The Power Of Macroeconomics

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The Power Of Macroeconomics
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The Warring Schools of Macroeconomics
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The Purpose Of This Lesson

• Is to examine three of the major controversies
  among the five major warring schools of
  macroeconomics.
• We also take a more in-depth look at New
  Classical economics.

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Lesson 6 Colander McConnell Samuelson
Schiller Brue Nordhaus 3rd Edition 14th
Edition 16th Edition 8th Edition
Complete Textbook (includes both Micro-and
Macroeconomics) Macroeconomics Text Only
17, 18 17 32 19
17, 18 17 16 19
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Supply Side Economics
Monetarism
Classical Economics
Keynesianism
New Classical Economics
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Three Important Questions

• What causes instability in the economy?
• Is the economy self-correcting?
• Should the government adhere to rules or use
  discretion in setting economic policy?

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New Classical Economics

• The so-called New Classical is rooted in the
  Classical economic tradition.
• It is important not just because of the strong
  influence it has had on recent macroeconomic
  theory but also because New Classical economists
  played a pivotal role in the 1992 defeat of
  George Bush by Bill Clinton.

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George Bushs Presidency

• When Bush assumed the presidency in 1988, the
  economy was saddled with both huge budget and
  trade deficits.
• Even more of a problem was that by 1990, the
  economy was sliding into a recession.

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Bushs Advisors

• This recession would have been a clear signal to
  engage in expansionary policy to any red-blooded
  Keynesian.
• In the Bush White House, Ronald Reagans Supply
  Side advisors had been supplanted not by
  Keynesians but rather by a new breed of
  economists significantly influenced by New
  Classical Thinking.

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New Classical Economics

• New Classical economics is based on the
  controversial theory of rational expectations.
  
• This theory was developed by Nobel Laureate
  Robert Lucas of the University of Chicago along
  with Thomas Sargent of Stanford and Robert Barro
  of Harvard.
• It provides a sharp contrast to the notion of
  adaptive expectations we previously introduced
  in our lesson on inflation and unemployment.

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Adaptive Expectations

• You may recall from that lesson that with
  adaptive expectations, people tend to assume that
  inflation will continue to be what it already is.
  
• For example, if inflation was 3 last year,
  adaptive expectations will lead you to predict
  that inflation will be 3 next year.

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Rational Expectations

• In contrast, if you form your expectations
  rationally, you will take into account all
  available information including the future
  effects of activist fiscal and monetary policies.
  
• The idea behind rational expectations is that
  such activist policies might be able to fool
  people for a while.

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The Policy Implication

• However, after a while, people will learn from
  their experiences, and then, you cant fool them
  at all.
• The central policy implication of this idea is
  profound rational expectations render activist
  fiscal and monetary policies completely
  ineffective so they should be abandoned.

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An Example

• Suppose the Federal Reserve undertakes
  expansionary monetary policy to close a
  recessionary gap.
• Repeated experiences with such activist policy
  have taught people that increases in the money
  supply fuel inflation.
• To protect themselves in a world of rational
  expectations, businesses will immediately respond
  to the Feds expansion by raising prices, workers
  will demand higher wages, and the attempted
  stimulus will be completely offset by the
  contractionary effects of inflation.

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Alternatively

• Suppose the government undertakes expansionary
  fiscal policy.
• People with rational expectations will respond by
  increasing their savings and reducing consumption
  and thereby likewise offset any expansionary
  effect.
• They will do this because they know that a larger
  budget deficit now means higher taxes later so
  they prepare for this future burden by saving
  more.

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A Graphical Analysis
General Price Level
Y1
Real Output

• Suppose, then, we first assume adaptive
  expectations, and the government undertakes
  expansionary policy to increase output above the
  full employment rate.

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A Graphical Analysis
General Price Level
A
P1
Y1
Real Output

• Suppose, then, we first assume adaptive
  expectations, and the government undertakes
  expansionary policy to increase output above the
  full employment rate.

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A Graphical Analysis
General Price Level
B
P2
A
P1
Y1
Y2
Real Output

• The end result is a short run spurt of growth
  above full employment output followed by a return
  to the natural rate--albeit, at a higher price
  level of P3.

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A Graphical Analysis
C
P3
General Price Level
B
P2

• What the New Classical school says is that rather
  than travel from Point A to Point B and back to
  point C, the economy will enjoy no short run
  growth spurt at Point B.
• Instead, the economy will move instantaneously
  from Point A to Point C, and the only result of
  the governments activist policy will be higher
  inflation.

Y1
Y2
Real Output
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Ration Expectations A Review

• Now there are several things to say about
  rational expectations theory from both an
  economic and political perspective.

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A Critique

• Critics say people are not as sophisticated in
  their economic thinking as the theory requires
  and therefore adjustments will not take place
  with the speed they are supposed to.
• This criticism should not detract from the
  central point of rational expectations, namely,
  that peoples behavior may partially, or perhaps
  completely, counteract the goals of activist
  fiscal and monetary policies.

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What Bush Learned

• Politically however, as George Bush painfully
  learned, relying on New Classical economic
  thinking can be hazardous to ones health.
• Indeed, President Bushs New Classical advisors
  flatly rejected any Keynesian quick fix to
  Bushs deepening recession.

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What Bush Did

• Instead, in their Economic Report to the
  President, they called for more stable and
  systematic policies based on long term goals
  rather than a continued reliance on
  short-sighted discretionary reactions.

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Bush Loses the 1992 Election
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The Clinton Promise

• What is perhaps most interesting about this
  transition of power is that Bill Clinton actually
  did very little to stimulate the economy.
• The mere fact, however, that Clinton promised a
  more activist approach helped restore business
  and consumer confidence.

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What Congress Did

• Congressional passage of Clintons deficit
  reduction legislation in 1993 sent Wall Street a
  clear signal that his Administration was serious
  about budget balance.
• These factors helped accelerate a recovery that
  had already begun by the end of Bushs term and
  set the stage for Clintons remarkably easy
  re-election.

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What Causes Macroeconomic Instability?

• Let's turn now to our broader discussion of how
  the warring schools of macroeconomics differ on
  some important issues.

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The Mainstream Keynesian View

• Instability in the economy arises from two
  sources
• The first, most common, problem is significant
  changes in investment spending, and to a lesser
  extent, consumption spending, both of which
  change aggregate demand.
• The second, more occasional, problem is adverse
  supply side shocks which change aggregate supply.
  

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CIGXGDP

• Now we know that in equilibrium, aggregate
  expenditures represented by the left side of the
  equation equal real output.

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CIGXGDP

• We also know that investment spending is
  particularly vulnerable to the "booms" and
  "busts" that affect an economy and, because of
  multiplier effects, they can create considerable
  volatility in the economy.
• At the same time, changes in consumer spending
  brought about by changes in such things as
  consumer confidence likewise can contribute to
  instability.

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Supply Side Shocks

• Oil price increases, world-wide droughts, and
  other such shocks can all lead a sizable decline
  in a nation's aggregate supply.
• This likewise can destabilize an economy by
  simultaneously causing cost-push inflation and
  recession, that is, stagflation.

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The Classical-Monetarist View

• The Monetarists hold that it is inappropriate
  government policies that are the major cause of
  macroeconomic instability.
• Like Classical economics, Monetarism argues that
  the price and wage flexibility provided by
  competitive markets cause fluctuations in
  aggregate demand to alter product and resource
  prices rather than output and employment.

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Why Wages Dont Adjust

• As Monetarists see it wages can't adjust freely
  downward because of government policies ranging
  from minimum wage and pro-union legislation to
  guaranteed prices for farm products, pro-business
  monopoly protections, and so on.
• The Monetarists also blame the government's
  clumsy and often misguided attempts to achieve
  greater stability through activist monetary
  policies.

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MVPQ

• If the velocity of money V is stable and real
  output Q is independent of the price level,
  changes in the money supply M can only lead to
  changes in inflation.
• Of course, it is a matter of some debate as to
  whether the velocity of money is stable and in
  fact, Keynesians, take the view that velocity is
  actually unstable.

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The Supply Side View

• Supply Siders agree with the Keynesians that
  macroeconomic instability can result from supply
  side shocks.
• However, Supply Siders at least partly share the
  Classical and Monetarist view that it is often
  the government -- not just droughts and oil price
  hikes -- that is to blame for causing the shocks.
  
• Of particular concern to the Supply Siders are
  high tax rates and regulations that reduce supply
  incentives.

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Regulatory Costs

• New regulatory costs on business were created in
  the 1990s by the Americans with Disabilities Act,
  the 1990 amendments to the Clean Air Act, and the
  Family Leave Act of 1993.
• All three of these laws provide important
  benefits to workers or the environment. At the
  same time, however, they also made it more
  expensive to supply goods and services.

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End of Part 1
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