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19
Debates in Macroeconomics:
Monetarism, New Classical
Theory, and Supply-Side
Economics
Prepared by: Fernando Quijano
and Yvonn Quijano
Keynesian Economics
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
Two major schools decidedly against
government intervention have
developed: monetarism and new
classical economics.
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Monetarism
The main message of monetarists is
that money matters.
Monetarism, however, is usually
considered to go beyond the notion
that money matters.
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Monetarism
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):
G D P
V
M
or V
P Y
M
since
then,
G D P P Y
M V P Y
Karl Case, Ray Fair
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M V P Y
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Inflation as a Purely
Monetary Phenomenon
Inflation is always a monetary
phenomenon. If the money supply
does not change, the price level will
not change.
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
The strict monetarist view is not
compatible with a nonvertical AS
curve.
Almost all economists agree that
sustained inflation is purely a
monetary phenomenon.
Inflation cannot continue indefinitely
without increases in the money
supply.
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Rational Expectations
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.
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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Rational Expectations
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
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
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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Y f (P P )
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(P P )
e
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Evaluating
Rational-Expectations Theory
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
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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Supply-Side Economics
Orthodox macro theory consists of
demand-oriented theories that failed to
explain the stagflation of the 1970s.
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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Testing Alternative
Macroeconomic Models
Models differ in ways that are hard to
standardize.
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.
There is only a small amount of data
available to test macroeconomic
hypothesesonly eight business
cycles since 1950.
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