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

Aggregate supply
independent of
Price level

aggregate demand

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
 Different aggregate supply curves: (b)

Aggregate supply
totally dependent on
Price level

aggregate demand

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)
Aggregate supply becoming
less and less responsive to
aggregate demand as full
employment is reached
AS
Price level

National output
 Different aggregate supply curves: (c)
Aggregate supply becoming
less and less responsive to
aggregate demand as full
employment is reached
AS
Price level

P1

AD1
O Y1
National output
 Different aggregate supply curves: (c)
Aggregate supply becoming
less and less responsive to
aggregate demand as full
employment is reached
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
labour market
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

Excess supply drives

interest rates down.

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

Excess demand drives

interest rates up.

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
Says 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
Says 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
Says 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
Says 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
Says 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

Effect is purely higher

Price level

prices not higher output

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
Disequilibrium
unemployment
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
Fall in consumption may
r2 discourage investment.

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 KEYNESIAN REVOLUTION

Keynes policy recommendations

demand management by fiscal and
monetary policies

Keynesian policies in 1950s and 60s

stopgo policies

criticisms of short-term demand

management
the breakdown of the Phillips curve
The Roots of Modern Macroeconomics

The Monetarist
Keynesian Debate
THE MONETARISTKEYNESIAN DEBATE

The monetarist counter-revolution

the restatement of the quantity theory
rejection of Keynesian demand
management policies
the problem of inflationary expectations
a vertical long-run Phillips curve
 The monetarist version of the long-run Phillips curve
Inflation (%)

O Un
Unemployment
THE MONETARISTKEYNESIAN DEBATE

The monetarist counter-revolution

the restatement of the quantity theory
rejection of Keynesian demand
management policies
the problem of inflationary expectations
a vertical long-run Phillips curve
monetarist policies
THE MONETARISTKEYNESIAN DEBATE

The monetarist counter-revolution

the restatement of the quantity theory
rejection of Keynesian demand
management policies
the problem of inflationary expectations
a vertical long-run Phillips curve
monetarist policies
attempts at such policies in the 1980s
THE MONETARISTKEYNESIAN 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