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Disputes Over Macro Theory and Policy

17. Disputes Over Macro Theory and Policy. Chapter Objectives. Differences Between Historical Keynesian and Classical Macro Perspectives Alternative Perspectives on the Causes of Macroeconomic Instability – Alternative Theory Viewpoints Equation of Exchange and Monetarism

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Disputes Over Macro Theory and Policy

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  1. 17 Disputes Over Macro Theory and Policy

  2. Chapter Objectives • Differences Between Historical Keynesian and Classical Macro Perspectives • Alternative Perspectives on the Causes of Macroeconomic Instability – Alternative Theory Viewpoints • Equation of Exchange and Monetarism • New Classical Economics – Self-Correction and Shocks • Debate over “Rules” and “Discretion” in Conducting Stabilization Policy

  3. Classical Economics and Keynes • The Classical View • Vertical Aggregate Supply Curve • Stable Aggregate Demand

  4. Causes of Macro Instability • Austrian view • Government interference is the problem • Laissez-faire • Monetary causes of instability • Instability in monetary and fiscal policies • Regulations • Stimuli 19-4

  5. Classical Economics and Keynes • Keynesian View • Horizontal Aggregate Supply to Full Employment • Unstable Aggregate Demand • Government must stabilize

  6. Classical Economics and Keynes Classical Theory Keynesian Theory AS b a P1 AS y x P1 Price Level Price Level c P2 AD1 AD1 AD2 AD2 Qu Qf Qf Real Domestic Output Real Domestic Output

  7. Causes of Macro Instability • Mainstream View • Changes in Investment Spending Ca + Ig + Xn + G = GDP • Adverse Aggregate Supply Shocks

  8. Causes of Macro Instability • Monetarist view • Government interference is the problem • Equation of exchange MV = PQ • Stable velocity • Monetary causes of instability • Inappropriate monetary policy • Fed’s job a constant MS

  9. Causes of Macro Instability • Monetarist View • Equation of Exchange MV = PQ • Velocity • Stable Velocity • Monetary Causes of Instability

  10. Causes of Macro Instability • Real-Business-Cycle View • Real-Business-Cycle Theory ASLR2 ASLR1 Price Level P1 AD1 AD2 Q2 Q1 Real Domestic Output

  11. Causes of Macro Instability • Coordination failures • Fourth modern view • Limited information • Expectations and self-fulfilling prophecy • Unemployment equilibrium • Inflation equilibrium

  12. Self-Correction • New classical view • Rational expectations theory • Monetarists • Automatic correction will occur • Speed of adjustment • Unanticipated price-level changes • Price-Level Surprises • Fully anticipated price-level changes

  13. Does the Economy Self-Correct? New Classical View of Self-Correction ASLR AS2 AS1 c P3 Price Level b P2 a P1 AD2 AD1 Q1 Q2 Real Domestic Output

  14. Does the Economy Self-Correct? New Classical View of Self-Correction ASLR AS1 AS3 Price Level f a P1 P4 d P5 e AD1 AD3 Q4 Q3 Q1 Real Domestic Output

  15. Does the Economy Self-Correct? • Mainstream View of Self-Correction • Downward Wage Inflexibility • Efficiency Wage Theory • Greater Work Effort • Lower Supervision Costs • Reduced Job Turnover • Insider-Outsider Relationships • Insider-Outsider Theory

  16. Rules or Discretion? • In Support of Policy Rules • Monetary Rule • Balanced Budget • In Defense of Discretionary Stabilization Policy • Discretionary Monetary Policy • Discretionary Fiscal Policy • Increased Macro Stability

  17. Rules or Discretion? • Reduce macro instability • Monetary rule • Shift AD to keep up with AS • Price stability achieved • Inflation Targeting • Inflation targeting • Balanced budget

  18. Rationale for Monetary Rule ASLR2 ASLR1 Price Level P1 AD2 P2 AD1 Q1 Q2 Real Domestic Output, GDP

  19. Summary of Alternative Views • Mainstream Macroeconomics (Keynesian) • New Classical Economics • Monetarism • Rational Expectations Theory • Austrian Business Cycle • Let’s take a small example.

  20. Contrasting Views of the Great Depression • Who is right?

  21. Bad Teacher’s Account  Stock market crash caused by unregulated margin trading.  Depression started because Herbert Hoover did nothing.  Depression ended because of FDR’s New Deal (and WW2).

  22. Paul Krugman’s Account  Hoover tried to shrink deficit in 1932, FDR in 1937.  Conventional monetary policy hindered by liquidity trap and gold standard.  Private debt-overhang depressed AD.  Depression ended because of WW2 deficit spending.

  23. Milton Friedman & Anna Schwartz’s Account  Fed didn’t create enough monetary base to offset the increased public demand to hold currency.  Low interest rates not synonymous with “easy money.”

  24. Murray Rothbard’s Account  Fed created artificial stock market boom, inevitably ending in 1929 crash.  Hoover engaged in unprecedented interventions to turn the necessary depression into the Great Depression.

  25. Robert P. Murphy’s Account  Monetary and fiscal policies far “worse” in 1920-1921, so Keynesians and Friedmanites wrong.  What would historical record look like, if FDR had not“gotten us out of the Depression”?

  26. Bob Higgs’s Account  “Regime uncertainty” crippled private investment under New Deal.  World War II spending did not end the Depression.

  27. Versus Propped Up Wages, Farm Prices Propped Up Wages, Farm Prices Tax Hikes/Deficits Tax Hikes/Deficits “Public Works” “Public Works”

  28. A Famous “Public Work”

  29. Labor Unions Herbert Hoover “The President’s conference has given industrial leaders a new sense of their responsibilities.… Never before have they been called upon to act together.” —Editorial in AmericanFederationist, 1/1/1930

  30. U.S. Unemployment Rate

  31. War! Good For GDP?

  32. Disaggregating the GDP Data

  33. Fed Inflation + Price Controls

  34. Next Chapter Preview… Money and Banking Unit IV

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