C H APTER

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31

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Debates in Macroeconomics:
Monetarism, New Classical
Theory, and Supply-Side
Economics

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Prepared by: Fernando Q uijano

and Yvonn Q uijano

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Principles of Economics, 7/e

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Karl Case, Ray Fair

C H A P T E R 31: D ebates in M acroeconom ics: M onetarism ,

N ew C lassicalTheory,and Supply
y-Side Econom ics

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Keynesian Economics

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In a broad sense, Keynesian
economics is the foundation of
modern macroeconomics. In a
narrower sense, Keynesian refers to
economists who advocate active
government intervention in the
economy.

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Keynesian Economics

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Two major schools decidedly against
government intervention have
developed: monetarism and new
classical economics.

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Monetarism

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The main message of monetarists is
that money matters.

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Monetarism, however, is usually

considered to go beyond the notion
that money matters.

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Monetarism

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The monetarist analysis of the
economy places emphasis on the
velocity of money, or the number of
times a dollar bill changes hands, on
average, during a year; the ratio of
nominal GDP to the stock of money
(M):
V

GDP
M

or V

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P Y
M

since
then,

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GDP P Y
M V P Y
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The Quantity Theory of Money

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The quantity theory of money is a
theory based on the identity
M x V = P x Y and the assumption
that the velocity of money (V) is
constant (or virtually constant).
Then, the theory can be written as
the following equality:

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M V = P Y

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The Quantity Theory of Money

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If there is equilibrium in the money
market, then the quantity of money
supplied is equal to the quantity of
money demanded. When M is taken
to be the quantity of money
demanded, this equality would make
the quantity of money demanded
dependent on nominal GDP, but not
the interest rate.

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The Quantity Theory of Money

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The demand for money may depend
not only on nominal income, but also
on the interest rate.

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Whether velocity is constant or not

may depend partly on how we
measure the money supply.

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The Velocity of Money,

1960 I 2003 II

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The velocity of money is far from constant. There is

a rising long-term trend, but fluctuations around this
trend have been quite large.

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Inflation as a Purely
Monetary Phenomenon

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Inflation is always a monetary

phenomenon. If the money supply
does not change, the price level will
not change.

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The view that changes in the money

supply affect only the price level,
without a change in the level of
output, is called the strict
monetarist view.

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Inflation as a Purely
Monetary Phenomenon

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The strict monetarist view is not

compatible with a nonvertical AS
curve.

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Almost all economists agree that

sustained inflation is purely a
monetary phenomenon.

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Inflation cannot continue indefinitely

without increases in the money
supply.

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The Keynesian/Monetarist Debate

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Milton Friedman has been the
leading spokesman for monetarism
over the last few decades.

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Most monetarists argue that inflation

in the United States could have been
avoided if only the Fed had not
expanded the money supply so
rapidly.

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The Keynesian/Monetarist Debate

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Most monetarists do not advocate an
activist monetary policy
stabilizationexpanding the money
supply during bad times and slowing
its growth during good times.

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The Keynesian/Monetarist Debate

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Time lags are the most common
argument against such
management.

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Monetarists advocate a policy of

steady and slow money growth, at a
rate equal to the average growth of
real output (Y).

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The Keynesian/Monetarist Debate

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Many Keynesians advocate the
application of coordinated monetary
and fiscal policy tools to reduce
instability in the economyto fight
inflation and unemployment.

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The Keynesian/Monetarist Debate

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Others reject the strict monetarist
position in favor of the view that both
monetary and fiscal policies make a
difference and at the same time
believe the best possible policy is
basically noninterventionist.

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New Classical Macroeconomics

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On the theoretical level, new
classical macroeconomists argue
that traditional models have
assumed that expectations are
formed in naive ways.

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New Classical Macroeconomics

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Naive expectations are inconsistent
with the assumptions of
microeconomics. If people are out to
maximize utility and profits, they
should form their expectations in a
smarter way.

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New Classical Macroeconomics

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On the empirical level, new classical
theories were an attempt to explain
the apparent breakdown in the
1970s of the simple inflationunemployment trade-off predicted by
the Phillips Curve.

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Rational Expectations

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The rational-expectations
hypothesis assumes people know
the true model of the economy and
that they use this model to form their
expectations of the future.

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By true model we mean a model

that is on average correct in
forecasting inflation.

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Rational Expectations

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People are said to have rational
expectations if they use all available
information in forming their
expectations.

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Rational Expectations

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Because there are costs associated
with making a wrong forecast, it is
not rational to overlook information,
as long as the costs of acquiring that
information do not outweigh the
benefits of improving its accuracy.

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Rational Expectations
and Market Clearing

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If firms have rational expectations,

on average, prices and wages will be
set at levels that ensure equilibrium
in the goods and labor markets. In
other words, on average, there will
be no unemployment.

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Rational Expectations
and Market Clearing

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When expectations are rational,

disequilibrium exists only temporarily
as a result of random, unpredictable
shocks.
On average, all markets clear and
there is full employment. There is no
need for government stabilization.

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The Lucas Supply Function

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The Lucas supply function is the
supply function that embodies the
idea that output (Y) depends on the
difference between the actual price
level (P) and the expected price level
(Pe):

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Y = f ( P Pe )

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The Lucas Supply Function

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The difference between the actual
price level and the expected price
level is the price surprise.

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( P Pe )

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The Lucas Supply Function

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The rationale for the Lucas supply
function is that unexpected increases
in the price level can fool workers
and firms into thinking that relative
prices have changed, causing them
to alter the amount of labor or goods
they choose to supply.

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The Lucas Supply Function

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Rational-expectations theory,
combined with the Lucas supply
function, proposes a very small role
for government policy in the
economy.

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Evaluating
Rational-Expectations Theory

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If expectations are not rational, there

are likely to be unexploited profit
opportunitiesmost economists
believe such opportunities are rare
and short-lived.

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Evaluating
Rational-Expectations Theory

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The argument against rational

expectations is that it required
households and firms to know too
much. People must know the true
model, or at least a good
approximation of it, and this is a lot
to expect.

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Real Business Cycle Theory

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The real business cycle theory is
an attempt to explain business cycle
fluctuations under assumptions of
complete price and wage flexibility
and rational expectations. It
emphasizes shocks to technology
and other shocks.

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Supply-Side Economics

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Orthodox macro theory consists of
demand-oriented theories that failed to
explain the stagflation of the 1970s.

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Supply-side economists believe that the

real problem was that high rates of taxation
and heavy regulation had reduced the
incentive to work, to save, and to invest.
What was needed was not a demand
stimulus but better incentives to stimulate
supply.

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The Laffer Curve

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With the tax rate measured on the
vertical axis and tax revenue
measured on the horizontal axis, the
Laffer curve shows there is some
tax rate beyond which the supply
response is large enough to lead to a
decrease in tax revenue for further
increases in the tax rate.

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The Laffer Curve

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The Laffer curve shows
the amount of revenue
the government collects
is a function of the tax
rate.

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The Laffer Curve

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When tax rates are very
high, an increase in the
tax rate could cause tax
revenues to fall.
Similarly, a cut in the
tax rate could generate
enough additional
economic activity to
cause revenues to rise.

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Evaluating Supply-Side Economics

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Among the criticisms of supply-side
economics is that it is unlikely a tax
cut would substantially increase the
supply of labor.

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When households receive a higher

after-tax wage, they might have an
incentive to work more, but they may
also choose to work less.

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Testing Alternative
Macroeconomic Models

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Models differ in ways that are hard to

standardize.

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If people have rational expectations,

they are using the true model, but
there is no way to know what model
is in fact the true one.

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There is only a small amount of data

available to test macroeconomic
hypothesesonly eight business
cycles since 1950.

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Review Terms and Concepts

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Laffer curve

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Lucas supply function

price surprise
quantity theory of money

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rational expectations hypothesis

real business cycle theory

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velocity of money

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