INTRODUCTION TO MACROECONOMICS (CONTINUED………..):The Monetarist School

<< INTRODUCTION TO MACROECONOMICS (CONTINUED………..)

THE USE OF MACROECONOMIC DATA, AND THE DEFINITION AND ACCOUNTING OF NATIONAL INCOME >>

Introduction to Economics ECO401

Lesson 8.3

INTRODUCTION TO MACROECONOMICS (CONTINUED...........)

Keynes' suggestions were taken on board by government but in a rather different context than

he might have anticipated, i.e. in the context of war. The Second World War broke out in 1939

and the higher defense expenditures by European governments to finance the War gave the

necessary boost to aggregate demand. But while the economy emerged from its low-demand

recession, it now faced supply-side destruction due to war.

Keynes was not a socialist, just someone who believed the market could not be left alone. He

was the brain child of institutions such as the IMF, WB and GATT.

Keynes Demand Management Policies:

Keynes exerted a phenomenal influence on economic thinking and policy-making in the 20th

century and to date. In the 1950s and 60s, Keynesian demand management policies were

practiced by many governments when demand went "off" due to cyclical fluctuations of the

economy. In recessions, the government increased spending and encouraged the private sector

to do the same. In booms the opposite was done to cool the economy down.

The major problem with Keynesian demand management policies was that they viewed

unemployment and inflation to be the opposite sides of the same coin. Thus, if unemployment

was high, prices must be low and vice versa. Keynes' policies could not be applied in a situation

where both prices and unemployment were rising (stagflation) this situation arose in the 1970s

with the two oil price shocks (which were essentially supply side shocks), and led to the decline

of Keynesian economics.

The Monetarist School:

The Monetarist School, led by Milton Friedman separated the explanation for inflation and

unemployment. He noted that inflation was always and everywhere a monetary phenomenon

and the key to keeping inflation low was to keep monetary growth aligned with expected real

output growth.

The Real Business Cycles (RBC) School:

The Real Business Cycles (RBC) School also gained currency in the 1970s. The exponents of

the business cycles view noted that output fluctuated mainly due to technology shocks faced by

the economy, and that no Keynesian type policy could, or should attempt to, neutralize their

effects.

The Rational Expectations School:

The same period, 1970s, saw the rise of the rational expectations school (as opposed to

Keynes' static expectations hypothesis) led by such people as Robert Lucas, Robert Barro and

Thomas Sargent who conceptualized agents as making use of all the information available to

them, and not just past information, while making decisions. Under these and other conditions

they showed that predictable macroeconomic policies (like Keynesian demand management

policies) had no effect on real output or unemployment.

Neo Classical Economics:

Coupled with the insights of the monetarist and business cycle schools, this view of the world

reinforced the pre-Keynesian beliefs in the power of the free market and stressed the micro-

foundations of macroeconomics. For this reason, it is called new or Neo Classical Economics.

The Neo Keynesian School:

Since the 1980s, the new or Neo Keynesian School has emerged, led by economists such as

Joseph Stiglitz. The new Keynesians have highlighted market failures at the micro level that may

arise due to information asymmetries and coordination failures (moral hazard and adverse

selection problems). As such they have shown avenues for meaningful government intervention.

This is broadly where modern macroeconomics currently stands.

Introduction to Economics ECO401

END OF UNIT 8 EXERCISES

Which of the following are macroeconomic issues, which are microeconomic ones and

which could be either depending on the context?

a) Inflation.

b) Low wages in certain service industries.

c) The rate of exchange between the pound and the euro.

d) Why the price of cabbages fluctuates more than that of cars.

e) The rate of economic growth this year compared with last year.

f) The decline of traditional manufacturing industries.

a) Macro. It refers to a general rise in prices across the whole economy.

b) Micro. It refers to specific industries

c) Either. In a world context, it is a micro issue, since it refers to the price of one currency in

terms of one other. In a national context it is more of a macro issue, since it refers to the

euro exchange rate at which all UK goods are traded internationally. (This is certainly a

less clearcut division that in (a) and (b) above.)

d) Micro. It refers to specific products.

e) Macro. It refers to the general growth in output of the economy as a whole.

f) Micro (macro in certain contexts). It is micro because it refers to specific industries. It

could, however, also help to explain the macroeconomic phenomena of high

unemployment or balance of payments problems.

This question is about the merits and demerits of an economic system (like socialism)

which mainly focuses on ways of achieving equality of incomes and wealth across

citizens. Would it ever be desirable to have total equality in an economy?

The objective of total equality may be regarded as desirable in itself by many people. There are

two problems with this objective, however.

The first is in defining equality. If there were total equality of incomes then households with

dependants would have a lower income per head than households where everyone was

working. In other words, equality of incomes would not mean equality in terms of standards of

living. If on the other hand, equality were to be defined in terms of standards of living, then

should the different needs of different people be taken into account? Should people with special

health or other needs have a higher income? Also, if equality were to be defined in terms of

standards of living, many people would regard it as unfair that people should receive different

incomes (according to the nature of their household) for doing the same amount of work.

The second major problem concerns incentives. If all jobs were to be paid the same (or people

were to be paid according to the composition of their household), irrespective of people's efforts

or skills, then what would be the incentive to train or to work harder?

Is it possible to disagree with the positions that the different countries have been

assigned in the spectrum diagram in Lecture 25 based on one's general knowledge about

these countries' economic systems?

Yes. Given that there is no clearly defined scale by which government intervention is measured,

the precise position of the countries along the spectrum is open to question.

Which macroeconomic problem(s) has/have generally been less severe since in the early

1990s than in the 1980s?

Inflation and, since the mid-1990s, unemployment. We must remember that unemployment was

a major problem in the 1920s and 1930s (during the Great Depression) and inflation was a major

problem in the 1970s and early 1980s.

This question is about wages, about whose rigidity and flexibility Classical economists

and Keynes argued for long. Why are real wages likely to be more flexible downwards

than money (or nominal) wages?

Introduction to Economics ECO401

Money (or nominal) wages are unlikely to fall. The reason is that price inflation is virtually always

positive. Thus if money wages were to fall, there would have to be a bigger fall in real wages.

For example if inflation were 10 per cent and firms wanted to cut money wages by 5 per cent,

this would mean cutting real wages by 15 per cent: something they would find hard to get away

with. Real wages, on the other hand frequently do fall. Because wage agreements are usually

made in money terms, it only needs inflation to go ahead of money wage increases, and real

wages will fall.

Another reason why money wages are less flexible downwards has to do with money illusion.

People will resist a cut in money wages, seeing this as a clear cut in their living standard. If,

however, a money wage increase is given a bit below the rate of inflation (i.e. a real wage cut),

many workers will perceive this as an increase and will be more inclined to accept it. And

indeed, because pay increases normally occur annually, any money rise (even if below the

annual rate of inflation) will be a temporary real rise for a few months, until inflation overtakes it.

Would it be possible for a short-run AS curve to be horizontal at all levels of output?

No. Given that some factors are fixed in supply in the short run, there will inevitably be a limit to

output. As that limit is approached, the AS curve will slope upwards until it becomes vertical at

that limit.

If firms believe the aggregate supply curve to be relatively elastic, what effect will this

belief have on the outcome of an increase in aggregate demand?

Firms will respond to the increase in aggregate demand by increasing their output and

investment. There are two main reasons. The first is that they will expect output elsewhere to

increase and that they will therefore be able to obtain supplies. The second is that, if they

believe that the rise in aggregate demand is not going to cause inflation to increase significantly,

they will not expect the government to start deflating the economy and thus dampening demand

again. They will therefore expect their increased sales to continue.

What might be the negative effects of higher government expenditure (the suggested

policy prescription of Keynes) on the private sector?

Increased government expenditure (financed from borrowing from banks) has two possible

negative effects on the private sector: financial crowding out and resource crowding out. In the

former, higher government borrowing from banks leaves fewer loanable funds with banks to lend

to the private sector. In any case, the interest rate rises due to a higher demand for lonabale

funds. This has a negative impact on private sector investment. As for resource crowding out,

government projects could divert key workers and other resources that are in short supply away

from the private sector. Since labour and other resources are not homogeneous and not

perfectly mobile, resource crowding out can occur even when the economy has some slack in it,

i.e. is operating at less than full employment.

What, in Keynes's view, would be the impact of a higher money supply on output, given

that there "is" slack in the economy?

A rise in money supply results in an increase in aggregate demand: as people hold more money

and their consumption demand increases. Interest rates also fall causing investment demand to

rise. All this will lead to a rise in output with little increase in the level of prices. Thus the nominal

increase in money supply translates fully into a real increase, delivering a strong output

response in the process.

What would be the Classical economists' criticism of this argument?

That the increases in money supply would simply lead to higher prices in the private sector, and

that the government projects (public works etc.) would lead to "full" crowding out - financial and

resource. Given that the cause of the problem, to Classical economists, was market rigidities,

the solution was to free-up markets: to encourage workers to accept lower wages, and

producers to charge lower prices.

Introduction to Economics ECO401

In the extreme Keynesian model, is there any point in supply-side policies?

Yes. Successful supply-side policies, by increasing potential output, will shift the upward sloping

and vertical portions of the AS curve to the right. As a result, expansionary demand

management policies could now increase output to a higher level than before.

In the new (or neo) Classical model, should supply side policies be used as a weapon

against inflation?

It is important o understand that new classical economics is strongly inspired by monetarist

thinking. Monetarists separated the explanation for inflation and unemployment. According to

them, the way to reduce unemployment was to invoke supply side measures which serve to

reduce the natural rate of unemployment, whereas demand side policies (which for monetarists

means monetary policy) policies should be used to tackle inflation. Therefore the answer to the

above question is "no".

If we assume that if prices and wages are flexible and agents form expectations

rationally, then is the task of the macroeconomic policymaker trivial?

The answer is no. This question is about neo-Keynesianism. As you know, the debate between

Classicals and Keynes was related to the functioning of markets and the flexibility of prices and

wages therein. Keynes said wages were rigid, Classicals said they shouldn't be. Then there was

the debate between Keynesian economists and neo-Classical economists over how agents

formed expectations about the future. Keynes believed in static expectations whereas neo-

Classical economists believed in rational expectations. Now if we assume that prices and wages

are perfectly flexible and expectations are rationally formed, then we are essentially subscribing

to the laissez faire, pre-Keynesian Classical view of things., in which there was very little role for

government intervention. However, this is where neo-Keynesians come in. The new Keynesians

have highlighted market failures at the micro level that may arise due to information asymmetries

and coordination failures (moral hazard and adverse selection problems). As such they have

shown avenues for meaningful government intervention.

How might expansionary aggregate demand policy positively affect aggregate supply?

If the expansion in demand comes about due to higher investment, and if the same leads to

technological change (this usually happens in the very long run), then the long-run AS curve

might also shift to the right. In this case, the expansionary impact on output and income effect

will be magnified.

Does the shape of the long-run AS curve depend on how the `long' run is defined?

Yes. If the long run is defined so as to include the possibility of technological change resulting

from investment, then the long-run aggregate supply curve can be deemed relatively elastic

(flat).

Assume that there is a fall in aggregate demand (for goods). Trace through the short-run

and long-run effect on employment.

Prices fall. This causes the real wage to rise. At this real wage rate there is a deficiency of

demand for labour. In the short run there will be an increase in unemployment. In the long run

the deficiency of demand will drive down the money wage rate until the real wage rate has

returned to its earlier level.

If AS and AD in an economy intersect at a point a, and after a rightward shift in AD and a

leftward shift in AS, the new equilibrium obtains at a g which is vertically above point a,

does this necessarily imply that the long-run AS curve is vertical?

It would only be so if the upward shifts in the (short-run) AS curves had been entirely due to the

increased aggregate demand feeding through into higher prices. If, however, AS had shifted

upwards partly as a result of cost-push pressures independent of aggregate demand, then point

g could still be vertically above point a (i.e. if the long-run AS curve were upward sloping and

Introduction to Economics ECO401

had shifted upwards). With an upward-sloping long-run AS curve, if there had been no such

cost-push pressures, g would be to the north east of a. Alternatively, if cost-push pressures had

been great enough, point g could be to the northwest of point a.

Is it possible for the AS curve shift to the right over time? If it did how would this

influence the effects of the rises in aggregate demand?

Potential GDP, Yp, and hence AS, will shift to the right over time as potential growth takes place

(new resources discovered and new technologies invented). Also the rise in aggregate demand

and in output may lead to increased investment and hence a bigger capital stock: this too will

shift Yp and AS to the right. The rightward shift of Yp and AS will allow the rise in aggregate

demand to lead to a bigger increase in actual output (Y) and a smaller increase in the price level.

Assume that there are two shocks. The first causes aggregate supply to shift to the left.

The second, occurring several months later, has the opposite effect on aggregate supply.

Show that if both these effects persist over a period of time, but gradually fade away, the

economy will experience a recession which will bottom out and be followed in smooth

succession by a recovery.

A fall (leftward shift) in aggregate supply in the new classical model will reduce output and hence

cause a recession. If the shock pushing the AS curve to the left persists for a period of time,

then the recession will deepen as aggregate supply falls, but less and less quickly as the effect

fades away. If the second shock has a rightward pushing effect on the AS curve, then, as the

first effect fades away, the second effect will become relatively stronger. Output will begin to rise

again and gather pace as the first effect disappears. Whether output will continue falling initially

after the appearance of the second effect depends on the relative size of the two effects at that

particular stage.

If you are living in a Keynesian world and there is slack in the economy and room for

expansionary macroeconomic policies, would you introduce these policies in a slow and

steady manner or haphazardly and suddenly?

Demand management would have be carried out in a steady and predictable way since Keynes

assigned a lot of importance to certainty and stability and the confidence they give to firms

undertaking investment.

If constant criticism of governments in the media makes people highly cynical and

skeptical about the government's ability to manage the economy, what effect will this

have on the performance of the economy?

The economy will become less manageable! It may become less stable and as a result

investment and growth may be lower and inflation higher. The worse people believe the long-

term economic prospects are for the country, the more pessimistic they are likely to become,

and thus the worse is likely to be the actual performance of the economy.

This question is about the Monetarist challenge to Keynesian economics. Since this is a

difficult question to answer, I would advise you to revisit it at the end of the course and

during the discussion on inflation, and the monetary sector.

How would a monetarist answer the Keynesian criticisms given below?

1. `The time lag with monetary policy could be very long.' Monetarists do not claim that

monetary policy can be used to fine tune the economy. It is simply important to maintain

a stable growth in the money supply in line with long-term growth in output.

2. `Monetary and fiscal policy can work together.' Monetarists would argue that it is the

monetary effects of fiscal policy that cause aggregate demand to change. Pure fiscal

policy will be ineffective, leading merely to crowding out.

3. `The velocity of money is not stable, thus making the predictions of the quantity theory of

money i.e. that monetary growth must necessarily lead to inflation is unreliable.'

Monetarists would accept that the velocity of money circulation fluctuates in the short

Introduction to Economics ECO401

term, but they will argue that there is still a strong correlation between monetary growth

and inflation over the longer term.

4. `Changes in aggregate demand cause changes in money supply and not vice versa.'

Monetarists would argue that if governments respond to a rise in aggregate demand by

allowing money supply to increase, then that is their choice to expand money supply. If

they had chosen not to and had pursued a policy of higher interest rates, then money

supply would have thereby been controlled and aggregate demand would soon have

fallen back again.

Suppose that, as part of the national curriculum, everyone in the country had to study

economics up to the age of 16. Suppose also that the reporting of economic news by the

media became more thorough (and interesting!). What effects would these developments

have on the government's ability to manage the economy? How would your answer

differ if you were a Keynesian from if you were a new classicist?

People's predictions would become more accurate (at least that's what teachers of economics

would probably hope!). Thus the government would be less able to fool people. In the new

classical world there would be less shifting of the short-run AS curve or the short-run Phillips

curve. The government would find it even more useless to try to reduce unemployment by

demand-side policy. On the other hand a tight monetary policy would be more likely to reduce

inflation very rapidly.

In the Keynesian world, correctly executed demand management policy would be seen to be so.

This would create a climate of confidence which would help to encourage stable growth and

investment. On the other hand, poorly executed government policy would again be seen to be

so. This could cause a crisis of confidence, a fall in investment and a rise in unemployment

and/or inflation.

Table of Contents: