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CHAPTER 36: CURRENT ISSUES IN MACRO THEORY AND POLICY
Introduction
What causes economic instability? Will the economy self-correct? Should the government
intervene to stabilize the economy, and if so, how? These questions are central to the differences
among macroeconomic theories. Chapter 36 introduces some of the most prominent economic
theories today and explores the differences among them. This chapter concludes the discussion
of domestic macroeconomic theory in preparation for the concluding chapters on the international
economy. Material from Chapter 36 tends to appear in a few multiple-choice questions on the AP
macroeconomics exam.
What Causes Economic Instability?
The Mainstream (Keynesian) View
The majority of economists believe that the rnacroeconomy is generally unstable, with most
economic instability resulting from unexpected shocks to aggregate demand and supply, as well
as wage and price stickiness. The formula for calculating output is GDP = C + I + G + X,
representing consumer spending, gross investment of firms, government spending, and net
exports. An increase in spending in anyone of these four sectors results in a rightward shift of
the aggregate demand curve, increasing real output, the price level, or both. Keynesians argue
that the investment sector is the most volatile, and because of the multiplier effect, initial changes
in investment spending can cause much greater changes in output. An increase in aggregate
demand can cause demand-pull inflation, while a decrease in aggregate demand can cause
recession. Keynesians also recognize supply shocks as a cause of economic instability, because
such shocks significantly increase the cost of production for firms . As aggregate supply shifts to
the left, the reduction in output, which increases cost-push inflation, and higher unemployment
combine to create stagflation.
The Monetarist View
Monetarism is a school of economic thought developed from the work of American economist
Milton Friedman. Monetarists believe that the macroeconomy is generally stable at fullemployment output because competitive markets and flexibility in prices and wages promote
stability. Monetarists argue that changes in aggregate demand cause changes in wages and prices
rather than output and employment. While Keynesians see government as the answer to
economic instability, monetarists instead see government intervention as a cause of economic
instability. Monetarists argue that minimum wage laws, pro-union legislation giving workers
bargaining power to settle multi-year contracts, price floor supports for agricultural products, and
similar laws have created the sticky prices and wages central to Keynesian theory. Even more
importantly, monetarists argue that government attempts to stabilize the economy-especially
through monetary policy- actually exacerbate the strength and duration of business cycles, rather
than reducing them.
Monetarists do not view the economy through the Keynesian formula GDP = C + I + G + X but
instead focus on the equation of exchange (also known as the quantity theory of money) as central
to their theory :
MxV=PxQ
M is the money supply, V is the velocity of money (the number of times a dollar turns over
during a year), P is the price level, and Q is the quantity of goods sold during a year. In the
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Chapter 36: Current Issues in Macro Theory and Policy
~quati?n of exchan~e, PQ is the nominal GDP. The money supply multiplied by the number of
times It turns over In a year equals the value of the output on which it is spent.
Monetarists argue that the velocity is stable and predictable because people tend to hold the same
amount m~ney over time. Therefore, according to monetarists, an increase in the money
supply wI!1 dIrectly lead to an increase in nominal GDP, which will only cause inflation when the
economy IS alr~ady producing at fun-employment output. While higher prices may temporarily
cau~e fi~s to Increase output due to higher profit, once wages and other costs of production
begIn to nse, firms will return to full-employment output but at the higher price level.
ot
Monetarists view the use of monetary policy as a primary cause of economic instability. Because
changes in the money supply and interest rates can run counter to what is appropriate at a
particular point in the cycle, can take so long to take effect that they actually exacerbate cycles
(for example, a significant increase in the money supply finally taking full effect just as inflation
is increasing), or can be ineffective if banks choose not to make loans or customers do not
redeposit funds to allow mUltiple expansion, monetarists oppose the use of monetary policy.
Taking the EEK! Out of Economics
It is important not to confuse monetarism with the similar term "monetary policy." While
monetarists and Keynesians both recognize the importance of money to the economy, monetarists
oppose government attempts to stabilize the economy-especially those involving monetary
policy. Monetary policy is instead associated with Keynesian theory.
The Real Business Cycle View
A third theory claims that economic instability is caused primarily by changes in aggregate
supply. According to the Real Business Cycle Theory, changes in aggregate supply, such as a
significant increase in production costs or a decline in productivity, cause the long-run aggregate
supply curve to shift to the left. With output falling, consumers buy less and the demand for
money falls. As aggregate demand falls , output and employment fall but prices do not (because
aggregate supply also fell). Conversely, significant increases in the long-run aggregate supply
through increased productivity and reduced costs shift aggregate supply to the right and aggregate
demand increases with the real output produced, though prices do not rise. As a result, those who
adhere to this view of the economy call for no government intervention to stabilize the economy,
believing the economy will stabilize itself.
The Coordination Failures View
A fourth theory suggests that instability in the macroeconomy results from a failure of consumers
and firms to coordinate information and the problem of expectations resulting from that lack of
coordination. A widespread belief that the economy is falling into recession causes firms to cut
investment spending to avoid overcapacity. At the same time, consumers reduce spending out of
concern their incomes will be reduced due to cuts in hours or layoffs. The actions of people and
firms fearing a recession, causes the very recession they feared: it is a self-fulfilling prophecy.
Acco~ding to this view, if consumers and firms could be ~onvinced to coordinate their efforts to
begin making purchases again, aggregate de~and w~uld Increase and they would an be better off.
But the lack of coordination leaves them all In recessIon.
Chapter 36: Current Issues in Macro Theory and Policy
261
Will the Economy Self-Correct?
The Neoclassical View
Classical economists believed that the economy was inherently stable, operating at full
employment until some temporary shock created temporary instability. But they believed that in
the long run, the economy would self-correct to full-employment output due to flexible wages
and prices. In the same way, neoclassical economists believe the economy will self-correct over
time. Economists from the neoclassical school of thought tend to be either monetarists or
believers of the Rational Expectations Theory. The Rational Expectations Theory holds that
consumers and firms are knowledgeable about economic conditions and fiscal and monetary
policy. When faced with certain economic conditions, firms and consumers anticipate the
policies Congress and the Fed will undertake and then take action to protect themselves from the
effects of those policies.
For example, during a recession, workers and banks may anticipate that the Fed will increase the
money supply in order to increase aggregate demand. But because such an action can create
inflation in the long run, workers will immediately act to negotiate higher wages to protect real
wages, and banks will add the higher expected inflation rate in determining the nominal interest
rate for loans. The higher wages and interest rates then serve to dampen the growth that would
have occurred as a result of the Fed ' s action. As a result, adherents of the Rational Expectations
Theory, like monetarists and classical economists, call for the government to avoid engaging in
stabilization policy and instead advocate waiting for the economy to self-correct.
Because the Rational Expectations Theory holds that consumers and firms anticipate government
policy and act even before it is enacted, adjustments occur instantaneously or at least very
quickly. Under this theory, if price and policy changes are anticipated, firms and consumers react
instantly and output does not change. If an unexpected increase in demand for exports increases
aggregate demand for products, firms will increase production based on the extra profit they
anticipate because of the increased price at which they can sell products. But under the Rational
Expectations Theory, even when the initial stimulus was unanticipated, workers almost instantly
recognize prices will increase and begin to demand higher wages, very quickly increasing the cost
of production and di ssipating any anticipated profit, so production very quickly returns to fullemployment output.
Monetarists differ from rational expectations theorists in projecting the speed with which such
adjustments will occur. Monetarists believe that people and firms react to changes in the
economy after they have begun to occur rather than anticipating them, so that long-run
adjustments may require two to three years or even longer.
The Mainstream (Keynesian) View
While nearly all economists agree that quick adjustments occur in markets that move very
quickly, such as the stock market and foreign exchange markets, relatively few economists
believe that such adjustments occur quickly across the broader economy. Because empirical
evidence has shown that prices and wages are indeed sticky downward, and because recessionary
and inflationary expectations of consumers and firms may linger for long periods of time, the
economy does not quickly self-adjust. When aggregate demand falls, workers do not readily
accept the lower wages necessary to shift the short-run aggregate supply curve back out and
return the economy to full-employment output. Instead, workers resist a decrease in wages, and
the minimum wage and long-term contracts may even prevent the lowering of wages in many
cases. Firms may also resist lowering wages due to concerns about worker morale, potential
shirking, and increased job turnover as workers leave to seek employment where they can find
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Chapter 36: Current Issues in Macro Theory and Policy
higher pay ..So, aggregate demand remains lower, with output at less than full-employment
output, possIbly for a sustained period of time. In the view of mainstream economists today, the
economy will not self-adjust-potentially not for years.
Should the Government Intervene to Stabilize the Economy, and If So, How?
The Monetarist View
Monetarists and other neoclassical economists are convinced that government attempts to
stabilize the economy instead actually destabilize the economy beyond the effects of the normal
business cycle. They point specifically to the problem of monetary policy, concerned that
increasing the money supply in an attempt to reduce unemployment will create inflation instead.
Monetarists call for a monetary rule, requiring the Fed to increase the money supply at the rate of
average real GDP growth annually, regardless of the state of the economy. Monetarists contend
that if the money supply grows at a steady rate, money will be available in the economy in times
of recession, while the limit on growth will prevent overstimulation in times of inflation, thereby
stabilizing economic growth. In addition , the increase in money supply would reduce interest
rates, fueling investment in plant and equipment and further promoting steady annual economic
growth.
Monetarists also oppose the use of fiscal policy to stabilize the economy, especially expansionary
fiscal policy. Because expansionary policy requires the government to run deficits, the increased
demand for money in the loanable fund s market forces up interest rates and crowds out private
investment- so while government spending may be increasing, it is offset by a decline in
spending in the private sector. Further, the increase in interest rates negatively affects long-run
economic growth , as firm s reduce investment in plant and equipment. Therefore, monetarists and
other neoclassical economists oppose the use of fi scal policy to stabilize the economy, and some
go so far as to advocate a balanced budget amendment, requiring to federal government to
balance its budget every year in an effort to restrict the use of fiscal policy.
The Mainstream (Keynesian) View
Because of the serious harm that can befall firms and consumers in periods of serious recession
and inflation, Keynesians see government intervention and stabilization as the answer to swings
in the business cycle. Through fiscal policy, consumers and firms respond to incentives in taxes
and spending, which directly affect aggregate demand. Through monetary policy, the Federal
Reserve changes the money supply and interest rates, affecting aggregate demand more indirectly
through interest rate incentives. Further, policies can be developed to promote long-run
economic growth that may not result from an economy constrained by monetary rules and
balanced budget requirements.
Referring to the equation of exchange, Keynesians note evidence that while the money supply
and nominal GDP do correlate over the long run, in the short run velocity actually does become
variable. Therefore, a strict monetary rule may not limit changes in aggregate demand and GDP
as effectively as monetarists contend it will. If firms significantly increase investment spending
because of optimistic expectations for the economy, limitations on the growth of the money
supply will not be effective if the velocity is increasing. While the money stock may remain the
same, it is turning over faster and faster, creating inflation. But discretionary monetary policy
allows the Fed to restrict the growth of the money supply and change interest rates in ways that
discourage firms from overinves~ing to the extent that th~y c~use inflation. In the same way,
business pessimism may reduce Investment, and ~he Fed s faIlure to act discourages confidence
that the economy will emerge soon from a receSSIOn. However, the right incentives to invest-
Chapter 36: Current Issues in Macro Theory and Policy
263
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Keyne ians also point to decades of hi torical usc of fi ca l and monetary policy to effecti vely
limit period of inflation and recession, allo\ ing the econom to reco er mo re qu ickly than
would be antici pated if the econom were left a lone to e lf-correct. It i impo rtant to note the
actions of the Federal Reser e, Congress, and Pres ident George " . Bush and Barack Obama in
dealing \ ith the \ orst fin ancial cri sis to strike the nited State in decades. In 2008, the Federal
Reserve 1110 ed to reduce key interest rates to the 0-0.25% range, while providing loans to
financial institutions facing a sol ency crisis. In late 2008, Congress passed a $700 billion bill to
bailout financial institutions and later auto manufacturers. In early 2009, Congress passed a
fi scal stimulus package of nearl y $800 billion in increased spending and tax cuts. The
etfectiveness of these and other fi scal and monetary measures in reversing the steep slide in
aggregate demand w ill be determined over time . Without question, economists of all theoretical
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Chapter 36: Current Issues in Macro Theory and Policy
backg~ounds will closely examine the situation and policy actions to learn how we can more
effecttvely address changes in our economy.
Multiple-Choice Questions
I.
The economic theory which holds that the economy is generally unstable is
(A)
classical theory.
(8)
Keynesian theory.
(C)
monetarist theory.
(D)
rational expectations theory.
(E)
neoclassical theory.
2.
Keynesians argue that the economy does not self-adjust to demand shocks because
(A)
increased unemployment only lowers wage rates.
(8)
reductions in demand cause significant deflation in the economy.
(C)
wages and prices tend to be downwardly sticky.
(D)
expansionary fiscal policy is unpopular, so consumers do not change their
spending in response to fiscal stimuli .
(E)
firms do not change output in response to reductions in demand.
3.
The monetarist equation of exchange states that the money supply times the velocity
equals
(A)
the inflation rate .
(8)
the unemployment rate.
(C)
the federal budget.
(D)
real GDP.
(E)
nominal GDP.
4.
According to the quantity theory of money, if the Fed increases the money supply in
response to a recession, the policy will result in
(A)
a reduction in unemployment.
(8)
a reduction in real output.
(C)
an increase in interest rates.
(D)
an increase in the price level.
(E)
a decrease in the velocity.
5.
Classical economists argue that when the economy experiences supply or demand shocks,
it self-corrects through the mechanism of flexible
(A)
output.
(8)
employment rates.
(C)
prices.
(D)
money supply.
(E)
tax rates.
6.
Economists who adhere to the Rational Expectations Theory argue that fiscal and
monetary policy are ineffective because
(A)
people anticipate policy changes and act. to protect themselves.
(8)
policymakers take too long to create polIcy.
(C)
lower wages during recessions onl~ furt~er reduce aggr.egate demand.
(D)
higher interest rates do n?t redu.ce mflatlOnary expectatIOns.
(E)
the policies have contradictory mterest rate effects.
Chapter 36: Current Issues in Macro Theory and Policy
265
7.
Monetarists advocate the monetary rule, saying the Federal Reserve should increase the
money supply
(A)
in response to a decrease in aggregate demand.
(8)
in response to a decrease in aggregate supply.
(C)
only when Congress simultaneously increases taxes.
(D)
at a steady rate of average GDP growth.
(E)
only when fiscal policy has failed to resolve a recession.
8.
Monetarists oppose the use of expansionary fiscal policy, claiming that it
(A)
increases unemployment.
(8)
reduces interest rates.
(C)
reduces the money supply.
(D)
causes deflation.
(E)
crowds out private investment.
Multiple-Choice Explanations
I.
(B)
The other theories hold that the economy is stable at full-employment output, and
if any event destabilizes the economy, it sel f-adjusts.
(C)
Prices and wages tend to be downwardly rigid due to long-tern1 contracts, so
2.
when demand falls , costs of production do not necessarily follow, leaving the economy
producing at less than full-employment output.
3.
(E)
Nominal GDP is the P x Q on the right side of the equation, representing the
price level and the quantity of output produced.
4.
(D)
Monetari sts argue that ve loc it y and real output are stable, so any increase in the
money supply will only cre ate inflati on.
5.
(C)
When prices are fl ex ibl e, wages and costs of production can change, allowing the
economy to adjust to shocks.
6.
(A)
According to the Rati onal Ex pectations Theory, people are fully aware of
economic conditions and the fi sca l and monetary policies policy makers are likely to
undertake. They then take actions to protect themselves from the effects of such policies.
7.
(D)
Because monetarists are convinced that increasing the money supply in an
attempt to stabilize the economy only causes inflation, they advocate only increasing the
money supply by the average rate of increase in the GOP to avoid further destabilizing
the economy.
8.
(E)
Expansionary fiscal policy requires the government to borrow to finance deficit
spending. Increased demand for money in the loanable funds market pushes up interest
rates, reducing private investment.
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Chapter 36: Current Issues in Macro Theory and Policy