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The Roots of Modern Macroeconomics
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The Roots of Modern Macroeconomics

• Setting the Scene Three Key Issues

3
THREE KEY ISSUES

• Issue 1 Flexibility of prices and wages
• the right flexible prices and wages
• the left price and wage rigidities
• Issue 2 Flexibility of aggregate supply
• the right aggregate supply determined
  independently of aggregate demand

4
Different aggregate supply curves (a)
Price level
O
Y
National output
5
Different aggregate supply curves (a)
AS
Price level
AD1
O
Y
National output
6
Different aggregate supply curves (a)
AS
Price level
P2
P1
AD2
AD1
O
Y
National output
7
THREE KEY ISSUES

• Issue 1 Flexibility of prices and wages
• the right flexible prices and wages
• the left price and wage rigidities
• Issue 2 Flexibility of aggregate supply
• the right aggregate supply determined
  independently of aggregate demand
• the left aggregate supply responsive to changes
  in aggregate demand

8
Different aggregate supply curves (b)
Price level
P
O
National output
9
Different aggregate supply curves (b)
Price level
AS
P
AD1
O
National output
10
Different aggregate supply curves (b)
Price level
AS
P
AD2
AD1
O
Y1
National output
11
THREE KEY ISSUES

• Issue 1 Flexibility of prices and wages
• the right flexible prices and wages
• the left price and wage rigidities
• Issue 2 Flexibility of aggregate supply
• the right aggregate supply determined
  independently of aggregate demand
• the left aggregate supply responsive to changes
  in aggregate demand
• some consensus on nature of short-run AS curve

12
Different aggregate supply curves (c)
Price level
O
National output
13
Different aggregate supply curves (c)
AS
Price level
AD1
O
National output
14
Different aggregate supply curves (c)
AS
Price level
P1
AD2
AD1
O
Y1
National output
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THREE KEY ISSUES

• Issue 3 The role of expectations in the working
  of the market
• the right expectations adjust rapidly to changes
  in prices
• the left expectations of prices depend on
  expectations of output and employment

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The Roots of Modern Macroeconomics

• Classical Macroeconomics

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CLASSICAL MACROECONOMICS

• Classical analysis of output and employment
• markets clear
• labour market
• market for loanable funds

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The market for loanable funds
Saving (supply)
Rate of interest
Investment (demand)
O
Quantity of loanable funds
19
The market for loanable funds
Saving (supply)
r1
Rate of interest
Investment (demand)
O
Quantity of loanable funds
20
The market for loanable funds
Saving (supply)
r1
Rate of interest
Investment (demand)
O
Quantity of loanable funds
21
The market for loanable funds
Saving (supply)
Rate of interest
Investment (demand)
O
Quantity of loanable funds
22
The market for loanable funds
Saving (supply)
Rate of interest
r2
Investment (demand)
O
Quantity of loanable funds
23
The market for loanable funds
Saving (supply)
Rate of interest
Investment (demand)
O
Quantity of loanable funds
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CLASSICAL MACROECONOMICS

• Classical analysis of output and employment
• markets clear
• labour market
• market for loanable funds
• market for imports and exportsthe gold standard

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CLASSICAL MACROECONOMICS

• Classical analysis of output and employment
• markets clear
• labour market
• market for loanable funds
• market for imports and exportsthe gold standard
• Says law

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CLASSICAL MACROECONOMICS

• Classical analysis of output and employment
• markets clear
• labour market
• market for loanable funds
• market for imports and exportsthe gold standard
• Says law
• Classical analysis of prices and inflation

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CLASSICAL MACROECONOMICS

• Classical analysis of output and employment
• markets clear
• labour market
• market for loanable funds
• market for imports and exportsthe gold standard
• Says law
• Classical analysis of prices and inflation
• the quantity theory of money

28
CLASSICAL MACROECONOMICS

• Classical analysis of output and employment
• markets clear
• labour market
• market for loanable funds
• market for imports and exportsthe gold standard
• Says law
• Classical analysis of prices and inflation
• the quantity theory of money
• the equation of exchange MV PY

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CLASSICAL MACROECONOMICS

• Classical analysis of output and employment
• markets clear
• labour market
• market for loanable funds
• market for imports and exportsthe gold standard
• Says law
• Classical analysis of prices and inflation
• the quantity theory of money
• the equation of exchange MV PY
• implications for monetary policy

30
CLASSICAL MACROECONOMICS

• The Great Depression and the return to the gold
  standard
• the depression of the 1920s

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UK unemployment and inflation 1919 - 38
Unemployment
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UK unemployment and inflation 1919 - 38
Unemployment
Inflation
33
CLASSICAL MACROECONOMICS

• The Great Depression and the return to the gold
  standard
• the depression of the 1920s
• return to the gold standard

34
CLASSICAL MACROECONOMICS

• The Great Depression and the return to the gold
  standard
• the depression of the 1920s
• return to the gold standard
• effects on the economy

35
CLASSICAL MACROECONOMICS

• The Great Depression and the return to the gold
  standard
• the depression of the 1920s
• return to the gold standard
• effects on the economy
• the policy response

36
CLASSICAL MACROECONOMICS

• The Great Depression and the return to the gold
  standard
• the depression of the 1920s
• return to the gold standard
• effects on the economy
• the policy response
• classical rejection of public works

37
CLASSICAL MACROECONOMICS

• The Great Depression and the return to the gold
  standard
• the depression of the 1920s
• return to the gold standard
• effects on the economy
• the policy response
• classical rejection of public works
• the fear of inflation

38
CLASSICAL MACROECONOMICS

• The Great Depression and the return to the gold
  standard
• the depression of the 1920s
• return to the gold standard
• effects on the economy
• the policy response
• classical rejection of public works
• the fear of inflation
• the problem of crowding out

39
The effect of printing extra money the classical
analysis
Price level
O
Q1
National output
40
The Roots of Modern Macroeconomics

• The Keynesian Revolution

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THE KEYNESIAN REVOLUTION

• Keynes rejection of classical theory
• rigidities in the labour market
• the problem of deficiency of demand

42
The problem of demand deficiency in the labour
market
ASL
Real wage rate (W / P)
ADL1
O
Quantity of labour
43
THE KEYNESIAN REVOLUTION

• Keynes rejection of classical theory
• rigidities in the labour market
• the problem of deficiency of demand
• rejection of increased saving as a means of
  increasing investment

44
Disequilibrium in the market for loanable funds
Savings 1
Rate of interest
Investment
O
Quantity of loanable funds
45
THE KEYNESIAN REVOLUTION

• Keynes rejection of classical theory
• rigidities in the labour market
• the problem of deficiency of demand
• rejection of increased saving as a means of
  increasing investment
• rejection of simple quantity theory

46
THE KEYNESIAN REVOLUTION

• Keynes rejection of classical theory
• rigidities in the labour market
• the problem of deficiency of demand
• rejection of increased saving as a means of
  increasing investment
• rejection of simple quantity theory
• rejection of a balanced budget

47
THE KEYNESIAN REVOLUTION

• Keynes rejection of classical theory
• rigidities in the labour market
• the problem of deficiency of demand
• rejection of increased saving as a means of
  increasing investment
• rejection of simple quantity theory
• rejection of a balanced budget
• Keynes analysis of employment and inflation

48
THE KEYNESIAN REVOLUTION

• Keynes rejection of classical theory
• rigidities in the labour market
• the problem of deficiency of demand
• rejection of increased saving as a means of
  increasing investment
• rejection of simple quantity theory
• rejection of a balanced budget
• Keynes analysis of employment and inflation
• the importance of aggregate demand

49
The effects of increases in aggregate demand on
national output
Price level
O
YP
National output
50
The effects of increases in aggregate demand on
national output
Price level
AD1
O
Y2
Y1
Y3
Y4
YP
National output
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THE KEYNESIAN REVOLUTION

• Keynes rejection of classical theory
• rigidities in the labour market
• the problem of deficiency of demand
• rejection of increased saving as a means of
  increasing investment
• rejection of simple quantity theory
• rejection of a balanced budget
• Keynes analysis of employment and inflation
• the importance of aggregate demand
• the multiplier process

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The circular flow of income
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The circular flow of income
Cd
54
The circular flow of income
Cd
Incomes
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The circular flow of income
Cd
Incomes
W S T M
56
The circular flow of income
J I G X
Cd
Incomes
W S T M
57
The circular flow of income
J I G X
Cd
Incomes
W S T M
58
The circular flow of income
J I G X
Cd
Incomes
W S T M
59
The circular flow of income
J I G X
Cd
Incomes
W S T M
60
THE KEYNESIAN REVOLUTION

• Keynes policy recommendations
• demand management by fiscal and monetary policies
• Keynesian policies in 1950s and 60s
• stopgo policies
• criticisms of short-term demand management
• the breakdown of the Phillips curve

61
The Roots of Modern Macroeconomics

• The Monetarist Keynesian Debate

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THE MONETARISTKEYNESIAN DEBATE

• The monetarist counter-revolution
• the restatement of the quantity theory
• rejection of Keynesian demand management policies
• the problem of inflationary expectations
• reappraisal of the Phillips curve
• unemployment
• inflation

63
The monetarist version of the long-run Phillips
curve
Inflation ()
O
Un
Unemployment
64
(a) Keynesian aggregate supply curve
Price level
O
National output
65
(b) Keynesian Phillips curve
Inflation ()
O
Unemployment
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THE MONETARISTKEYNESIAN DEBATE

• The monetarist counter-revolution
• the restatement of the quantity theory
• rejection of Keynesian demand management policies
• the problem of inflationary expectations
• reappraisal of the Phillips curve
• unemployment
• inflation
• monetarist policies

67
THE MONETARISTKEYNESIAN DEBATE

• The monetarist counter-revolution
• the restatement of the quantity theory
• rejection of Keynesian demand management policies
• the problem of inflationary expectations
• reappraisal of the Phillips curve
• unemployment
• inflation
• monetarist policies
• attempts at such policies in the 1980s

68
THE MONETARISTKEYNESIAN DEBATE

• Modern-day Keynesians
• inflation
• unemployment
• structural problems
• hysteresis
• low capital stock
• deskilling
• insiders and outsiders
• criticisms of monetarism
• Keynesian policy proposals

69
The Roots of Modern Macroeconomics

• The Current Position

70
THE CURRENT POSITION

• The current range of views
• new classical / rational expectations school
• moderate monetarists
• moderate Keynesians (new Keynesians)
• extreme Keynesians
• the radical left
• eclectic economists

71
THE CURRENT POSITION

• A mainstream consensus?
• short-run effects of changes in AD
• long-run effects of changes in AD
• no simple trade-off between inflation and
  unemployment
• role of expectations
• effects of excessive growth in the money supply
• importance of supply-side policies
• erosion of governments' power by the process of
  globalisation