macsg18 - 18 [33] Debates in Macroeconomics: Monetarism,...

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459 18 [33] Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics C hapter objectives: 1. Outline the assumptions of the quantity theory and discuss the rationale for policy actions advised by monetarists that distinguish them from Keynesians. 2. State the assumptions of the new classical macroeconomic theory, especially the role of expectations, and describe the model’s policy conclusions. Outline the reasoning behind the real business cycle theory. 3. Outline the reasoning behind (and summarize the evidence about) the supply-side policies that found prominence in the 1980s. This chapter exposes some of the controversies that have boiled up within macroeconomics. It should alert you to the fact that no single model is accepted by all economists. Economics, unlike the physical sciences, is not governed by a set of undeniable laws. The model that is preferred often has as much to do with the prevailing philosophical attitude as it does with tested theories. A political dimension may be detected too. The activist “demand-side” Keynesian view is fairly liberal; Milton Friedman, the most famous monetarist, attracted the attention of Presidents Nixon and Ford; the supply-side theory was a major plank of Ronald Reagan’s presidential campaign in 1980; and the new classical economics advocates a “hands-off” approach to government intervention in the economy. BRAIN TEASER: The Lucas supply function, which is discussed in this chapter, argues that if inflation is higher than expected, the economy’s output will increase. You expect 5% inflation and negotiate a 5% wage increase. What happens to your real wage if inflation actually runs at 10%? What happens to your employer’s real wage bill? What would firms have an incentive to do in such a case? How would output be affected?
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460 Study Guide to Principles of Macroeconomics OBJECTIVE 1: Outline the assumptions of the quantity theory and discuss the rationale for policy actions advised by monetarists that distinguish them from Keynesians. The short-run AS/AD model is essentially Keynesian. Keynesians believe that the money market and goods market are linked—cyclical unemployment can persist; government policy can influence economic activity (in the short-run). Eventually, “Keynesianism” became associated with both “activist” fiscal policy and “activist” monetary policy. The quantity theory (monetarist) view of the economy relates the money supply ( M ) to nominal GDP ( PY ). On average, each dollar must be used a given number of times to buy all the goods produced; this given number is the velocity of money ( V ) and it is assumed to be (practically) constant. The central idea of the quantity theory is captured in the equation of exchange: MV = PY Given V , any change in M must cause a change in PY . If the economy tends to remain close to full employment and potential GDP (another part of the monetarist view), then sustained changes in M must
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This note was uploaded on 02/13/2010 for the course ECON 1102 taught by Professor Wissink during the Spring '09 term at Cornell University (Engineering School).

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macsg18 - 18 [33] Debates in Macroeconomics: Monetarism,...

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