Chapter 15. Twentieth-Century Economic Theory

Chapter 15Twentieth-Century Economic TheoryCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.15-1Chapter ObjectivesThe equation of exchangeThe quantity theory of moneyClassical economicsKeynesian economicsThe monetarist schoolSupply-side economicsThe rational expectations theory15-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Equation of ExchangeMuch of the Keynesian-Monetarist debate revolves around the quantity theory of money which itself is based on the equation of exchangeThe equation of exchange and the quantity theory of money are easy to confusePerhaps because the equation of exchange is used to explain the quantity theory of money 15-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Equation of ExchangeThe equation of exchange is MV = PQM is the total dollars in the nation’s money supplyV is the number of times per year each dollar is spentP is the average price of all the goods and services sold during the yearQ is the quantity of goods and services sold during the year15-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.15-5The Equation of ExchangeM times V (MV) would be total spending. Total spending by a nation during a given year is GDP. Therefore, MV = GDPP times Q (PQ) is the total amount of money received by sellers of all final goods and services produced by a nation during a given year. This also is GDP. Therefore, PQ = GDPThings equal to the same thing are equal to each other, therefore, MV = PQ Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.15-6The Equation of ExchangeThe following example will be in billions of dollars without the dollar signs MV = PQ900 X 9 = PQ 8,100 = PQ 8,100 = 81 X Q 8,100 = 81 X 100 8,100 = 8, 100The equation of exchange must always balance, as must all equations.The Quantity Theory of Money15-7The Crude version of the Quantity Theory of MoneyThis version holds that when the money supply (M) changes by a certain percentage, the price level (P) changes by that same percentage MV = PQ 900 X 9 = 81 X 100 1800 X 9 = 162 X 100 16,200 = 16,200Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Quantity Theory of Money15-8The Crude version of the Quantity Theory of MoneyThis version holds that when the money supply (M) changes by a certain percentage, the price level (P) changes by that same percentage MV = PQ 900 X 9 = 81 X 100 1800 X 9 = 162 X 100 16,200 = 16,200If V and Q remain constant, the crude version of the quantity theory of money is correct Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.A Closer Look at Q and VSince 1950 V has risen fairly steadily from about three to nearly sevenDuring recessions, production, and therefore Q will fallQ fell at an annual rate of about 4% during the 1981-82 recessionDuring recoveries, production picks up, so we go from a declining Q to a rising QObviously, neither V or Q are constantTherefore, the crude version of the quantity theory of money is invalid15-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.15-10The Quantity Theory of Money The sophisticated version of the “Quantity Theory of Money” assumes any short term changes in V are either very small or predictable But what happens next is entirely up to the level of production, QCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Sophisticated Quantity Theory of Money 15-11If we are well below full employment, an increase in M will lead mainly to an increase in QIf we are close to or at full employment, an increase in M will lead mainly to an increase in PCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Classical EconomicsThe classical school of economics was mainstream from roughly 1775 to 1930The classical school has the following tenetsRecessions cure themselvesSay’s law operatesSavings will be investedInterest rate mechanismQuantity theory of moneyAssume V and Q are constantGovernment can’t cure recessions15-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Keynesian EconomicsThe Keynesian school of economics was mainstream from the early 1930s to about 197015-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Keynesian EconomicsThe Keynesian school has the following tenetsThe problem with recessions is inadequate demandThe only hope is for the government to spend enough money to raise aggregate demand sufficiently to get people back to workThe government could print the money or borrow itIf enough (newly created money) was spent, the recession would end No one would invest in new plant and equipment when much of their capacity was idleWages and prices were not downwardly flexible because of institutional barriersIf M rises, people may not spend the additional money, but just hold itSo much for the quantity theory of money15-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monetarist SchoolStresses the Importance of the Rate of Monetary GrowthMilton Friedman, an economist who did exhaustive studies of the relationship between the rate of growth of the money supply concluded thatThe United States has never had a serious inflation that was not accompanied by rapid monetary growthWhen the money supply has grown slowly, the country has had no inflation 15-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monetarist SchoolStresses the Importance of the Rate of Monetary GrowthBuilding on the quantity theory of money, the monetarists agree with the classicals that when the money supply grows, the price level rises, albeit not at exactly the same rateRecessions are caused when the Federal Reserve increases the money supply at less than the rate needed by business – say, anything less than 3 percent a yearBy and large the facts have borne out the monetarists’ analysis15-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monetarist SchoolThe Basic Propositions of MonetarismThe key to stable economic growth is a constant rate of increase in the money supplyExpansionary monetary policy will only temporarily depress interest ratesExpansionary monetary policy will only temporarily reduce the unemployment rate Expansionary fiscal policy will only temporarily raise output and employment 15-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monetarist SchoolThe Monetary RuleIncrease the money supply at a constant rateWhen there is a recession, this steady infusion of monetary growth will pick up the economyWhen there is inflation, a steady rate of monetary growth will slow it down• When the country has a steady diet of money, the economic health will be relatively good – if not always excellent - no very fat years and no very lean years 15-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monetarist SchoolThe Decline of MonetarismMonetarism’s popularity started to decline in the late 1970s and early 1980sThe Fed’s policy on monetary growth, sky high interest rates, combined with two recessions seemed to cause people to look elsewhere for their economic gurus 15-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Supply-Side EconomicsSupply-side economics came into vogue in the early 1980sSupply-siders mantra was to cut tax rates, government spending, and government regulationThe object of supply-siders is to raise aggregate supplyMany of the undesirable effects of high marginal tax rates are the work effect, the savings and investment effect, and the elimination of productive market exchanges15-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Work EffectFacing high marginal tax rates, many people refuse to work more than a certain number of hours overtime or take on second jobs and other forms of extra workInstead, they opt for more leisure timeOutput is less when people work lessWhen people work less, their income is less 15-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Saving and Investment EffectHigh marginal tax rates on interest income will provide a disincentive to save, or at least to make savings available for investment purposesPeople who borrow money for investment purposes hope that this will lead to greater profitsBut, if these profits are subject to a high marginal tax rate, once again this is a disincentive to investThe economy will stagnate15-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Elimination of Productive Market Exchanges A productive market exchange is when you work at what your are good at and hire someone who is working at what they are good at to do something for youThere is a serious misallocation of labor(perhaps hundreds of millions of dollars) when the productive market exchange is eliminated because of high marginal tax rates It will pay you to work less at what you are good at to do another job that you are not so good at (you don’t hire some one is is better at it than you to do it)15-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Laffer Curve15-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The rationale of the Laffer curve is that when marginal tax rates are too high, we can raise tax revenues by lowering themRational Expectation TheoryRational expectations theory is based on three assumptionsIndividuals and firms learn through experience to anticipate the consequences of changes in monetary and fiscal policyIndividuals and firms act instantaneously to protect their economic interestAll resource and product markets are purely competitive 15-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Rational Expectation TheoryRational expectations theorists say the government should do as little as possibleBasically, then, the government should figure out the right policies to follow and stick to themThe right policies areSteady monetary growth of 3 to 4% a yearA balanced budget15-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Rational Expectation TheoryCriticism of the rational expectations schoolIt is not reasonable to expect individuals and business firms to accurately predict the consequences of macroeconomic policyMany of our economic markets are not purely competitive: some are not competitive at allThe rigidities imposed by contracts restrict adjustments to changing economic conditions15-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Economic BehavioristsEconomic behaviorists are a hot new group of young economists who are complete new comers to the economic theory sceneThey maintain that while the mainstream beliefs that rational behavior and economic self-interest are important, they are not the only motivating factorsTheir goal is to apply a wider range of psychological concepts to economic theory 15-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Conclusion“Each of the major schools of economic thought can be useful on occasion. The insights of Keynesian economics proved appropriate for Western societies attempting to get out of the depression in the 1930s. The tools of monetarism were powerfully effective in squeezing out the inflationary force of the 1970s. Supply-side economics played an important role in getting the public to understand the high cost of taxation and thus to support tax reform in the 1980s. But sensible public policy cannot long focus on any one objective or be limited to one policy approach.” [Murray Weidenbaum]15-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.