollars in the nation’s money supply • V is the number of times per year each dollar is spent • P is the average price of all the goods and services sold during the year • Q is the quantity of goods and services sold during the year 15-4 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

5. The Equation of Exchange M times V (MV) would be total spending. Total spending by a nation during a given year is GDP. Therefore, MV = GDP P times Q (PQ) is the total amount of money received by sellers of all final goods and services produced by a nation during a given year. This also is GDP. Therefore, PQ = GDP Things equal to the same thing are equal to each other, therefore, MV = PQ 15-5 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

6. The Equation of Exchange The following example will be in billions of dollars without the dollar signs MV = PQ 900 X 9 = PQ 8,100 = PQ 8,100 = 81 X Q 8,100 = 81 X 100 8,100 = 8, 100 The equation of exchange must always balance, as must all equations. 15-6 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

7. The Quantity Theory of Money The Crude version of the Quantity Theory of Money This version holds that when the money supply (M) changes by a certain percentage, the price level (P) changes by that same percentage MV = PQ 900 X 9 = 81 X 100 1800 X 9 = 162 X 100 16,200 = 16,200 15-7 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

8. The Quantity Theory of Money The Crude version of the Quantity Theory of Money This version holds that when the money supply (M) changes by a certain percentage, the price level (P) changes by that same percentage MV = PQ 900 X 9 = 81 X 100 1800 X 9 = 162 X 100 16,200 = 16,200 If V and Q remain constant, the crude version of the quantity theory of money is correct 15-8 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

9. A Closer Look at Q and V • Since 1950 V has risen fairly steadily from about three to nearly seven • During recessions, production, and therefore Q will fall • Q fell at an annual rate of about 4% during the 1981-82 recession • During recoveries, production picks up, so we go from a declining Q to a rising Q • Obviously, neither V or Q are constant • Therefore, the crude version of the quantity theory of money is invalid 15-9 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

10. The Quantity Theory of Money The sophisticated version of the “Quantity Theory of Money” assumes any short term changes in V are either very small or predictable But what happens next is entirely up to the level of production, Q 15-10 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

11. The Sophisticated Quantity Theory of Money If we are well below full employment, an increase in M will lead mainly to an increase in Q If we are close to or at full employment, an increase in M will lead mainly to an increase in P 15-11 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

12. Classical Economics • The classical school of economics was mainstream from roughly 1775 to 1930 • The classical school has the following tenets • Recessions cure themselves • Say’s law operates • Savings will be invested • Interest rate mechanism • Quantity theory of money • Assume V and Q are constant • Government can’t cure recessions 15-12 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

13. Keynesian Economics • The Keynesian school of economics was mainstream from the early 1930s to about 1970 15-13 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

14. Keynesian Economics • The Keynesian school has the following tenets • The problem with recessions is inadequate demand • The only hope is for the government to spend enough money to raise aggregate demand sufficiently to get people back to work • The government could print the money or borrow it • If enough (newly created money) was spent, the recession would end • No one would invest in new plant and equipment when much of their capacity was idle • Wages and prices were not downwardly flexible because of institutional barriers • If M rises, people may not spend the additional money, but just hold it • So much for the quantity theory of money 15-14 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

15. The Monetarist School • Stresses the Importance of the Rate of Monetary Growth • Milton Friedman, an economist who did exhaustive studies of the relationship between the rate of growth of the money supply concluded that • The United States has never had a serious inflation that was not accompanied by rapid monetary growth • When the money supply has grown slowly, the country has had no inflation 15-15 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

16. The Monetarist School • Stresses the Importance of the Rate of Monetary Growth • Building on the quantity theory of money, the monetarists agree with the classicals that when the money supply grows, the price level rises, albeit not at exactly the same rate • Recessions are caused when the Federal Reserve increases the money supply at less than the rate needed by business – say, anything less than 3 percent a year • By and large the facts have borne out the monetarists’ analysis 15-16 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

17. The Monetarist School • The Basic Propositions of Monetarism • The key to stable economic growth is a constant rate of increase in the money supply • Expansionary monetary policy will only temporarily depress interest rates • Expansionary monetary policy will only temporarily reduce the unemployment rate • Expansionary fiscal policy will only temporarily raise output and employment 15-17 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

18. The Monetarist School • The Monetary Rule • Increase the money supply at a constant rate • When there is a recession, this steady infusion of monetary growth will pick up the economy • When there is inflation, a steady rate of monetary growth will slow it down • When the country has a steady diet of money, the economic health will be relatively good – if not always excellent - no very fat years and no very lean years 15-18 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19. The Monetarist School • The Decline of Monetarism • Monetarism’s popularity started to decline in the late 1970s and early 1980s • The Fed’s policy on monetary growth, sky high interest rates, combined with two recessions seemed to cause people to look elsewhere for their economic gurus 15-19 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

20. Supply-Side Economics • Supply-side economics came into vogue in the early 1980s • Supply-siders mantra was to cut tax rates, government spending, and government regulation • The object of supply-siders is to raise aggregate supply • Many of the undesirable effects of high marginal tax rates are the work effect, the savings and investment effect, and the elimination of productive market exchanges 15-20 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

21. The Work Effect • Facing high marginal tax rates, many people refuse to work more than a certain number of hours overtime or take on second jobs and other forms of extra work • Instead, they opt for more leisure time • Output is less when people work less • When people work less, their income is less 15-21 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

22. The Saving and Investment Effect • High marginal tax rates on interest income will provide a disincentive to save, or at least to make savings available for investment purposes • People who borrow money for investment purposes hope that this will lead to greater profits • But, if these profits are subject to a high marginal tax rate, once again this is a disincentive to invest • The economy will stagnate 15-22 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

23. The Elimination of Productive Market Exchanges • A productive market exchange is when you work at what your are good at and hire someone who is working at what they are good at to do something for you • There is a serious misallocation of labor(perhaps hundreds of millions of dollars) when the productive market exchange is eliminated because of high marginal tax rates • It will pay you to work less at what you are good at to do another job that you are not so good at (you don’t hire some one is is better at it than you to do it) 15-23 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

24. The Laffer Curve The rationale of the Laffer curve is that when marginal tax rates are too high, we can raise tax revenues by lowering them 15-24 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

25. Rational Expectation Theory • Rational expectations theory is based on three assumptions • Individuals and firms learn through experience to anticipate the consequences of changes in monetary and fiscal policy • Individuals and firms act instantaneously to protect their economic interest • All resource and product markets are purely competitive 15-25 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

26. Rational Expectation Theory • Rational expectations theorists say the government should do as little as possible • Basically, then, the government should figure out the right policies to follow and stick to them • The right policies are • Steady monetary growth of 3 to 4% a year • A balanced budget 15-26 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

27. Rational Expectation Theory • Criticism of the rational expectations school • It is not reasonable to expect individuals and business firms to accurately predict the consequences of macroeconomic policy • Many of our economic markets are not purely competitive: some are not competitive at all • The rigidities imposed by contracts restrict adjustments to changing economic conditions 15-27 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

28. The Economic Behaviorists • Economic behaviorists are a hot new group of young economists who are complete new comers to the economic theory scene • They maintain that while the mainstream beliefs that rational behavior and economic self-interest are important, they are not the only motivating factors • Their goal is to apply a wider range of psychological concepts to economic theory 15-28 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

29. Conclusion • “Each of the major schools of economic thought can be useful on occasion. The insights of Keynesian economics proved appropriate for Western societies attempting to get out of the depression in the 1930s. The tools of monetarism were powerfully effective in squeezing out the inflationary force of the 1970s. Supply-side economics played an important role in getting the public to understand the high cost of taxation and thus to support tax reform in the 1980s. But sensible public policy cannot long focus on any one objective or be limited to one policy approach.” [Murray Weidenbaum] 15-29 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.