Chapter 11 Competing Macro Theories and Issues
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.
C. Monetarism states changes in the money supply are both a necessary and sufficient condition to
D. New Classical economics states market forces and not government manipulation of aggregate
demand and the money supply to control economic activity.
E. 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
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.
c. Say's law - wiki has more information
d. 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.
C. "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
II. 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
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
B. Keynesian explanation
1. Output adjusts, prices are stable.
2. Changes in AD cause changes in employment and
Support this site by
| C. Aggregate supply over the
1. QU represents a recessionary level of Real GDP.
2. QF represents a full-employment level of Real GDP.
3. 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.
3. 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.
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.
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
c. Government should therefore 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
1. Quantity Theory of Money? is a concise narrative.
2. Quantity theory of money - Wikipedia, explores the algebra.
3. 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
from new school/money
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 Europeans. Video 1 Video 2
3. Modern Monetary Policy vs. The Austrian Society video
4. Inflation, Fear of Inflation an Public Debt Video Princeton professor and Nobel Laureate Christopher A. Sims 9/2/14
New classical macroeconomics-
A. Lead by Milton Friedman - wiki , these economists revived the quantity theory of money.
1. 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
2. Efficient wage theory states higher wages lower required supervision and lower per unit cost.
3. 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
E. For more on New Classical Economics
1. New Classical Macroeconomics, by Robert King: The Concise
2. Critique of neoclassical econmics, did anything change 2/26/14
IX. 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 16.
Cheat sheet for understanding the different schools of economics
policy has yet to work. The Economist Magazine of 1/12/13
XI Additional Learning Materials
1. Reconciling Hayek and Keynes short article 6/7/14
2. GDP A Brief But Affectionate History 7/20/14
3. Democratic Capitalism vs. Capitalistic Democracy
4. History of New Keynesianism/
5 How Laissez Faire Economics Lead to Inequality and Recession 10/14/14
B. Video Crash Course in Non-Equilibrium Economics 6 videos
XII. Our Current Events Internet Library has an interesting economics section.
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