Disputes Over Macro Theory and Policy

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”

29. A Famous “Public Work”

30. 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

32. U.S. Unemployment Rate

33. War! Good For GDP?

34. Disaggregating the GDP Data

35. Fed Inflation + Price Controls

36. Next Chapter Preview… Money and Banking Unit IV