Ch14 TwentiethCentury Economic Theory

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Ch14 Twentieth-Century Economic Theory

• Chapter Objectives
• The equation of exchange
• The Quantity theory of money
• Classical economics
• Keynesian economics
• The monetarist school
• Supply-side economics
• The rational expectations theory

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Ch14 Twentieth-Century Economic Theory

• The equation of exchange is
• MV PQ GDP
• The Quantity Theory of Money
• The crude quantity theory of money holds that
  when the money supply changes by a certain
  percentage, the price level changes by that same
  percentage.
• Sophisticated quantity theory
• (1) If we are well below full employment, an
  increase in M will lead mainly to an increase in
  Q.
• (2) If we are close to full employment, an
  increase in M will lead mainly to an increase in
  P.

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Ch14 Twentieth-Century Economic Theory

• Classical Economics(1775-1930)
• The classical believed our economy was
  self-regulating.
• Saving investment
• Interest rate mechanism
• flexible wages and prices(workers find lower
  wages jobs if they were unemployed, firms lower
  the price if too many inventories)
• MVPQ (V and Q are constant)

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Ch14 Twentieth-Century Economic Theory

• Keynesian Economics
• Keyne defined AD as consumer spending, investment
  spending, and government spending. Consumption is
  a function of disposable income, when disposable
  income is low, consumption is low.
• Increase government spending, raise AD
• Where would the government got the money? Print
  it or borrow it. Not a big problem even we have a
  budget deficit.
• Keyne did not agree with the quantity theory of
  money. If M rises, what if people do not spend
  additional money, but just hold it? Is Keynesian
  economics valid just during recession?
• Keynesian economics may have reached its high
  point in 1964.

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Ch14 Twentieth-Century Economic Theory

• The Monetarist School
• Friedman found that the United States has never
  had a serious inflation that was not accompanied
  by rapid monetary growth. Second, when the money
  supply has grown slowly, the country has had no
  inflation.
• The Basic Propositions of Monetarism
• (1) The key to stable economic growth is a
  constant rate of increase in the money supply
• (2) Expansionary monetary policy will only
  temporarily depress interest rates
• (3) Expansionary monetary policy will only
  temporarily reduce the unemployment rate
• (4) Expansionary fiscal policy will only
  temporarily raise output and employment

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Ch14 Twentieth-Century Economic Theory

• The Monetary Rule
• The policy prescription of the monetarists is to
  increase the money supply at a constant rate.
• When there is a recession, this steady infusion
  of money will pick up the economy. When there is
  inflation, a steady rate of monetary growth
  will slow it down.
• The Decline of Monetarism
• No longer would the Fed focus only on keeping
  interest rates on an even keel. From now on the
  Fed would set monetary growth targets and stick
  to them.

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Ch14 Twentieth-Century Economic Theory

• Supply-Side Economics
• Supply-side economics came into vogue in the
  early 1980.
• The objective of supply -side economics is to
  raise AS, the total amount of goods and services
  we produce. Since high tax rates are hurting the
  incentive to work and to invest. All the
  government should do is cut taxes and increase
  production.
• The Work Effect(Work-Leisure decisions)
• High marginal tax rates rob people not only of
  some potential income but of the incentive to
  work longer hours.
• The Saving Investment Effect
• A high marginal tax rate on interest income will
  provide a disincentive to save, or at least to
  make savings available for investment purposes, A
  high marginal tax rate will also discourage
  producer to invest. Since those profits are
  subject to a high marginal tax rate.

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Ch14 Twentieth-Century Economic Theory

• The Elimination of Productive Market Exchanges
• The Laffer Curve
• It isnt necessary true that a tax rate cut will
  lead to a fall in tax revenue.
• The problem is to figure out where we are on the
  Laffer curve, or what the parameters of the curve
  itself are before we start cutting taxes.
• Rational Expectations Theory
• To fight inflation lower the rate of growth of
  the money supply and reduce federal government
  budget deficits.
• To fight recessionincrease the rate of growth of
  the money supply and reduce federal government
  budget deficits

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Ch14 Twentieth-Century Economic Theory

• Rational expectationists say no to any form of
  government economic intervention. No matter how
  well intentioned, would do a lot more harm than
  good. They argue that anti-inflationary and
  antirecessionary policies would have no effect
  whatsoever.
• Lucus believes that people can anticipate
  government policies to fight inflation and
  recession, given their knowledge of policy, past
  experience, and expectations about the future.
  They act on this anticipation, effectively
  nullifying the intended effects of those policies.

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Ch14 Twentieth-Century Economic Theory

• Three Assumptions
• (1) that individuals and business firms learn
  through experience to anticipate the
  consequences of changes in monetary and fiscal
  policy
• (2)they act instantaneously to protect their
  economic interest
• (3) all resource and product markets are purely
  competitive.

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Chapter 15 A Guide to Macropolicy

• Chapter Objectives
• Conventional monetary fiscal policies to fight
  recessions and inflation
• Income policies
• How to attain a satisfactory rate of economic
  growth

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Chapter 15 A Guide to Macropolicy

• To Fight Recessions
• Conventional fiscal policy--run a budget deficit
• Conventional monetary policy -- speed up money
  growth to fight recessions(lower interest rates)
• Two policy Dilemmas
• A budget deficit aimed to stimulate the economy,
  necessitates massive Treasury borrowing, driving
  up interest rates and ultimately choking off
  recovery.
• -Rapid monetary growth may lead to inflation,
  people will demand more interest for their
  savings. With inflation and higher interest
  rates, it is difficult for the economy to
  recover.

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Chapter 15 A Guide to Macropolicy

• To Fight Inflation
• Conventional Fiscal Policy--reduce the budget
  deficit
• Conventional Monetary Policy --slow the rate of
  money growth
• To fighting inflationary Recessions
• One approach is to try a combination of tight
  money to fight the inflation and a large budget
  deficit to provide the economic stimulus needed
  to fight the recession
• Conventional monetary and fiscal policy tools are
  sufficient to deal with simple recessions or
  inflation. Conventional macropolicy cannot cure
  them without a great deal of suffering,
  especially by those who lose their jobs.

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Chapter 15 A Guide to Macropolicy

• Income Policies An Alternate Approach
• Wage and price controls break the back of
  inflationary expectations
• Two main argument against such controls they
  interfere with the price mechanism. A second
  objection to wage and price controls is that once
  they are removed, wages and prices will surge to
  make up for lost time.
• Attaining a Satisfactory Rate of Economic Growth
• In recent years, Americans have been saving less
  than 5 percent of their income.
• Productivity is defined as output per unit of
  input.
• Growth Theory