Chapter 11 Competing Macro Theories and Issues

I. Theories Overview
II. Classical Economics
III. Keynesian Economics
IV. Classical v Keynesian

V. Quantity Theory of Money
VI. Monetarism
VII. New Classical Economics
VIII. Supply-side Economists

IX. Great Recession Analized
X. Additional Learning Materials

I. Theories Overview

     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 cause inflation.
     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 economics - Wiki discussed in chapter 16, stated emphasizes increasing 
         aggregate supply rather than increasing aggregate demand.
F. Freiburg School of the Austrian School developed in 1930's 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) An excess inventory slowdown which causes unemployment was not a necessity.
               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.

        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 produced 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

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 
           4. Use deficit spending to stop recessions with a surplus
               to slow inflation with budget balanced over cycle.






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
         B. Keynesian explanation
             1. Output adjusts, prices are stable.
             2. Changes in AD cause changes in employment and Real GDP
         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.
              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.
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 Money Velocity  = Average Price Level X Transactions 

           1. Velocity of money is how often the money supply is spent.
           2. Transactions is the number in 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
         1. Quantity Theory of Money? is a concise narrative.
         2.Quantity theory of money - Wiki
requires algebra.
The money-inflation connection: It's baaaack!

     4. Debt-Deflation from Irving Fisher  was popular in
            the early 1930's though Keynes won. Revisited 
            because of the Great Recession
5. Monetary theory is non ergodic as 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  The Concise Encyclopedia of

     Economics from Library of Economics and Liberty and 
         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
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. See Milton Friedman from Cato Institute
             1. Milton Friedman Video on  Greed from You Tube
             2. Milton Friedman Video 30 minute interview on Open Mind
        B. Market forces and not government manipulation of aggregate
            demand and the money supply 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. It assumes market participants will learn from experience
                 and use current information to predict and adjust to an 
                 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 low morale and less efficiency.
            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 
                productivity differences).
       E. For more on New Classical Economics
           1.  New Classical Macroeconomics, by Robert King: The Concise
           2. Critique of neoclassical economics, did anything change 2/26/14
New Classical Macroeconomics from Wiki

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 


  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, it is discussed in
            Stagflation and the Rise of Supply-Side Economics.

IX. Great Recession Macro Theories
         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. Economist Magazine
Cheat Sheet for Understanding the Different Schools of Economics

X. Additional Learning Materials
       A. Readings and Videos   
           1. Reconciling Hayek and Keynes short article 6/7/14
           2. GDP A Brief But Affectionate History
           3. Democratic Capitalism vs. Capitalistic Democracy
4. History of New Keynesianism/
           5 How Laissez Faire Economics Lead to Inequality
, Recession
Stagflation and the Rise of Supply-Side Economics:
              the brake-down of the Phillips curve.
          7. Progression of Economic Theory from Classical to Keynesian

                        back to Classical to ?  9 min 
          8. Great Recession from a Classical-Keynesian View
              from Roger Farmer Pepperdine School of Public Policy
Who are the Academic Sc
ribblers 9.11
Refining Cassical Economics 9.29
           c. Effect of the Great Depression 9.14
           d. 1970's oil shock shocks the world of economics 8.52
          e. How bad is the economy and where is it going 7.41

           9. Crash Course in Non-Equilibrium Economics  6 videos
Current Political Economic Controversies has an interesting 
           economics section.

Federal Reserve in Action

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