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Disputes over Macro Theory and Policy
CHAPTER NINETEEN
DISPUTES OVER MACRO THEORY AND POLICY
CHAPTER OVERVIEW
One of the great traditions in scholarship is the challenge to mainstream thinking. Many such
challenges to the “conventional wisdom” fail; either the new theories are not logical or they don’t
conform to the facts. At the opposite extreme, some new theories gain full support and replace the
existing theories. More often, the new ideas modify mainstream thinking, which thereafter is improved
or extended. This is true in economics.
In this chapter we examine some of the major disputes in macro theory and policy. We initially provide
historical background by contrasting classical and Keynesian macroeconomic theories. Then we turn to
contemporary disagreements on three interrelated questions: (1) What causes instability in the
economy? (2) Is the economy self-correcting? (3) Should government adhere to rules or use discretion in
setting economic policy?
WHAT’S NEW
Except for some revisions and updates, this chapter is largely unchanged. Discussion of the vertical
classical aggregate supply curve is consolidated, as much of it appears now in Chapter 11.
The fading of the call for a Friedman monetary rule and the new call for inflation targeting are discussed.
A “Consider This” box has been added, using the Lerner-Friedman steering wheel analogy to illustrate
the rules versus discretion debate.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to
1. Contrast the classical and Keynesian views of the aggregate supply curve.
2. Compare the classical and Keynesian views of the stability of the aggregate demand curve.
3. Give two reasons for macroeconomic instability according to mainstream economists.
4. Explain the equation of exchange.
5. Identify the single most important cause of macroeconomic instability according to the
monetarists.
6. Explain the main reasons for macroeconomic instability according to the real-business-cycle
theory.
7. Construct an example to demonstrate a coordination failure.
8. Explain the view of self-correction held by mainstream economists.
9. List three reasons why a higher wage could result in greater efficiency.
10. Explain how insider-outsider relationships contribute to downward wage inflexibility.
11. Describe the monetary rule and explain why monetarists prefer it to discretionary monetary policy.
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Disputes over Macro Theory and Policy
12. Compare the views of mainstream economists with monetarists and RET economists regarding the
use of discretionary fiscal policy and the need for an annually balanced budget.
13. Compare and contrast the Taylor Rule with the Monetary Rule advocated by monetarists.
14. Define and explain the terms and concepts listed at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. This chapter illuminates basic disagreements and controversies in macroeconomic theory. Stress
that, despite the disagreements, there is considerable agreement about the basic macro concepts,
the tools of analysis, and the framework for discussion.
2. This may be a good time to reemphasize the difference between positive and normative economics.
Remind students that value judgments about the economy, that is, which economic goals are most
important, influence opinions about a particular economic policy, as much as any empirical data.
3. Ask students to evaluate the last presidential election, or the views of new candidates vying for the
presidency. Can they identify the school of thought most closely associated with each candidate
for president? Consider the candidates for local elective office; is there enough information
available to make a judgment about the candidates’ opinions about economic policies?
4. Mainstream economists believe that nominal wages are inflexible downward because of labor
contracts, efficiency wages, and insider-outsider relationships. Have students interview a business
manager with first-hand experience in this area; or ask students to consider what kind of empirical
data they would need to collect to evaluate the flexibility or inflexibility of wages.
5. Arthur Okun published a work in the 1960s that is still a good basis for discussion, Equality and
Efficiency, the Big Tradeoff.
6. In discussing Rational Expectations Theory, the following “Concept Illustration” may be useful. It
appeared on the website for the previous edition in the “Analogies, Anecdotes, and Insights”
section.
CONCEPT ILLUSTRATION … Rational Expectations
The following story illustrates forward-looking behavior, which is part of the theory of rational
expectations.
When Lucas Sargent declared his college major, he sketched out a plan for his courses for the next
two or three years. He based his plan on the course requirements set out in the university catalog
and his expectation that these requirements would continue.
Also suppose that a very difficult, poorly designed course is required in Lucas’s major. Everyone
is complaining about the course, but since it is required, Lucas decides to stay with his plan and
register for it for the second term. Many other majors do the same thing.
Next, suppose that the word gets out that the faculty has voted to eliminate this requirement for the
major. This curriculum change, however, must go through university procedures and thus will not
be finalized until next year. Lucas visits with other students and concludes that this change will
most likely happen. He therefore changes his registration for the second term, substituting another
course for the one in question. Because many other students also opt out, registration for the
course plummets for the second term, surprising the faculty.
Lucas and the other students initially registered for this course based on a particular expectation
about the future: that the course would be required. The policy change produced a new
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Disputes over Macro Theory and Policy
expectation about the future: that the course would no longer be required. This new expectation
led students to alter their present behavior. Lucas and his fellow students changed their current
behavior based on rational expectations.
STUDENT STUMBLING BLOCK
This is not easy material for many students. Students may become frustrated when they consider more
than one point of view. It may be helpful to point out that acceptance or rejection of a theory depends in
part on (1) assumptions made about economic behavior and (2) opinions about which economic goals are
most important for the country.
LECTURE NOTES
I.
Introduction: Disagreements about Macro Theory and Policy
A. This chapter contrasts the classical and Keynesian macroeconomic theories.
B. Contemporary disagreements on three interrelated questions are considered.
1. What causes instability in the economy?
2. Is the economy self-correcting?
3. Should government adhere to rules or use discretion in setting economic policy?
II.
Some History: Classical Economics
A. Classical economics dominated the discipline from Adam Smith (1776) until the 1930s. It
maintained that full employment was normal and that a “laissez-faire” (let it be) policy by
government is best.
B. Keynes observed in the 1930s that laissez-faire capitalism is subject to recurring recessions
or depressions with widespread unemployment, and contended that active government
stabilization policy is required to avoid the waste of idle resources.
C. Classical View.
1. The aggregate supply curve is vertical and located at the full-employment level of real
output.
2. Stress that classical economists believed that real output does not change in response to
changes in the price level because wages and other input prices would be flexible.
3. The economy would operate at its full-employment level of output because of
a. Say’s law (See Last Word Chapter 10), which states that “supply creates its own
demand.”
b. Responsive, flexible prices and wages in cases where there might be temporary oversupply.
4. Money underlies aggregate demand. Classical economists theorize that aggregate
demand will be stable as long as the supply of money is controlled with limited growth.
5. The downward-sloping demand curve is stable and is solely responsible for setting the
price level. (See Figure 19-1a)
6. Changes in the money supply would shift AD right for an increase and left for a
decrease, but responsive, flexible prices and wages will ensure that full employment
output is maintained.
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Disputes over Macro Theory and Policy
D. Keynesian View.
1. The core of Keynesianism is that product prices and wages are downwardly inflexible
(don’t fall easily). This is graphically represented as a horizontal aggregate supply
curve. (See Figure 19-1b.)
2. A decline in real output will have no impact on the price level. Once full employment is
reached at Qf, the aggregate supply curve is vertical.
3. Keynesian economists view aggregate demand as unstable from one period to the next,
even without changes in the money supply.
4. The investment component of aggregate demand is especially likely to fluctuate and the
sole impact is on output and employment, while the price level remains unchanged. (See
shift AD1, to AD2 in Figure 19-1.)
5. Active government policies are essential to increase aggregate demand and move the
economy back toward full employment.
III.
What Causes Macro Instability such as Great Depression, Recessions, Inflationary
Periods?
A. Mainstream View: This term is used to characterize the prevailing perspective of most
economists.
1. Mainstream macroeconomics is Keynesian based, and focuses on aggregate demand and
its components. C(a) + I(g) + X(n) + G = GDP (Aggregate expenditures) = (real output)
2. Any change in one of the spending components in the aggregate expenditure equation
shifts the aggregate demand curve. This, in turn, changes equilibrium real output, the
price level or both.
a. Investment spending is particularly subject to variation.
b. Instability can also arise from the supply side. Artificial supply restriction, wars, or
increased costs of production can decrease supply, destabilizing the economy by
simultaneously causing cost-push inflation and recession.
B. Monetarist View: This label is applied to a modern form of classical economics.
1. The money supply is the focus of monetarist theory.
2. Monetarism argues that the price and wage flexibility provided by competitive markets
cause fluctuations in product and resource prices, rather than output and employment.
3. Therefore, a competitive market system would provide substantial macroeconomic
stability if there were no government interference in the economy.
a
It is government that has caused downward inflexibility through the minimum wage
law, prounion legislation, and guaranteed prices for some products as in agriculture.
b. Monetarists say that government also contributes to the economy’s business cycles
through clumsy, mistaken, monetary policies.
4. The fundamental equation of monetarism is the equation of exchange. MV = PQ
a. The left side, MV, represents the total amount spent [M, the money supply x V, the
velocity of money, (the number of times per year the average dollar is spent on final
goods and services)].
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b. The right side, PQ, equals the nation’s nominal GDP [P is the price level or more
specifically, the average price at which each unit of output is sold; Q is the physical
volume of all goods and services produced (real output)].
c. Monetarists say that velocity, V, is stable, meaning that the factors altering velocity
change gradually and predictably. People and firms have a stable pattern to holding
money.
d. If velocity is stable, the equation of exchange suggests there is a predictable
relationship between the money supply and nominal GDP (PQ).
5. Monetarists say that inappropriate monetary policy is the single most important cause of
macroeconomic instability. An increase in the money supply will increase aggregate
demand.
6. Mainstream economists view instability of investment as the main cause of the
economy’s instability. They see monetary policy as a stabilizing factor since it can adjust
interest rates to keep investment and aggregate demand stable.
C. Real Business Cycle View: A third perspective on macroeconomic stability focuses on an
aggregate supply. (See Figure 19-2.)
1. This takes the view that business cycles are caused by real factors affecting aggregate
supply such as a decline in productivity, which causes a decline in AS.
2. In the real-business cycle theory, declines in GDP mean less demand for money. Here,
the supply of money is decreased after the demand declines. AD falls, but price level is
the same because AS also declined.
D. Coordination Failures: A fourth view relates to so-called coordination failures.
1. Macroeconomic instability can occur “when people do not reach a mutually beneficial
equilibrium because they lack some way to jointly coordinate their actions.”
2. There is no mechanism for firms and households to agree on actions that would make
them all better off if such a failure occurs. The initial problem may be due to
expectations that are not justified, but if everyone believes that a recession may come,
they reduce spending, firms reduce output, and the recession occurs. The economy can
be stuck in a recession because of a failure of households and businesses to coordinate
positive expectations.
IV.
Does the Economy “Self-Correct”?
A. New Classical View of Self-Correction
1. Monetarist and rational expectation economists believe that the economy has automatic,
internal mechanisms for self-correction.
2. Figure 19-3 demonstrates the adjustment process, which retains full employment output
according to this view.
3. The disagreement among new classical economists is over the speed of the adjustment
process.
a. Monetarists usually hold the adaptive expectations view of gradual change. The
supply curve shifts shown in Figure 19-3 may take 2 or 3 years or longer.
c. Rational expectations theory (RET) holds that people anticipate some future
outcomes, making change very quick, even instantaneous.
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i. Where there is adequate information, people’s beliefs about future outcomes
accurately reflect the likelihood that those outcomes will occur.
ii. RET assumes that new information about events with known outcomes will be
assimilated quickly.
4. In RET unanticipated price-level changes do cause temporary changes in real output.
Firms mistakenly adjust their production levels in response to what they perceive to be a
relative price change in their product alone. Any change in GDP is corrected as prices
are flexible and firms readjust output to its previous level.
5. In RET fully anticipated price-level changes do not change real output, even for short
periods. Firms are able to maintain profit and production levels.
B. Mainstream View of Self-Correction
1. There is ample evidence that many prices and wages are inflexible downward for long
periods of time. However, some aspects of RET have been incorporated into the more
rigorous model of the mainstream.
2. Graphical analysis shown in Figure 19-3b demonstrates the adjustment process along a
horizontal aggregate supply curve.
3. Downward wage inflexibility may occur because firms are unable to cut wages due to
contracts and the legal minimum wage. Firms may not want to reduce wages if they fear
problems with morale, effort, and efficiency.
4. An efficiency wage is one that minimizes the firm’s labor cost per unit of output. Firms
may discover that paying higher than market wages lowers wage cost per unit of output.
a. Workers have an incentive to retain an above-market-wage job and may put forth
greater work effort.
b. Lower supervision costs prevail if workers have more incentive to work hard.
d. An above-market wage reduces job turnover.
5. Some economists believe wages don’t fall easily because already employed workers
(insiders) keep their jobs even though unemployed outsiders might accept lower pay.
Employers prefer a stable work force. (Key Question 7)
V.
Rules or Discretion?
A. Monetarists and other new classical economists believe that policy rules would reduce
instability in the economy.
1. A monetary rule would direct the Fed to expand the money supply each year at the same
annual rate as the typical growth of GDP. (See Figure 19-4.)
a. The rule would tie increases in the money supply to the typical rightward shift of
long-run aggregate supply, and ensure that aggregate demand shifts rightward along
with it.
b. A monetary rule, then, would promote steady growth of real output along with price
stability.
2. A few economists favor a constitutional amendment to require the federal government to
balance its budget annually.
a. Others simply suggest that government be “passive” in its fiscal policy and not
intentionally create budget deficits or surpluses.
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b. Monetarists and new classical economists believe that fiscal policy is ineffective.
Expansionary policy is bad because it crowds out private investment.
c. RET economists reject discretionary fiscal policy for the same reason they reject
active monetary policy. They don’t believe it works because the effects are fully
anticipated by the private sector.
B. Mainstream economists defend discretionary stabilization policy.
1. In supporting discretionary monetary policy, mainstream economists argue that the
velocity of money is more variable and unpredictable and in short-run monetary policy
can help offset changes in AD that monetarists contend.
2. Mainstream economists oppose requirements to balance the budget annually because it
would require actions that would intensify the business cycle, such as raising taxes and
cutting spending during recession and the opposite during booms. They support
discretionary fiscal policy to combat recession or inflation even if it causes a deficit or
surplus budget.
C. The U.S. economy has been about one-third more stable since 1946 than in earlier periods.
Discretionary fiscal and monetary policies were used during this period and not before,
which makes a strong case for its success.
D. A summary of alternative views presents the central ideas and policy implications of four
main macroeconomic theories: Mainstream macroeconomics, monetarism, rational
expectations theory, and supply side economics. (See Table 19-1.)
E. CONSIDER THIS … On the Road Again
Keynesian Abba Lerner compared the economy to a car without a steering wheel, and said
that the prudent addition and use of a steering wheel (discretionary fiscal and monetary
policy) would stabilize the macroeconomy. Monetarist Milton Friedman argued that the
steering wheel already exists, and that the discretionary use of monetary policy by the Fed
keeps jerking on it, causing the car (the macroeconomy) to swerve. If the Fed would just
hold the steering wheel steady, the macroeconomy would be stable.
VI.
Last Word: The Taylor Rule: Could a Robot Replace Alan Greenspan?
A. Macroeconomist John Taylor of Stanford University calls for a new monetary rule that
would institutionalize appropriate Fed policy responses to changes in real output and
inflation.
B. Traditional “monetarist rule” is passive. It required the Fed to expand the money supply at a
fixed annual rate regardless of economic conditions.
C. “Discretion” is associated with the opposite: an active monetary policy where the Fed
changes the money supply and interest rates in response to changes in the economy or to
prevent undesirable results.
D. Taylor’s policy proposal would dictate active monetary actions that are precisely defined. It
combines monetarism and the more mainstream view.
E. Taylor’s rule has three parts.
1. If real GDP rises 1% above potential GDP, the Fed should raise the Federal funds rate by
0.5% relative to the current inflation rate.
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2. If inflation is 1% above its target of 2%, the Fed should raise the Federal funds rate by
0.5% above the inflation rate.
3. If real GDP equals potential GDP and inflation is 2%, the Federal funds rate should be
about 4%, implying real interest rate of 2%.
F. Taylor would retain the Fed’s power to override the rule, so a robot really couldn’t replace
the Board. But a rule increases predictability and credibility.
G. Critics of the proposal see no reason for this rule given the success of monetary policy in the
past decade.
ANSWERS TO END-OF-CHAPTER QUESTIONS
19-1
(Key Question) Use the aggregate demand-aggregate supply model to compare the “old” classical
and Keynesian interpretations of (a) the aggregate supply curve and (b) the stability of the
aggregate demand curve. Which of these interpretations seems more consistent with the realities
of the Great Depression?
(a) Classical economists envisioned the AS curve as being perfectly vertical. When prices fall,
real profits do not decrease because wage rates fall in the same proportion. With constant
real profits, firms have no reason to change the quantities of output they supply. Keynesians
viewed the AS curve as being horizontal at outputs less than the full-employment output and
vertical only at full employment. Declines in aggregate demand do not change the price level
because wages and prices are assumed to be inflexible downward.
(b) Classical economists viewed AD as stable so long as the monetary authorities hold the
money supply constant. Therefore inflation and deflation are unlikely. Keynesians viewed
the AD curve as unstable—even if the money supply is constant—since investment spending
is volatile. Decreases in AD can cause a recession; rapid increases in AD can cause demandpull inflation.
(c) The Keynesian view seems more consistent with the facts of the Great Depression; in that
period, real output declined by nearly 40 percent in the United States and remained low for a
decade.
19-2
According to mainstream economists what is the usual cause of macroeconomic instability?
What role does the spending-income multiplier play in creating instability? How might adverse
aggregate supply factors cause instability, according to mainstream economists?
The mainstream view of macroeconomic instability is Keynesian-based and focuses on aggregate
spending and its components. Particularly significant are changes in investment spending, which
change aggregate demand and, occasionally, adverse supply shocks, which change aggregate
supply.
Investment spending is subject to wide variations, and a “multiplier effect” magnifies these
changes into even greater changes in aggregate demand, which can cause demand-pull inflation
in the forward direction or a recession if investment spending falls.
In the mainstream view, a second source of instability could arise on the supply side. Wars or an
artificial supply restrictions boost may increase per-unit production costs. The result is a sizable
decline in a nation’s aggregate supply, which could destabilize the economy by simultaneously
causing cost-push inflation and recession.
19-3
State and explain the basic equation of monetarism. What is the major cause of macroeconomic
instability, as viewed by monetarists?
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Disputes over Macro Theory and Policy
The fundamental equation of monetarism is the equation of exchange. MV = PQ. The left side,
MV, represents the total amount spent [M, the money supply x V, the velocity of money, (the
number of times per year the average dollar is spent on final goods and services)]. The right
side, PQ, equals the nation’s nominal GDP [P is the price level or more specifically, the average
price at which each unit of output is sold. Q is the physical volume of all goods and services
produced].
Monetarists believe changes in the money supply, in particular, inappropriate monetary policy, is
the single most important cause of macroeconomic stability.
19-4
(Key Question) Suppose that the money supply and the nominal GDP for a hypothetical
economy are $96 billion and $336 billion, respectively. What is the velocity of money? How
will households and businesses react if the central bank reduces the money supply by $20
billion? By how much will nominal GDP have to fall to restore equilibrium, according to the
monetarist perspective?
Velocity = 3.5 or 336/96. They will cut back on their spending to try to restore their desired ratio
of money to other items of wealth. Nominal GDP will fall to $266 billion (= the $76 billion
remaining money supply x 3.5) to restore equilibrium.
19-5
Briefly describe the difference between a so-called real business cycle and a more traditional
“spending” business cycle.
In the real-business-cycle theory, business fluctuations result from significant changes in
technology and resource availability. These changes affect productivity and thus the long-run
growth trend of aggregate supply. The changes in aggregate supply then induce changes in the
demand for money, which in this controversial scenario then leads to a change in the money
supply, which allows adjustment in output without changes in the price level. The conclusion of
the real-business-cycle theory is that macro instability arises on the aggregate supply side of the
economy, not on the aggregate demand side as both mainstream economists and monetarists
generally say.
19-6
Craig and Kris were walking directly toward each other in a congested store aisle. Craig moved
to his left to avoid Kris, and at the same time Kris moved to his right to avoid Craig. They
bumped into each other. What concept does this example illustrate? How does this idea relate to
macroeconomic instability?
This example illustrates a coordination failure that occurs in macroeconomics when people do
not reach a mutually beneficial equilibrium because they lack some way to jointly coordinate
their actions.
Expectations of households and business firms can create an undesirable outcome. If individuals
expect others to cut spending and anticipate excess capacity, they will cut their own investment
and consumption as well. Aggregate demand will decline and the economy will experience a
recession due to a self-fulfilling prophecy. Once the economy is depressed, producers and
households have no individual incentive to increase spending. If all participants would agree to
simultaneously increase spending, then aggregate demand would rise and real output and real
income would expand. Each producer and consumer would be better off. But this mutually
beneficial outcome will not occur because there is no mechanism by which to coordinate their
actions.
19-7
(Key Question) Use an AD-AS graph to demonstrate and explain the price-level and real-output
outcome of an anticipated decline in aggregate demand, as viewed by RET economists. (Assume
that the economy initially is operating at its full-employment level of output.) Then, demonstrate
and explain on the same graph the outcome, as viewed by mainstream economists.
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Disputes over Macro Theory and Policy
See the graph and the decline in aggregate demand from AD1 to AD2. RET view: The economy
anticipates the decline in the price level and immediately moves from a to d. Mainstream view:
The economy first moves from a to b and then to c. In the long run AS will shift right (as
nominal wages fall), intersecting AD2 at point d. In view of historical evidence, the mainstream
view seems more plausible to us than the RET view.
19-8
What is an efficiency wage? How might payment of an above-market wage reduce shirking by
employees and reduce worker turnover? How might efficiency wages contribute to downward
wage inflexibility, at least for a time, when aggregate demand declines?
An efficiency wage is one that minimizes the firm’s labor cost per unit of output. Normally, we
could assume that the market wage for the particular type of labor would be efficient, since it is
the lowest wage that could be paid to obtain workers in the classification. Firms may discover,
however, that paying a wage that is higher than the market wage will lower their wage cost per
unit of output. There are a number of reasons for this possible outcome.
First, the above-a market wage raises the opportunity cost of losing the job and gives workers
an incentive to retain their relatively high-paying job. Worker productivity is likely to be
higher and in a sense the higher wage more than pays for itself.
Second, motivated workers require less supervision. If the firm needs fewer supervisory
personnel to monitor work performance, the overall wage cost per unit of output can be
lower.
Third, the above-market pay discourages workers from voluntarily leaving their jobs and the
lower turnover rate reduces the firm’s cost of hiring and training new workers. It also gives
the firm a better selection of potential workers, since the above-market wage would increase
applications. With a high retention rate and a good pool of applicants, the firm is likely to
maintain a more experienced and productive work force.
Efficiency wages are likely to contribute to downward wage inflexibility. Wage cuts may
encourage shirking, require more supervising personnel and increased turnover. Wage cuts that
reduce productivity and raise per-unit labor costs are self-defeating.
19-9
How might relationships between so-called insiders and outsiders contribute to downward wage
inflexibility?
Insiders are workers who retain employment even during recession. Outsiders are workers laid
off from a particular firm and other unemployed workers who would like to work at that firm.
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Disputes over Macro Theory and Policy
Insider-outsider theory suggests that wages will be inflexible downward even when aggregate
demand declines. Employers seem to believe that hiring unemployed workers at a reduced wage
is not worth the disruption it could cause the business. Insiders are already trained, know their
jobs, and may work in teams. Replacing them with outsiders may cost more than the saving in
reduced wages.
19-10 Use the equation of exchange to explain the rationale for a monetary rule. Why will such a rule
run into trouble if V unexpectedly falls because of, say, a drop in investment spending by
businesses?
MV = PQ. If we assume that V (velocity) is constant, increasing the money supply at the same
rate as the anticipated increase in real output (Q) would leave the price level (P) unchanged. If
velocity is not stable and changes unexpectedly, a steady rate of growth of the money supply may
not be sufficient to keep the economy on the desired path of noninflationary growth of real
output.
19-11 Answer parts (a) and (b) on the basis of the following information for a hypothetical economy in
year 1: money supply = $400 billion; long-term annual growth of potential GDP = 3 percent;
velocity = 4. Assume that the banking system initially has no excess reserves and the reserve
requirement is 10 percent. Also assume that velocity is constant and the economy initially is
operating at its full-employment real output.
(a) What is the level of nominal GDP in year 1?
(b) Suppose the Fed adheres to a monetary rule through open-market operations. What amount
of U.S. securities will it have to sell to, or buy from, banks or the public between years 1 and
2 to meet its monetary rule?
The equation of exchange MV = PQ allows us to calculate nominal GDP by multiplying M (400
billion) times V(4).
(a) Nominal GDP is 1,600 billion in year 1
(b) To achieve a 3% growth rate, an increase in nominal GDP of $48 billion, the money supply
would have to increase by $12 billion.
MV = 1,648 (412 x 4) = 1,648.
Assuming a 10% reserve requirement and all money in the form of bank deposits, a money
multiplier of 10 would suggest that the Federal Reserve would need to purchase $1.2 billion in
U.S. Government securities in order to achieve the required monetary growth over the course of
the year.
19-12 Explain the difference between “active” discretionary fiscal policy advocated by mainstream
economists and “passive” fiscal policy advocated by new classical economists. Explain: “The
problem with a balanced-budget amendment is that it would, in a sense, require active fiscal
policy—but in the wrong direction—as the economy slides into recession.”
Active discretionary fiscal policy entails the use of deficit spending during recessions, that is,
increasing government spending, and/or cutting taxes to expand aggregate demand, and to use
contractionary fiscal policy, running a budget surplus, all to ward off inflationary pressures when
necessary.
New classical economists, monetarists, and rational expectationists see the economy as
automatically self-correcting when disturbed from its full-employment level of real output. They
are opposed to using discretionary fiscal policy to create budget deficits or budget surpluses.
Mainstream economists vigorously defend the use of both discretionary fiscal and monetary
policies. They believe that both theory and empirical data support the use of countercyclical
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Disputes over Macro Theory and Policy
measures. Requiring an annually balanced budget would require the use of fiscal policy that
would intensify the swings in the business cycle, rather than help reduce variations in output.
19-13 (Key Question) Place “MON,” “RET,” or “MAIN” beside the statements that most closely
reflect monetarist, rational expectations, or mainstream views, respectively.
a. Anticipated changes in aggregate demand affect only the price level; they have no effect on
real output.
b. Downward wage inflexibility means that declines in aggregate demand can cause longlasting recession.
c. Changes in the money supply M increase PQ; at first only Q rises because nominal wages are
fixed, but once workers adapt their expectations to new realities, P rises and Q returns to its
former level.
d. Fiscal and monetary policy smooth out the business cycle.
e. The Fed should increase the money supply at a fixed annual rate.
(a) RET
(b) MAIN
(c) MON
(d) MAIN
(e) MON
19-14 You have just been elected president of the United States, and the present chairman of the
Federal Reserve Board has resigned. You need to appoint a new person to this position, was well
as a person to chair your Council of Economic Advisers. Using Table 19-1 and your knowledge
of macroeconomics, identify the views on macro theory and policy you would want your
appointees to hold. Remember, the economic health of the entire nation—and your chances for
reelection—may depend on these selections.
The appointments to chair the Federal Reserve Board and the Council of Economic Advisors
would depend on what coalition of interest groups contributed to my campaign and helped put
me in office.
A Democratic president is likely to appoint economists with a mainstream approach and who are
in favor of active fiscal and monetary policies. Since labor unions may have contributed, supplysiders need not apply.
During the Reagan administration (1981-1988) supply-side policies were implemented. One of
the first actions taken was to fire striking air traffic controllers. Labor unions were shaken by the
action, since they are usually most successful representing highly skilled workers and air traffic
controllers are among the most specialized and skilled workers in the nation. This risky but
successful move set the tone for supply-side policies, which were designed to reduce the costs of
production, increase worker productivity and shift aggregate supply to the right. In addition to
reducing the power of labor unions the Reagan administration tried to reduce government
regulation of business in many areas and cut marginal tax rates in an effort to increase saving and
investment.
Conservative Republican candidates for president are most likely to surround themselves with
economic advisers who are monetarists or rational expectationists since both favor a reduced role
for government and would be against the use of discretionary fiscal policy to manage aggregate
demand. Both would favor the use of a monetary rule and reliance upon the market system to be
self-adjusting.
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Disputes over Macro Theory and Policy
19-15 (Last Word) Compare and contrast the Taylor Rule for monetary policy with the older, simpler
monetary rule advocated by Milton Friedman.
The monetary rule advocated by Friedman, the “monetarist rule,” is passive. It requires
consistent expansion of the money supply regardless of economic conditions. The “Taylor rule”
is activist and counter cyclical. It allows the Fed to adjust the money supply and interest rates in
expansionary or contractionary fashion depending on economic conditions. However, it is
similar to the monetarist prescription by stating the Fed’s policy changes precisely in response to
a variety of economic conditions.
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