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Chapter 19 Disputes Over Macro Theory and Policy

Chapter 19 Disputes Over Macro Theory and Policy - Chapter...

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Chapter 19 Disputes Over Macro Theory and Policy I. Introduction: Disagreements about Macro Theory and Policy A. This chapter contrasts the classical and Keynesian macroeconomic theories. B. Contemporary disagreements on three inter-related questions are considered. 1. What causes instability in the economy? 2. Is the economy self-correcting? 3. Should government adhere to rules or use discretion in setting economic policy? II. Some History: Classical Economics A. Classical economics dominated the discipline from Adam Smith (1776) until the 1930s. It maintained that full employment was normal and that a “laissez-faire” (let it be) policy by government is best. B. Keynes observed in the 1930s that laissez-faire capitalism is subject to recurring recessions or depressions with widespread unemployment, and contended that active government stabilization policy is required to avoid the waste of idle resources. C. Classical View. 1. The aggregate supply curve is vertical and located at the full-employment level of real output. 2. Stress that classical economists believed that real output does not change in response to changes in the price level because wages and other input prices would be flexible. 3. The economy would operate at its full employment level of output because of: a. Say’s law (See Chapter 9) which states “supply creates its own demand.” b. responsive, flexible prices and wages in cases where there might be temporary over-supply. 4. Money underlies aggregate demand. Classical economists theorize that aggregate demand will be stable as long as the supply of money is controlled with limited growth. 5. The downward sloping demand curve is stable and is solely responsible for setting the price level. (See Figure 19- 1a) 6. Changes in the money supply would shift AD right for an increase and left for decrease, but responsive, flexible prices and wages will insure that full employment output is maintained. D. Keynesian View. 1. The core of Keynesianism is that product prices and wages are downwardly inflexible (don’t fall easily). This is graphically represented as a horizontal aggregate supply curve. (See Figure 19-1b)
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2. A decline in real output will have no impact on the price level. Once full employment is reached at Q f , the aggregate supply curve is vertical. 3. Keynesian economists view aggregate demand as unstable from one period to the next, even without changes in the money supply. 4. The investment component of aggregate demand is especially likely to fluctuate and the sole impact is on output and employment, while the price level remains unchanged. (See shift AD 1 , to AD 2 in Figure 19-1) 5. Active government policies are essential to increase aggregate demand and move the economy back toward full employment.
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Chapter 19 Disputes Over Macro Theory and Policy - Chapter...

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