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Chapter 15
A Century of Economic Theory
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Objectives
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The equation of exchange
The quantity theory of money
Classical economics
Keynesian economics
The monetarist school
Supply-side economics
The rational expectations theory
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Equation of Exchange
• Much of the Keynesian-Monetarist
debate revolves around the quantity
theory of money which itself is based on
the equation of exchange
– The equation of exchange and the quantity
theory of money are easy to confuse
– Perhaps because the equation of exchange is
used to explain the quantity theory of money
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Equation of Exchange
• The equation of exchange is MV = PQ
– M is the total dollars in the nation’s money
supply
– V is the number of times per year each dollar
is spent [i.e., velocity]
– P is the average price of all the goods and
services sold during the year
– Q is the quantity of goods and services sold
during the year
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Equation of Exchange
M times V (MV) would be total spending. Total spending by
a nation during a given year is GDP. Therefore,
MV = GDP
P times Q (PQ) is the total amount of money received by
sellers of all final goods and services produced by a nation
during a given year. This also is GDP. Therefore,
PQ = GDP
Things equal to the same thing are equal to each other,
therefore,
MV = PQ
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Equation of Exchange
The following example will be in billions of dollars without the
dollar signs
MV = PQ
900 X 9 = PQ
8,100 = PQ
8,100 = 81 X Q
8,100 = 81 X 100
8,100 = 8,100
The equation of exchange must always balance, as must all
equations.
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Quantity Theory of Money
The Crude version of the Quantity Theory of Money
This version holds that when the money supply (M) changes by a
certain percentage, the price level (P) changes by that same
percentage
MV = PQ
900 X 9 = 81 X 100
1800 X 9 = 162 X 100
16,200 = 16,200
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Quantity Theory of Money
The Crude version of the Quantity Theory of Money
This version holds that when the money supply (M) changes by a
certain percentage, the price level (P) changes by that same
percentage
MV = PQ
900 X 9 = 81 X 100
1800 X 9 = 162 X 100
16,200 = 16,200
If V and Q remain constant, the crude version of the quantity
theory of money is correct
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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A Closer Look at Q and V
• Since 1950 V has risen fairly steadily from about
three to nearly seven
• During recessions, production, and therefore Q
will fall
– Q fell at an annual rate of about 4 percent during the
1981-82 recession
• During recoveries, production picks up, so we go
from a declining Q to a rising Q
• Obviously, neither V or Q are constant
• Therefore, the crude version of the quantity
theory of money is not valid
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Quantity Theory of Money
The sophisticated version of the “Quantity Theory
of Money” assumes any short-term changes in V are
either very small or predictable
But what happens next is entirely up to the level of
production, Q
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Sophisticated Quantity Theory
of Money
Hypothetical
Aggregate
Supply
Curve
Fullemployment
GDP
National output (real GDP)
If we are well below full employment, an increase in M will
lead mainly to an increase in Q
If we are close to or at full employment, an increase in M will
lead mainly to an increase in P
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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Classical Economics
• The classical school of economics was
mainstream from roughly 1775 to 1930
• The classical school has the following tenets
–
–
–
–
Say’s law is operating
Savings will be invested
Interest rate mechanism
Quantity theory of money
• Assume V and Q are constant
– Flexible wages and prices
– Recessions cure themselves
• Government can’t cure recessions
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Keynesian Economics
• The Keynesian school has the following tenets
– The problem with recessions is inadequate demand
– The only hope is for the government to spend
enough money to raise aggregate demand
sufficiently to get people back to work
• The government could print the money or borrow it
• If enough (newly created money) was spent, the recession
would end
– No one would invest in new plant and equipment
when much of their capacity was idle
– Wages and prices were not downwardly flexible
because of institutional barriers
– If M rises, people may not spend the additional
money, but just hold it
• So much for the quantity theory of money
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Monetarist School
• The Importance of the Rate of Monetary
Growth
– Milton Friedman, an economist who did
exhaustive studies of the relationship
between the rate of growth of the money
supply concluded
• The United States has never had a serious
inflation that was not accompanied by rapid
monetary growth
• When the money supply has grown slowly, the
country has had no inflation
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Monetarist School
• The Importance of the Rate of Monetary
Growth
• Building on the quantity theory of money, the
monetarists agree with the classicals that when
the money supply grows, the price level rises,
albeit not at exactly the same rate
• Recessions are caused when the Federal Reserve
increases the money supply at less than the rate
needed by business – say, anything less than 3
percent a year
• By and large the facts have borne out the
monetarists’ analysis
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Monetarist School
• The Basic Propositions of
Monetarism
– The key to stable economic growth
is a constant rate of increase in the
money supply of at least 3 percent
a year
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Basic Propositions of Monetarism
• The Key to Stable Economic Growth Is a
Constant Rate of Increase in the Money
Supply
• Expansionary Monetary Policy Will Only
Temporarily Depress Interest Rates
• Expansionary Monetary Policy Will Only
Temporarily Reduce the Unemployment
Rate
• Expansionary Monetary Policy Will Only
Temporarily Raise Output and
Employment
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Monetarist School
• The Decline of Monetarism
– Monetarism’s popularity started to decline
in the late 1970s and early 1980s
– The Fed’s policy on monetary growth, sky
high interest rates, combined with two
recessions seemed to cause people to look
elsewhere for their economic gurus
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Supply-Side Economics
• Supply-side economics came into vogue in the
early 1980s
• Supply-siders mantra was to cut tax rates,
government spending, and government
regulation
• The object of supply-siders is to raise aggregate
supply
• Many of the undesirable effects of high
marginal tax rates are the work effect, the
savings and investment effect, and the
elimination of productive market exchanges
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Work Effect
• Facing high marginal tax rates, many
people refuse to work more than a certain
number of hours overtime or take on
second jobs and other forms of extra
work
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–
–
–
Instead, they opt for more leisure time
Output is less when people work less
When people work less, their income is less
Why work if the government gets most of the
money?
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Saving and Investment
Effect
• High marginal tax rates on interest
income will provide a disincentive to
save, or at least to make savings available
for investment purposes
• People who borrow money for investment
purposes hope that this will lead to
greater profits
– But, if these profits are subject to a high
marginal tax rate, once again there is a
disincentive to invest
• The economy will stagnate
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Elimination of Productive
Market Exchanges
– A productive market exchange is when you
work at what your are good at and hire
someone who is working at what they are
good at to do something for you
– There is a serious misallocation of labor
(perhaps hundreds of millions of dollars)
when the productive market exchange is
eliminated because of high marginal tax
rates
• It will pay you to work less at what you are good
at to do another job that you are not so good at
(you don’t hire some one is is better at it than you
to do it)
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Laffer Curve
100
90
80
70
60
A
50
B
40
C
30
20
10
0
Tax revenue (in hundreds of $billions)
The rationale of the Laffer curve is that when marginal tax rates
are too high, we can raise tax revenues by lowering them
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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Rational Expectation Theory
• Rational expectations theory is based on three
assumptions
– Individuals and firms learn through experience to
anticipate the consequences of changes in monetary
and fiscal policy
– They act instantaneously to protect their economic
interest thus nullifying the intended effects
– All resource and product markets are purely
competitive
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Rational Expectation Theory
• Rational expectations theorists say the
government should do as little as possible
• Basically, then, the government should figure
out the right policies to follow and stick to them
• The right policies are
– Steady monetary growth of 3 to 4 percent a year
– A balanced budget
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Rational Expectation Theory
• Criticism of the rational expectations school
– Is it reasonable to expect individuals and business
firms to accurately predict the consequences of
macroeconomic policy?
– Our economic markets are not purely competitive:
some are not competitive at all
– The rigidities imposed by contracts restrict
adjustments to changing economic conditions
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Economic Behaviorists
• Economic behaviorists are a hot new group of
young economists who are complete newcomers to the economic theory scene
• They maintain that while the mainstream
beliefs that rational behavior and economic
self-interest are important, they are not the
only motivating factors
• Their goal is to apply a wider range of
psychological concepts to economic theory
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Conclusion
• “Each of the major schools of economic
thought can be useful on occasion. The insights
of Keynesian economics proved appropriate for
Western societies attempting to get out of the
depression in the 1930s. The tools of
monetarism were powerfully effective in
squeezing out the inflationary force of the
1970s. Supply-side economics played an
important role in getting the public to
understand the high cost of taxation and thus
to support tax reform in the 1980s. But
sensible public policy cannot long focus on any
one objective or be limited to one policy
approach”
– Murray Weidenbaum
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Current Issue: Is George W. Bush
a Supply-Sider or a Keynesian?
• President Bush did make supply-side tax cuts
as well as Keynesian spending increases
– But, he continued huge deficit spending increases in
non-recession years
– Keynes would have recommended spending cuts and
reduced deficit spending in non-recession years
– Supply-side economists hold that tax cuts should
lead to reductions in government spending, not huge
spending increases as did Bush
• Guess what? George W. Bush is neither a
Keynesian or Supply-Sider
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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