Chapter 11 Competing Macro Theories and Issues

 I. Overview of Current Theories
II. Classical Economics
III. Keynesian Economics
IV. Classical vs. Keynesian Equilibrium
V. The Quantity Theory of Money
VI. Monetarism
VII. New Classical Economics

VIII. Supply-side Economists
IX. Macro Theories and the Great Recession
X. Additional Learning Materials
Discussion Questions
Homework Questions
Table of Contents

Macro Test Reviews   Test 1     Test 2      Test 3

  Micro Test Review    Test 1      Test 2     Test 3

Economics Video Lectures review concepts quickly

I. Overview of Current Theories

    A. Classical economics
         1. Dominated philosophically during the late 18th, 19th and early 20th centuries.
         2. First defined by Adam Smith in The Wealth of Nations - Wikipedia published in 1776.
         3. Two primary beliefs
             a. Full employment was a norm of capitalism.
             b. Laissez-faire (hands-off) government policy was best.
    B. Keynesian economics
        1. Macro equilibrium could settle at an unacceptable level of unemployed resources.
        2. Government intervention could be required to fully employ resources.
Monetarism states changes in the money supply are both a necessary and sufficient condition to
         cause inflation.
    D. New Classical economics states market forces and not government manipulation of aggregate
         demand and the money supply to control economic activity. 
Supply-side ececonomics - Wiki discussed in chapter 16, stated emphasizes increasing 
        aggregate supply rather than increasing aggregate demand.
F. Freiburg School of the Austrian School developed during 1930's in Germany after their great inflation,
         is followed by Angela Merkel and stresses free markets with rigorous regulation. 

II. Classical Economics
     A. Basic philosophy
         1. The economy is self-adjusting, government doesn't have to interfere. 
         2. Except for unusual circumstances (war, speculative crises), full
employment would be the norm.
     B. Two basic theories
         1. Say's law
             a. Supply created enough factor income to clear the market 
                 1) Inventories will not accumulate.
                 2) A slow down to use excess inventory, which causes unemployment, was not necessary.
             b. Savings is not a leakage because interest rates adjust to insure saving is borrowed and 
                 invested (spent).
                 1) Leakage describes the loss of a variable required to maintain a state of equilibrium (stable
                     level of economic activity).
                 2) Interest rates drop when savings increase to insure savings is invested and there isn't leakage.
Say's law - wiki has more information
Will Say’s law stay dead? (Rumplestatskin, Macro Business 03/12/13
         2. Price-Wage flexibility
             a. During periods of slow economic activity wage rates would fall and everyone wanting to work
                 could find work.
             b. All factor prices, not just wages, would adjust downward and all factors would be fully employed. 
                 "Real" factor prices would therefore remain constant.
In France, John Baptist Say has the merit of producing a very superior work on the subject of Political 
           Economy. His arrangement is luminous, ideas clear, style perspicuous, and the whole subject brought 
           within half the volume of [Adam] Smith's work. Add to this considerable advances in correctness and 
           extension of principles.
Thomas Jefferson, letter to Joseph Milligan, April 6, 1816 Friesian.School
     D. Free Course Great Economists: Classical Economics and its Forerunners

Macro Chapters

8) Measuring Total Economic Activity 
9) The Business Cycle

10) Macro Equilibrium 
11) Competing Macro Theories and Issues
10) Macro Equilibrium 
11) Competing Macro Theories and Issues
12 Keynesian Economics: An Expanded View
13 Money, Banking, and the Creation of Money

Financial Crisis and The Great Recession
14) Fiscal Policy
15) Monetary Policy  
16) Stagflation % Rise of Supply-Side Economics
17) Budget Deficits
See Democratic Capitalism vs Capitalistic Democracy 


III. Keynesian Economics
      A. The Great Depression discredited classical economics.
      B. John Maynard Keynes
          1. Wrote The General Theory of Employment, Interest, and Money (1936). 
          2. Disagreed with Say's Law: savings may not be invested.
              a. Interest rates are not the sole determinate of savings and investing.
             b. Saving and investment are done by different people with different motives.
                 Saving may not equal investment causing goods to go unsold and inventories
                 to increase.
             c. Saving is based upon "liquidity preference," the need to hold money
                 1) Transactionary Motives: for every day use.
                 2) Speculative Motives: save because prices may drop (Japan in late 1990's).
                 3) Precautionary Motives: save for uncertainty (recession, oil prices).
             d. Investment decisions are based upon profit expectations and interest rates
             e. Money balances (savings) are also important in determining aggregate demand.
       3. Disagreed with price-wage flexibility: that prices would adjust downward insuring all 
             resources are fully employed. Great Recession data proves Keynes correct see
wage growth and unemployment, wages did not adjust. 7/16/13, Global Economic Intersection and
Why are wages sticky 2/6/14

         4. Use deficit spending to stop recessions with a surplus to slow inflation.
              a. Resource prices are inflexible downward meaning resource 
                  prices may not adjust and unemployment may persist.
              b. Wages are sticky downward because of unions, monopoly 
                   power of corporations, and government policies.
          5. As a result, government involvement may be required to keep
              AD high enough to maintain full employment.
John Maynard Keynes

Keynes argued against a return to the gold standard after the war.

IV. Classical vs. Keynesian Equilibrium
A. Classical explanation
           1. Prices are flexible, output is stable.
           2. Changes in AD cause prices to change, AS determines 
               Real GDP.

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      B. Keynesian explanation
          1. Output adjusts, prices are stable.
     2. Changes in AD cause changes in employment and
              Real GDP.

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      C. Aggregate supply over the business cycle
          1. QU represents a recessionary level of Real GDP.
          2. QF represents a full-employment level of Real GDP.
Aggregate supply - Wikipedia






   D. Manipulating equilibrium
       1. Classical economists didn't see a need as Real GDP was fixed..
       2. Keynesian economists want to manipulate AD by changing  
           C + I + G + XN to maintain noninflationary full employment.
Aggregate demand - from Wikipedia has a more complete
           explanation of the Keynesian view.
E.  Comparing Classical and Keynesian macro models
1. Classical and Keynesian Economics  is a concise narrative
            of this material. 
        2. Aggregate Spending Model from Dr.  Barbara Mikalson,
            Rio Hondo College
        3. Elmer G. Wiens: Classical & Keynesian AD-AS Model -
            An on-line, interactive model of the Canadian Economy.
     F. Keynes and Classical Economics is a concise summary 
         followed by fill-in the blank questions with answers. Provided
         by Pearson Education.

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V. The Quantity Theory of Money


       A. Represents the basic theory behind macroeconomics prior to the Keynesian Revolution
       B. Believed that changes in the money supply would only affect price
and not economic activity.
       C. The equation of exchange
                                                                                       MV = PT
Money Supply
X Velocity of Money  = Average Price Level X Number of Transactions

          1. Velocity of money is how often the money supply is spent.
          2. Number of transactions is real economic activity
          3. The equation is an identity
              a. Dollars spent = dollars received
              b. MV = Aggregate Demand and PT = Nominal GDP = C + I + G + XN = GDP
          4. Classical theory stated that V was basically stable and that there existed some natural level of growth
               for T. 
              a. This natural level was a function of individual and business interaction. 
              b. V and T were essentially unalterable which meant changes in M would change P and not the natural
                  level of T. 
              c. Government should
thus refrain from interfering with market activity by adjusting the money supply.
       D. Came into disfavor in the 1930's with the popularity of Keynesian economics which stated that real
             output could be changed by
affecting aggregate demand.
      E. Additional reading

 Quantity Theory of Money? is a concise narrative.
2 Quantity theory of money - Wikipedia, explores the algebra.
The money-inflation connection: It's baaaack! from macroblog of the Atlanta Federal Reserve
          4. Debt-Deflation
from Irving Fisher  was popular in the early 1930's though Keynes won. Revisited
              because of the Great Recession
          5.Debt, Deficits, and Modern Monetary Theory Harvard International Review 

          6. Monetary theory is non ergodic because data can't be averaged.

from new school/money

Editors Note:
Things have happened since the equation of exchange was developed and they increase current aggregate demand and run the risk on decreases AD in the future.
1) Nixon took us completely off gold in early 70's. Money supply can change up or down without printing so we will never need wheel barrows.
3) Federal debt, once only used to finance war once they had begun now finances social programs  and 2.5 wars that might happen.
3) States and companies promise retirement they may not easily finance in the future.
Question! How many econometric models incorporate these concepts?
VI. Monetarism
A. Monetarists believe that changes in the money supply are both a necessary and sufficient condition
            to cause inflation.
       B. If AD was low, increasing the money supply would only increase short-run economic activity. 
           1.Eventually short-term expansion stops and increasing M only adds to inflation. 
           2. Public anticipation stops the process from being repeated. 
           3. Monetarists believe that government involvement in the economy, especially monetary intervention,
                increases the magnitude of the business cycle.
      C. Keynes believed changing the money supply would affect interest rates which would affect investment
           which in turn would affect Real GDP
      D. To some degree monetarism is an extension of classical economics. Its advocates believe that a
            competitive market,
           free from
government interference, results in economic stability and a reasonable growth rate.
      E. For more on Monetarism visit
Monetarism from The Concise Encyclopedia Of Economics and
Monetarism from the History of Economic Thought Website. 
      F. Extra Stuff
           1. PRIVATIZE THE GAINS, SOCIALIZE THE LOSSES is a concise history of our 20th century
               monetary system.
           2. Austrian School of Economics
are monetarists whose theories are followers by conservative
 Video 1  
Video 2
           3. Modern Monetary Policy vs. The Austrian Society video
 Inflation, Fear of Inflation an Public Debt Video Princeton professor and Nobel Laureate
                Christopher A. Sims 9/2/14
            5. Bill Mitchell Demystifies Modern Monetary Theory

  VII. New Classical Economics
         A. Lead by Milton Friedman - wiki , these economists revived the quantity theory of money. 
Milton Friedman Video on  Greed from You Tube
               2. Milton Friedman Video 30 minute interview on Open Mind
         B. They rely on market forces and not government manipulation of aggregate demand and the money supply to 
              control economic activity. 
         C. This economic school of thought has much in
common with those who believe in Rational expectations.
              1. This
recently formed school does not assume market participants have perfect knowledge. 
              2. Instead, it assumes market participants will learn from experience and use current information to predict and
                  adjust to the expected future. 
              3. The result is not the disequilibrium of Keynesian economics with its inflationary and deflationary gaps but a
                  constant equilibrium with economic behavior adjusting to be compatible with different levels of economic activity. 
              4. As with the classical school, the new classical school, monetarist,
and those believing in rationalist expectation feel 
                  government involvement in economic activity is not beneficial.
          D. Reasons for self-correction nature of capitalism
              1. Wages are Inflexible downward as employers face a minimum wage and lower wages cause a moral problem and
                   lower efficiency.
              2. Efficient wage theory states higher wages lower required supervision and lower per unit cost.
Insider-outsider theory of employment - wiki there is absence of wage underbidding even when many 
                  unemployed workers are willing to work for wages lower than existing insider wages (normalized for 
                  productivity differences).
For more on New Classical Economics
New Classical Macroeconomics, by Robert King: The Concise

               2. Critique of neoclassical econmics, did anything change 2/26/14

New Classical Macroeconomics from Wiki

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  VIII. Supply-side Economists
        A. Slow economic growth and high inflation of the 1970's caused some economists
             to emphasize increasing Aggregate Supply.
        B. Known as Supply-Side Economics, this theory is discussed in chapter

  IX. Macro Theories and the Great Recession
        A. U.S. has successfully used Keynesian economics to quickly negate the recession,
             will inflation follow.
        B. Germany's enforcing Austrian School austerity and slow growth in the money supply
             for Europe has resulted in recessions and slow growth.
Great Brittan is still in or close to recession because of austerity and an easy money
             policy has yet to work.
The Economist Magazine of 1/12/13
Cheat Sheet for Understanding the Different Schools of Economics
  X. Additional Learning Materials
           1. Reconciling Hayek and Keynes short article 6/7/14
           2. GDP A Brief But Affectionate History
           3. Democratic Capitalism vs. Capitalistic Democracy
History of New Keynesianism/
           5 How Laissez Faire Economics Lead to Inequality and Recession 10/14/14
Stagflation and the Rise of Supply-Side Economics:the brake-down of the Phillips curve.
     B.  Video Crash Course in Non-Equilibrium Economics 
6 videos
 C. Our Current Events Internet Library has an interesting economics section. 

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Chapter 11 Class Discussion Questions Table of Contents
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