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The Roots of Modern

Macroeconomics
The Roots of Modern Macroeconomics

Setting the Scene: Three


Key Issues
THREE KEY ISSUES

■ Issue 1: Flexibility of prices and wages


✜ the right: flexible prices and wages
✜ the left: price and wage rigidities

■ Issue 2: Flexibility of aggregate supply


✜ the right: aggregate supply determined
independently of aggregate demand
Different aggregate supply curves: (a)
AS
Price level

O Y
National output
Different aggregate supply curves: (a)
AS
Price level

P1

AD1
O Y
National output
Different aggregate supply curves: (a)
AS
Price level

P2

P1
AD2

AD1
O Y
National output
THREE KEY ISSUES

■ Issue 1: Flexibility of prices and wages


✜ the right: flexible prices and wages
✜ the left: price and wage rigidities

■ Issue 2: Flexibility of aggregate supply


✜ the right: aggregate supply determined
independently of aggregate demand
✜ the left: aggregate supply responsive to
changes in aggregate demand
Price level Different aggregate supply curves: (b)

P AS

National output
Price level Different aggregate supply curves: (b)

P AS

AD1
O Y1
National output
Price level Different aggregate supply curves: (b)

P AS

AD2

AD1
O Y1 Y2
National output
THREE KEY ISSUES

■ Issue 1: Flexibility of prices and wages


✜ the right: flexible prices and wages
✜ the left: price and wage rigidities
■ Issue 2: Flexibility of aggregate supply
✜ the right: aggregate supply determined
independently of aggregate demand
✜ the left: aggregate supply responsive to
changes in aggregate demand
✜ some consensus on nature of short-run
AS curve
Different aggregate supply curves: (c)

AS
Price level

National output
Different aggregate supply curves: (c)

AS
Price level

P1

AD1
O Y1
National output
Different aggregate supply curves: (c)

AS
Price level

P2
P1
AD2

AD1
O Y1 Y2
National output
THREE KEY ISSUES

■ Issue 3: The role of expectations in the


working of the market
✜ the right: expectations adjust rapidly to
changes in prices

✜ the left: expectations of prices depend on


expectations of output and employment
The Roots of Modern Macroeconomics

Classical
Macroeconomics
CLASSICAL MACROECONOMICS

■ Classical analysis of output and


employment
✜ markets clear
✦ labourmarket
✦ market for loanable funds
The market for loanable funds
Saving (supply)
Rate of interest

Investment (demand)
O
Quantity of loanable funds
The market for loanable funds
Saving (supply)
Rate of interest

r1

Investment (demand)
O
Quantity of loanable funds
The market for loanable funds
Saving (supply)
Rate of interest

r1

Investment (demand)
O
Quantity of loanable funds
The market for loanable funds
Saving (supply)
Rate of interest

r2

Investment (demand)
O
Quantity of loanable funds
The market for loanable funds
Saving (supply)
Rate of interest

r2

Investment (demand)
O
Quantity of loanable funds
The market for loanable funds
Saving (supply)
Rate of interest

re

Investment (demand)
O
Quantity of loanable funds
CLASSICAL MACROECONOMICS

■ Classical analysis of output and


employment
✜ markets clear
✦ labour market
✦ market for loanable funds
✦ market for imports and exports:
the gold standard
CLASSICAL MACROECONOMICS

■ Classical analysis of output and


employment
✜ markets clear
✦ labour market
✦ market for loanable funds
✦ market for imports and exports:
the gold standard
✜ Say’s law
CLASSICAL MACROECONOMICS

■ Classical analysis of output and


employment
✜ markets clear
✦ labour market
✦ market for loanable funds
✦ market for imports and exports:
the gold standard
✜ Say’s law
■ Classical analysis of prices and
inflation
CLASSICAL MACROECONOMICS

■ Classical analysis of output and


employment
✜ markets clear
✦ labour market
✦ market for loanable funds
✦ market for imports and exports:
the gold standard
✜ Say’s law
■ Classical analysis of prices and
inflation
✜ the quantity theory of money
CLASSICAL MACROECONOMICS

■ Classical analysis of output and


employment
✜ markets clear
✦ labour market
✦ market for loanable funds
✦ market for imports and exports:
the gold standard
✜ Say’s law
■ Classical analysis of prices and
inflation
✜ the quantity theory of money
✜ the equation of exchange: MV = PY
CLASSICAL MACROECONOMICS

■ Classical analysis of output and


employment
✜ markets clear
✦ labour market
✦ market for loanable funds
✦ market for imports and exports:
the gold standard
✜ Say’s law
■ Classical analysis of prices and
inflation
✜ the quantity theory of money
✜ the equation of exchange: MV = PY
✜ implications for monetary policy
CLASSICAL MACROECONOMICS

■ The Great Depression and the return to


the gold standard
✜ the depression of the 1920s
UK unemployment and inflation: 1919 − 38
24 15
Unemployment
22
10
20
Unemployment (% of workforce)

18 5
16
0

Inflation (%)
14
12 -5
10
-10
8
6 -15
4
-20
2
0 -25
1919 1921 1923 1925 1927 1929 1931 1933 1935 1937
UK unemployment and inflation: 1919 − 38
24 15
Unemployment
22
10
20
Unemployment (% of workforce)

18 Inflation 5
16
0

Inflation (%)
14
12 -5
10
-10
8
6 -15
4
-20
2
0 -25
1919 1921 1923 1925 1927 1929 1931 1933 1935 1937
CLASSICAL MACROECONOMICS

■ The Great Depression and the return to


the gold standard
✜ the depression of the 1920s
✜ return to the gold standard
CLASSICAL MACROECONOMICS

■ The Great Depression and the return to


the gold standard
✜ the depression of the 1920s
✜ return to the gold standard
✜ effects on the economy
CLASSICAL MACROECONOMICS

■ The Great Depression and the return to


the gold standard
✜ the depression of the 1920s
✜ return to the gold standard
✜ effects on the economy
✜ the policy response
CLASSICAL MACROECONOMICS

■ The Great Depression and the return to


the gold standard
✜ the depression of the 1920s
✜ return to the gold standard
✜ effects on the economy
✜ the policy response
✜ classical rejection of public works
CLASSICAL MACROECONOMICS

■ The Great Depression and the return to


the gold standard
✜ the depression of the 1920s
✜ return to the gold standard
✜ effects on the economy
✜ the policy response
✜ classical rejection of public works
✦ the fear of inflation
CLASSICAL MACROECONOMICS

■ The Great Depression and the return to


the gold standard
✜ the depression of the 1920s
✜ return to the gold standard
✜ effects on the economy
✜ the policy response
✜ classical rejection of public works
✦ the fear of inflation
✦ the problem of crowding out
The effect of printing extra money: the classical analysis

AS
Price level

P2

P1
AD2

AD1
O Q1
National output
The Roots of Modern Macroeconomics

The Keynesian
Revolution
THE KEYNESIAN REVOLUTION

■ Keynes’ rejection of classical theory


✜ rigidities in the labour market
✜ the problem of deficiency of demand
The problem of demand deficiency in the labour market
ASL
Real wage rate (W / P)

W1

ADL1

ADL2
O
Quantity of labour
THE KEYNESIAN REVOLUTION

■ Keynes’ rejection of classical theory


✜ rigidities in the labour market
✜ the problem of deficiency of demand
✜ rejection of increased saving as a means
of increasing investment
Disequilibrium in the market for loanable funds
Savings 1
Savings 2
Rate of interest

r1

r2

Investment
O
Quantity of loanable funds
THE KEYNESIAN REVOLUTION

■ Keynes’ rejection of classical theory


✜ rigidities in the labour market
✜ the problem of deficiency of demand
✜ rejection of increased saving as a means
of increasing investment
✜ rejection of simple quantity theory
THE KEYNESIAN REVOLUTION

■ Keynes’ rejection of classical theory


✜ rigidities in the labour market
✜ the problem of deficiency of demand
✜ rejection of increased saving as a means
of increasing investment
✜ rejection of simple quantity theory
✜ rejection of a balanced budget
THE KEYNESIAN REVOLUTION

■ Keynes’ rejection of classical theory


✜ rigidities in the labour market
✜ the problem of deficiency of demand
✜ rejection of increased saving as a means
of increasing investment
✜ rejection of simple quantity theory
✜ rejection of a balanced budget

■ Keynes’ analysis of employment and


inflation
THE KEYNESIAN REVOLUTION

■ Keynes’ rejection of classical theory


✜ rigidities in the labour market
✜ the problem of deficiency of demand
✜ rejection of increased saving as a means
of increasing investment
✜ rejection of simple quantity theory
✜ rejection of a balanced budget

■ Keynes’ analysis of employment and


inflation
✜ the importance of aggregate demand
The effects of increases in aggregate demand on national output

AS
Price level

O YP
National output
The effects of increases in aggregate demand on national output

AS
Price level

AD4

AD3
AD1 AD2
O Y1 Y2 Y3 Y4 YP
National output
THE KEYNESIAN REVOLUTION

■ Keynes’ rejection of classical theory


✜ rigidities in the labour market
✜ the problem of deficiency of demand
✜ rejection of increased saving as a means
of increasing investment
✜ rejection of simple quantity theory
✜ rejection of a balanced budget

■ Keynes’ analysis of employment and


inflation
✜ the importance of aggregate demand
✜ the multiplier process
The circular flow of income
The circular flow of income

Cd
The circular flow of income

Incomes Cd
The circular flow of income

Incomes Cd

W=S+T+M
The circular flow of income

J=I+G+X

Incomes Cd

W=S+T+M
The circular flow of income

J=I+G+X

Incomes Cd

W=S+T+M
The circular flow of income

J=I+G+X

Incomes Cd

W=S+T+M
The circular flow of income

J=I+G+X

Incomes Cd

W=S+T+M
THE KEYNESIAN REVOLUTION

■ Keynes’ policy recommendations


✜ demand management by fiscal and
monetary policies

■ Keynesian policies in 1950s and 60s


✜ stop–go policies
✜ criticisms of short-term demand
management
✜ the breakdown of the Phillips curve
The Roots of Modern Macroeconomics

The Monetarist–
Keynesian Debate
THE MONETARIST–KEYNESIAN DEBATE

■ The monetarist counter-revolution


✜ the restatement of the quantity theory
✜ rejection of Keynesian demand
management policies
✜ the problem of inflationary expectations
✜ reappraisal of the Phillips curve
✦ unemployment

✦ inflation
The monetarist version of the long-run Phillips curve
Inflation (%)

O Un
Unemployment
(a) Keynesian aggregate supply curve
AS
Price level

O Ymax YP
National output
Inflation (%) (b) Keynesian Phillips curve

O
Umin
Unemployment
THE MONETARIST–KEYNESIAN DEBATE

■ The monetarist counter-revolution


✜ the restatement of the quantity theory
✜ rejection of Keynesian demand
management policies
✜ the problem of inflationary expectations
✜ reappraisal of the Phillips curve
✦ unemployment

✦ inflation

✜ monetarist policies
THE MONETARIST–KEYNESIAN DEBATE

■ The monetarist counter-revolution


✜ the restatement of the quantity theory
✜ rejection of Keynesian demand
management policies
✜ the problem of inflationary expectations
✜ reappraisal of the Phillips curve
✦ unemployment

✦ inflation

✜ monetarist policies
✜ attempts at such policies in the 1980s
THE MONETARIST–KEYNESIAN DEBATE

■ Modern-day Keynesians
✜ inflation
✜ unemployment
✜ structural problems
✜ hysteresis
✦ low capital stock
✦ deskilling

✦ insiders and outsiders


✜ criticisms of monetarism
✜ Keynesian policy proposals
The Roots of Modern Macroeconomics

The Current Position


THE CURRENT POSITION

■ The current range of views


✜ new classical / rational expectations school
✜ moderate monetarists
✜ moderate Keynesians (new Keynesians)
✜ extreme Keynesians
✜ the radical left
✜ eclectic economists
THE CURRENT POSITION

■ A mainstream consensus?
✜ short-run effects of changes in AD
✜ long-run effects of changes in AD
✜ no simple trade-off between inflation and
unemployment
✜ role of expectations
✜ effects of excessive growth in the money
supply
✜ importance of supply-side policies
✜ erosion of governments' power by the
process of globalisation