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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
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PART IV FURTHER MACROECONOMICS ISSUES
Debates in Macroeconomics:
Monetarism, New
Classical Theory, and
Supply-Side Economics
18
Prepared by:
Fernando & Yvonn Quijano
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
Principles of Macroeconomics 9e by Case, Fair and Oster
CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
PART IV FURTHER MACROECONOMICS ISSUES
Debates in Macroeconomics:
Monetarism, New
Classical Theory, and
Supply-Side Economics
© 2009 Pearson Education, Inc. Publishing as Prentice Hall
18
CHAPTER OUTLINE
Keynesian Economics
Monetarism
The Velocity of Money
The Quantity Theory of Money
Inflation as a Purely Monetary Phenomenon
The Keynesian/Monetarist Debate
New Classical Macroeconomics
The Development of New Classical
Macroeconomics
Rational Expectations
Evaluating Rational-Expectations Theory
Real Business Cycle Theory
Supply-Side Economics
Evaluating Supply-Side Economics
Testing Alternative Macroeconomic
Models
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
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.
Two major schools decidedly against government
intervention developed: monetarism and new
classical economics.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
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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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
In the model of aggregate supply and aggregate demand, money
matters because:
a.
Changes in the money supply affect the AD curve.
b.
Changes in the money supply shifts affect the AS curve in the
short run.
c.
Changes in the money supply shifts affect the AS curve in the long
run.
d. All of the above.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
In the model of aggregate supply and aggregate demand, money
matters because:
a.
Changes in the money supply affect the AD curve.
b.
Changes in the money supply shifts affect the AS curve in the
short run.
c.
Changes in the money supply shifts affect the AS curve in the long
run.
d. All of the above.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Monetarism
The Velocity of Money
velocity of money The number of times a dollar
bill changes hands, on average, during a year; the
ratio of nominal GDP to the stock of money.
The income velocity of money (V) is the ratio of
nominal GDP to the stock of money (M):
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GDP
V
M
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Monetarism
The Velocity of Money
We can expand this definition slightly by noting that
nominal income (GDP) is equal to real output
(income) (Y) times the overall price level (P):
GDP  P x Y
Through substitution:
V
P xY
M
or
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M xV  P xY
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Monetarism
The Velocity of Money
quantity theory of money The theory based on
the identity M × V ≡ P × Y and the assumption that
the velocity of money (V) is constant (or virtually
constant).
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Monetarism
The Quantity Theory of Money
The key assumption of the quantity theory of
money is that the velocity of money is constant (or
virtually constant) over time. If we let V denote the
constant value of V, the equation for the
quantity theory can be written as follows:
M xV  P xY
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Monetarism
The Quantity Theory of Money
Testing the Quantity Theory of Money
 FIGURE 18.1 The Velocity of Money, 1960 I–2007 IV
Velocity has not been constant over the period from 1960 to 2007. There is a long-term trend—velocity has
been rising. There are also fluctuations, some of them quite large.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Monetarism
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.
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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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
The “strict monetarist” view states that:
a.
Changes in aggregate demand cause an increase in both
aggregate income and the price level.
b.
Inflation is a real phenomenon, not a purely monetary
phenomenon.
c.
Changes in the money supply affect only the price level (P), not
real output (Y).
d.
Since velocity is constant, a change in M affects both P and Y.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
The “strict monetarist” view states that:
a.
Changes in aggregate demand cause an increase in both
aggregate income and the price level.
b.
Inflation is a real phenomenon, not a purely monetary
phenomenon.
c. Changes in the money supply affect only the price level (P),
not real output (Y).
d.
Since velocity is constant, a change in M affects both P and Y.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Monetarism
The Keynesian/Monetarist Debate
Milton Friedman has been the leading spokesman
for monetarism over the last few decades.
Most monetarists do not advocate an activist
monetary policy stabilization.
Monetarists advocate a policy of steady and slow
money growth, at a rate equal to the average
growth of real output (Y).
Keynesianism and monetarism are at odds with
each other.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
New Classical Macroeconomics
The challenge to Keynesian and related theories
has come from a school sometimes referred to as
the new classical macroeconomics. Like
monetarism and Keynesianism, this term is vague.
No two new classical macroeconomists think
exactly alike, and no single model completely
represents this school.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Most monetarists, including Milton Friedman, blame most of the
instability in the economy on:
a.
The volatility of investment spending.
b.
Changes in aggregate demand.
c.
Changes in aggregate supply.
d.
The federal government.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Most monetarists, including Milton Friedman, blame most of the
instability in the economy on:
a.
The volatility of investment spending.
b.
Changes in aggregate demand.
c.
Changes in aggregate supply.
d. The federal government.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
New Classical Macroeconomics
The Development of New Classical Macroeconomics
On the theoretical level, new classical
macroeconomists argue that traditional models
have assumed that expectations are formed in
naive ways.
Naive expectations are inconsistent with the
assumptions of microeconomics. If people are out
to maximize utility and profits, they should form
their expectations in a smarter way.
New classical theories were an attempt to explain
the apparent breakdown in the1970s of the simple
inflation-unemployment trade-off predicted by the
Phillips Curve.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Which of the following events helped motivate the formulation of new
classical economics?
a.
The Great Depression.
b.
The mercantilist revolution and the birth of laissez faire.
c.
The stagflation of the 1970s.
d.
The turnaround from federal budget deficits to surpluses during
the Clinton administration.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Which of the following events helped motivate the formulation of new
classical economics?
a.
The Great Depression.
b.
The mercantilist revolution and the birth of laissez faire.
c.
The stagflation of the 1970s.
d.
The turnaround from federal budget deficits to surpluses during
the Clinton administration.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
New Classical Macroeconomics
Rational Expectations
rational-expectations hypothesis The
hypothesis that people know the “true model” of the
economy and that they use this model to form their
expectations of the future.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
New Classical Macroeconomics
Rational Expectations
Rational Expectations and Market Clearing
If firms have rational expectations and if they set
prices and wages on this basis, then, on average,
prices and wages will be set at levels that ensure
equilibrium in the goods and labor markets.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
When expectations are rational, which of the following stabilization
policies is more desirable?
a.
Fiscal policy tools as the preferred means of stabilization.
b.
Monetary policy tools as the preferred means of stabilization.
c.
Intervention only when unpredictable shocks affect the economy.
d. No need for government stabilization policies of any kind.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
When expectations are rational, which of the following stabilization
policies is more desirable?
a.
Fiscal policy tools as the preferred means of stabilization.
b.
Monetary policy tools as the preferred means of stabilization.
c.
Intervention only when unpredictable shocks affect the economy.
d. No need for government stabilization policies of any kind.
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Principles of Macroeconomics 9e by Case, Fair and Oster
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
New Classical Macroeconomics
Rational Expectations
The Lucas Supply Function
Lucas supply function The supply function
embodies the idea that output (Y) depends on the
difference between the actual price level and the
expected price level.
Y  f (P  Pe )
price surprise Actual price level minus expected
price level.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
New Classical Macroeconomics
Rational Expectations
The Lucas Supply Function
How Are Expectations
Formed?
How are expectations in fact
formed? Are expectations
rational, as some macroeconomists believe, reflecting
an accurate understanding
of how the economy works? Or are they formed in
simpler, more mechanical ways? A recent research paper
by Ronnie Driver and Richard Windram from the Bank of
England sheds some light on this issue.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
New Classical Macroeconomics
Rational Expectations
Policy Implications of the Lucas Supply Function
Rational-expectations theory combined with the
Lucas supply function proposes a very small role
for government policy in the economy.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
To derive his supply function, Lucas starts with the idea that:
a.
People and firms are specialists in production but generalists in
consumption.
b.
People and firms are specialists in consumption but generalists in
production.
c
People are generalists in both consumption and production.
d
Firms are specialists in production, and households are specialists
in consumption.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
To derive his supply function, Lucas starts with the idea that:
a.
People and firms are specialists in production but generalists
in consumption.
b.
People and firms are specialists in consumption but generalists in
production.
c
People are generalists in both consumption and production.
d
Firms are specialists in production, and households are specialists
in consumption.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
New Classical Macroeconomics
Evaluating Rational-Expectations Theory
If expectations are not rational, there are likely to
be unexploited profit opportunities—most
economists believe such opportunities are rare
and short-lived.
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 the true model) to
form rational expectations, and this knowledge is a
lot to expect.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
New Classical Macroeconomics
Real Business Cycle Theory
real business cycle theory An attempt to explain
business cycle fluctuations under the assumptions
of complete price and wage flexibility and rational
expectations. It emphasizes shocks to technology
and other shocks.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
In the context of the AS/AD model, if prices and wages are perfectly
flexible, then:
a.
The AS curve is vertical in the long run but not in the short run.
b.
Events that shift the AD curve have a strong impact on real output.
c.
The AS curve is vertical, even in the short run.
d.
Nominal wages are always ahead of real wages.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
In the context of the AS/AD model, if prices and wages are perfectly
flexible, then:
a.
The AS curve is vertical in the long run but not in the short run.
b.
Events that shift the AD curve have a strong impact on real output.
c.
The AS curve is vertical, even in the short run.
d.
Nominal wages are always ahead of real wages.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Supply-Side Economics
Orthodox macro theory consists of demandoriented 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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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Supply-Side Economics
The Laffer Curve
 FIGURE 18.2 The Laffer Curve
The Laffer curve shows that the
amount of revenue the
government collects is a function
of the tax rate. It shows that when
tax rates are very high, an
increase in the tax rate could
cause tax revenues to fall.
Similarly, under the same
circumstances, a cut in the tax
rate could generate enough
additional economic activity to
cause revenues to rise.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Refer to the figure below. At which point should tax rates be cut?
a.
b.
c.
d.
At point A.
At point B.
At both points A and B.
At neither point A nor B.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Refer to the figure below. At which point should tax rates be cut?
a.
b.
c.
d.
At point A.
At point B.
At both points A and B.
At neither point A nor B.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Supply-Side Economics
The Laffer Curve
Laffer curve With the tax rate measured on the
vertical axis and tax revenue measured on the
horizontal axis, the Laffer curve shows that there is
some tax rate beyond which the supply response
is large enough to lead to a decrease in tax
revenue for further increases in the tax rate.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
Supply-Side Economics
Evaluating Supply-Side Economics
Among the criticisms of supply-side economics is
that it is unlikely a tax cut would substantially
increase the supply of labor.
When households receive a higher after-tax wage,
they might have an incentive to work more, but
they may also choose to work less.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
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 hypotheses—only eight
business cycles since 1950.
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CHAPTER 18 Debates in Macroeconomics: Monetarism, New Classical
Theory, and Supply-Side Economics
REVIEW TERMS AND CONCEPTS
Laffer Curve
Lucas supply function
price surprise
quantity theory of money
rational-expectations hypothesis
real business cycle theory
velocity of money
GDP
V
M
M xV  P xY
M xV  P xY
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