DIFFERENT MACRO

THEROIES
Lecture 7
 Learning Objectives
1. Review of the different macro economic
theories.
2. Comparison between quantity theory of
money; Keynes vs. monetarist view.
3. Causes of Macroeconomic stability;
Keynes vs. monetarist view.
4. Comparison between Keynesians vs
new-classical
 1st Goal: Macroeconomic theories
G & T
(1934-1950`s) 3-5%
No “G” Monetary
Rule
1960`s

Adam Smith John M. Keynes Milton Friedman

Classicals Keynesians Monetarists
Get the G
Expectations
off of our
negate fiscal Keynesian Based
backs.
and monetary
(1080`s) Monetary Policy matters
Policy.(1970`s)
Fiscal policy matters
Money supply matters
Anticipations matter
Robert Lucas Ronald Reagan AS fiscal policy matters
Rational Ex. Supply-siders Mainstreamers
Disputes In Macroeconomics
 MAINSTREAM ECONOMISTS
[New Keynesian] – Keynesian based

1. The economy is stable but potentially unstable [supply

shocks or booms and busts impact investment].
2. Many prices/wages are inflexible downward, particularly
wages [contracts and efficiency wages].
3. Velocity is unstable [direct with the interest rate and
inverse with the money supply]
4. Inflation can be caused by excess MS, but it may also be
caused by “investment booms”, or “adverse supply
shocks.”
5. The Fed targets the interest rate in the SR but monitors
the MS in the LR.
 New Neo-classical Synthesis
(1960`s-1970`s)
• Economists begin to incorporate New
Keynesian models of price stickiness into
unified Real Business Cycle framework.
– These models explain which type of policies can
which might lead to offset effects of price-
stickiness underemployment without leading to
wage-price spirals.
• Economists also incorporate models of
financial market imperfections into unified
framework to explain financial crises in
emerging markets.
Monetarism (1960`s)(Neo-classical )
• In 1960’s, monetarists led by
Milton Friedman began to
emphasize the role of the money
supply (as opposed to real
demand factors) as determinants
of fluctuations in output and
especially inflation.
• In particular, Friedman pointed out
the way that demand stimulus,
once it becomes expected it may
lose its effectiveness.
 Monetarists

Monetary Rule
Motto:
“Increase the MS 3-5% year”
MXV=PXQ
Quantity theory of Money
Friedman Equation of Exchange
 Robert Lucas (1970`s)(Neo-classical )
Rational Expectations
• Lucas(1970) develops economic
theories which rigorously incorporate
the formation of expectations of
future in economic models.
• Rational expectations models offer theoretical
challenges but also explanations for rise of
inflationary spirals and seeming ineffectiveness
of monetary policy.
• Expectations based models also offer
 Robert Lucas Wins Nobel Prize in Economics

Dr. Lucas’ teachings suggest that

consumers and businesses will adjust
their behavior and doom Fed policies
aimed at stimulating or cooling off the
economy.
Ex: If a government attempts to lower unemployment
through expansionary monetary policy economic
agents will anticipate the effects of the change of policy and raise
their expectations of future inflation accordingly. This in turn will
counteract the expansionary effect of the increased money supply. All that
the government can do is raise the inflation rate, not employment.

The notion that G policies may prove self-defeating in a world

of RATEX gives rise to the idea of “policy impotence,” in which
the G is seen as virtually powerless to effect long-term change.

8 University of Chicago profs have won the Nobel prize in economics.

and he was the 5th in the last 6 years.
 Ronald Reagan(1980`s) (Neo-classical )
Supply-side economics
• Supply-side economics developed during the
1970s in response to Keynesian economic policy,
and in particular the failure of demand
management to stabilize Western economies
during the stagflation of the 1970s.
• Ronald Reagan was a supply-side economist, he
suggested:
1. Lower marginal tax rates : Reduction in income tax rates
and an even larger reduction in capital gains tax rates.
2. Less regulation: Economic growth can be most effectively
created by lowering barriers for people to produce (supply)
goods and services as well as invest in capital
Let’s look at another Keynesian.

Chapter 19

Monetarist Keynesian
• Full employment is the norm.
• Laissez-faire “Let it be”
• Vertical Aggregate Supply Curve
• Stable Aggregate Demand
• Real Output Depends Upon…
1.. Say’s Law
2. Responsive, Flexible, Prices and
Wages
 Classical Theory
AS
Price Level

P1

AD1

Qf
Real Domestic Output
 Classical Theory
AS
Price Level

P1

P2 AD1
AD2
Qf
Real Domestic Output
• Their hero and leader was John Maynard
Keynes
• Active government policy is needed to
stabilize the economy.
• “Laissez-Faire” is subject to recessions
and widespread unemployment
• AD is Unstable (Investment fluctuates)
• Prices and Wages Downwardly Inflexible
• Horizontal AS Curve to Full-Employment
 Keynesian View
AS

Prices are downwardly

Price Level

Inflexible, or “Sticky”
P1

AD1
AD2
Qu Qf
Real Domestic Output
 Keynesian View
AS

P1
Price Level

AD1

Q1
Real Domestic Output
 Keynesian View
“The economy has fallen and can’t get up.”
Prices and wages are AD2 AD1 AS
downwardly inflexible
Active government policy required
to stabilize the economy
Horizontal AS to Full-Employment
Unstable AD [because of investment] PL1
G is needed to move the economy
out of recession

“Businesses don’t let

prices fall so easily”
Y2 Y1
“Workers don’t let Real Domestic Output

wages fall so easily.”

 Keynesian View
Price Level AS

P1

AD1

Qf
Real Domestic Output
2nd Goal: The Equation of Exchange
or Quantity Theory of Money
MV x PQ was the cornerstone of Classical theory.

$ spent $ received

MxV=PxQ
1. Velocity is stable.
2. The amount of goods/services that can be produced
is fixed in the short run.
3. If the Fed increases the MS by 15%, we will
see a proportional 15% increase in prices.
4. V and Q aren’t in the equation & a change in MS
will result in a change in P.
Let’s Take A Look At Milton Friedman’s License Plate
 Fiscal Policy Monetary Rule

The Keynesian -
Monetarist Debate

Keynesian View Monetarist View

Velocity is not stable or predictable. Velocity is stable and
So an increase in M or V could increase P. predictable.

M V = P Y The Fed cannot predict

short-run variations in V.
Thus, no monetary rule policy.
Adjustments to M will be
MS needs to be adjusted. wrong and destabilizing.
3rd Goal: CAUSES OF MACRO INSTABILITY
Mainstream View (Keynesian)
Changes in Investment
Ca + Ig + Xn + G = GDP
Adverse Aggregate Supply
Shocks
Monetarist View (Classical)
Equation of Exchange
M V = P Q (Nom. GDP)

Stable Velocity
CAUSES OF MACRO INSTABILITYSummary
Mainstream View (Keynesian)
Instability of Investment is the Main Cause of Output
Changes
Monetary Policy is a Stabilizing Factor
Downward Wage Inflexibility
Efficiency Wage Theory
• Greater Work Effort
• Lower Supervision Costs
• Reduced Job Turnover
Monetarist View (Classical)
With a Stable Velocity, Nominal GDP Depends
Upon the Money Supply
 RATIONALE FOR A MONETARY RULE
Federal Reserve Increases Money Supply at
the Long-Run Growth Rate of GDP
ASLR1 ASLR2

Fed Increases
The Money Price Level
Supply
Resulting in… P1
P2
AD1
Q1 Q 2
Real Domestic Output, GDP
RATIONALE FOR A MONETARY RULE
Federal Reserve Increases Money Supply at
the Long-Run Growth Rate of GDP
ASLR1 ASLR2

Growth Price Level

Without
Inflation or P1
Deflation
P2 AD2
AD1
Q1 Q 2
Real Domestic Output, GDP
 4th Goal. Contrasting Keynesian and new
classical macroeconomics
Keynesian macroeconomics New classical
macroeconomics
1. The overarching aim of explaining unemployment explaining the business cycle
macroeconomics
2. Basic model the IS-LM model the Lucas-Rapping supply function

3. Relative role of supply emphasis on demand emphasis on supply

and demand
4. The wage-employment stable Phillips curve allowing the policy no possibility of a policy exploitation of
relationship exploitation of the inflation/ unemployment the inflation/ unemployment inverse
inverse relation relation
5. Micro/macro under the mantle of the neoclassical rejection of the neoclassical synthesis;
relationship synthesis; macroeconomics is concerned its equilibrium long-period leg can
with its disequilibrium short-period leg provide all the explanation necessary

6. Expectations Adaptive expectations rational expectations

7. Econometric modelling Keynesian macro-econometric models are Models are simplified general
complex systems of equations, whose equilibrium models which ought to be
parameters are fixed by economically- based on ‘deep structural’ parameters
estimated coefficients based on the calibration method

8. Methodology Marshallian Walrashian

9. The nature of the the business cycle is viewed as a market fluctuations express agents’
business cycle and policy failure — the policy aim is to bring the optimizing reaction to exogenous
conclusions economy towards full employment through shocks — no activation policy should
 Review
• We have learned about the different macro
economic theories.
• We have compared between quantity
theory of money; Keynes vs. monetarist
view.
• We have learned about the causes of
Macroeconomic stability; Keynes vs.
monetarist view.
 THANK YOU
2ND ASSIGNMENT SUBMISSION & 2ND
QUIZ DUE ON 23 & 24 OCT 2014