copyright 2007 mcgraw-hill australia pty ltd ppts t/a macroeconomics by jackson and mciver slides...

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIverSlides prepared by Muni Perumal

12-1

Chapter 12

Macroeconomic ideas — evolution and debates


12-2

Learning objectives• Review the classical and Keynesian views

of the economy and then present them within a simplified aggregate demand–aggregate supply framework

• Examine the monetarist position, and its emphasis on the money supply through a development of the equation of exchange


12-3

Learning objectives (cont.)• Briefly describe rational expectations theory

(RET) and its implications for policy makers• Review supply-side economics and its implications• Discuss the insights that these alternative

views have provided for us on the operation of the macroeconomy


12-4

Classical employment theory• Underspending in a capitalist economy

highly unlikely, and prices and wages adjust very rapidly to ensure full employment at all times

• Two basic assumptions of the classical theory– Underspending is most unlikely to occur– Prices and wages adjust to ensure that a decline

in spending would not result in a fall in real output, employment and real incomes


12-5

Say’s law• The foundation of the classical theory

is Say’s law– The very act of producing goods generates

an amount of income exactly equal to the value of the goods produced

– Production of output automatically generates the incomes required to purchase this output, i.e. supply creates its own demand


12-6

Problems with Say’s law• Saving

– If households saved a given portion of their income, supply would not create its own demand

– Saving would cause a deficiency of consumption, resulting in unsold goods, unemployment and falling income


12-7

Problems with Say’s law• Saving, investment and the interest rate

– The money market will ensure that the interest rate (the price of money) would adjust to bring about equilibrium between saving and investment

– Interest rate will ensure that the leakage from the income–expenditure stream will reappear as investment dollars


12-8

Classical view of the money market

IR

ate

of in

tere

st (%

)

Dollars saved and invested

I

Dollars saved/invested

I

r r1

Rat

e of

inte

rest

(%)

SS (saving)

I

S’

r2

Increasein saving

Increasein Investment


12-9

Classical employment theory• Price–wage flexibility

– The assumption that all prices, including wages and interest rates, are flexible and will rapidly adjust to remove disequilibria

• Classical theory and laissez-faire– The price system ensured that price–wage flexibility

and fluctuations in the interest rate were capable of maintaining full employment


12-10

Keynesian economics• The Great Depression of the 1930s• Keynes and Keynesian economics

– Keynes (1936), General theory of employment, interest and money

– The capitalist economy is inherently unstable and likely to achieve equilibrium with considerable unemployment or severe inflation, and the possibility of persistent unemployment


12-11

Keynesian economics (cont.)Unlinking of savings and investment plans• Savers and investors are different groups

– Saving and investment decisions are made by different groups of individuals

– Firms also save in the form undistributed profits• Savers and investors are differently motivated

– Savings decisions are motivated by diverse considerations

– Motivations for business investment are complex


12-12

Keynesian economics (cont.)Money balances and banks• Savings and investment plans can be at odds

and result in fluctuations in total output, income, employment and the price level


12-13

Keynesian economics (cont.)Discrediting price–wage flexibility• The existence of price–wage flexibility

– Prices and wages are inflexible downwards– It is doubtful that price–wage declines would

alleviate widespread unemployment


12-14

AD–AS in the classical theory• Vertical aggregate supply curve

– Exclusively determines level of real domestic output• Stable down-sloping aggregate demand

– Exclusively determines price level


12-15

Classical view of the macroeconomy

Pric

e le

vel

Real domestic outputQ1

AS

P1

AD1

AD2

P2


12-16

Keynesian view of AD–AS• Horizontal aggregate supply curve

– SR prices and wages are downwardly inflexible• Unstable aggregate demand

– Especially investment– Demand management and stabilisation policies

by the government are required


12-17

Keynesian view of the macroeconomy

P1

Q1

Pric

e le

vel

Real domestic output

AD1

Q2

AS

AD2


12-18

Monetarism• Built on classical foundations

– Assume price and wage flexibility• Markets are competitive with a high degree

of macroeconomic stability• Monetarist argue government policies interfere with

competition and promote downwards price–wage inflexibility– Minimum wages, pro-union legislation, rural price

supports, pro-business monopoly legislation etc.


12-19

Monetarism (cont.)• Economy is essentially stable

– Competitive markets cause adjustments to product and resource price and not output and employment

• Government creates rigidities and weaknesses in the market – Government intervention must be avoided

Inefficient, harmful to incentives and policy mistakes that destabilise the economy


12-20

Keynesian aggregate expenditure equation• C + I + G + NX = GDP• Aggregate spending by buyers equals total

value of goods and services bought• Money plays a secondary role• Lengthy transmission mechanism


12-21

Monetarist equation of exchange• MV = PQ

Where M is the supply of moneyV is the velocity of moneyP is the price levelQ is the physical volume of goods and services produced

• MV refers to actual spending! (whereas C + I + G + NX refers to planned expenditure)


12-22

Monetarist equation of exchange (cont.)• Simple and direct transmission mechanism:

– Change in money supply causes a change in GDP


12-23

Velocity of money (V)• The number of times per year the average dollar is spent

on final goods and services• Monetarists: V is stable or on a steady long-term trend

– Why? Money is the primary medium of exchange– Store-of-money function is inconsequential– Over time transactions demand increases steadily

• Keynesians: V is unstable– Why? Money is held for transactions and as assets– No dependable relationship between M and V


12-24

The money supply and the level of GDP 1968–69 to 2004–05


12-25

The velocity of money and interest rate 1968–69 to 2004–05


12-26

Fiscal policy debate• Monetarists

– Fiscal policy is weak due to crowding-out effects– Funding deficits by selling securities crowds out

private investment– Relatively inelastic demand-for-money curve– Relatively elastic investment demand curve– Argue for the use of monetary rules


12-27

Fiscal policy debate (cont.)• Keynesians

– Crowding-out of investment is insubstantial– Relatively elastic demand-for-money curve– Relatively inelastic investment demand curve


12-28

Monetary mismanagement• According to monetarists, the two sources

of monetary mismanagement are:1. Irregular time lags2. Wrong target — interest rates vs money supply


12-29

Monetary rule• According to monetarists, monetary authorities

should stabilise the rate of growth of the money supply, not the interest rate

• Keynesians argue against this– V is variable both secularly and cyclically– A money rule could contribute to fluctuations


12-30

AD–AS analysis: Keynesians vs monetarists• Monetarists believe that the AS curve is

relatively steep• Any change in AD through monetary policy

will have little impact on equilibrium real GDP, but will result in large increases in the price level


12-31

Monetarist AD–AS perspective

Pric

e le

vel


AS

AD1

AD2

P1

GDP1 GDP2

P2


12-32

AD–AS analysis: Keynesians vs monetarists• Keynesians believe that the AS curve is

relatively flat• Thus, changes in AD through fiscal or

monetary policy will have a larger impact on equilibrium real GDP but only a small impact on the price level


12-33

Keynesian AD–AS perspective

Pric

e le

vel


AS

AD1

AD2

P1

GDP1 GDP2

P2


12-34

Rational expectations theory (RET)• Also known as new-classical economics• Businesses, consumers and workers understand

the workings of the economy and use this knowledge to assess the anticipated effects of current economic policies upon the future of the economy in order to further their own self-interest


12-35

Rational expectations theory (cont.)• Theoretical underpinnings:

– Expectations about the future– Assumes all markets are purely competitive

Prices and wages are highly flexible– Markets instantly adjust to new changes– AS curve is vertical


12-36

RET and policy frustration• Aggregated responses of the public will make

discretionary stabilisation policies ineffective• Increases in AD will result in an offsetting

increase in the price level, leaving output and employment unchanged

• Compared to traditional classical theory — RET does not result in temporary lapses from full-employment level of output


12-37

RET and the AD–AS model

Q1

Pric

e le

vel


AS

AD1

P1 a

P2

AD2

b


12-38

Rational expectations theory• Further consequences

– Pro-cyclical policy: businesses may come to expect tax relief whenever a recession occurs and postpone investment purchases

• Evaluation• Behaviour

– Knowledge and understanding about the workings of the economy may be overstated by RET

• Sticky prices– Markets are not purely competitive

• Policy and stability– Empirical evidence that economic policy does

affect GDP and employment


12-39

Supply-side economics• Economic disturbance can be generated from

the supply side• Change in aggregate supply is an active force

in determining the levels of inflation and unemployment

• Stagflation of the 1970s and 1980s contributed to by growth in public sector due to the growing tax wedge between production costs and product prices


12-40

Supply-side economics (cont.)• Tax transfer disincentive

– Incentives to work– Transfer disincentives– Incentives to save and invest

• Resource misallocation– Resources of large numbers of lawyers and

accountants discovering ways to avoid taxes, could be more effectively used elsewhere

• Overregulation– Government involvement in the economy has

adverse effects on productivity and costs

copyright 2007 mcgraw-hill australia pty ltd ppts t/a macroeconomics by jackson and mciver slides...

Documents