Disputes in Macro Theory and Policy

CHAPTER NINETEEN
DISPUTES OVER MACRO THEORY AND POLICY
CHAPTER OVERVIEW
One of the great traditions in scholarship is the challenge to mainstream thinking. Many such
challenges to the conventional wisdom fail; either the new theories are not logical or they dont
conform to facts. At the opposite extreme some new theories gain full support and replace the existing
theories. More often the new ideas modify mainstream thinking which thereafter is improved or
extended. !his is true in economics.
"n this chapter we examine some of the ma#or disputes in macro theory and policy. $e initially provide
historical %ackground %y contrasting classical and &eynesian macroeconomic theories. !hen we turn to
contemporary disagreements on three interrelated 'uestions( )* $hat causes insta%ility in the economy+
,* "s the economy self-correcting+ .* /hould government adhere to rules or use discretion in setting
economic policy+
WHATS NEW
This chapter covers topics that were in Chapter 17 of the 14
th
edition. Otherwise, changes are few and
mainly editorial. References to natural rate hypothesis and adoptive e!pectations are no longer used.
" new #ast $ord appears at the end of the chapter on the Taylor Rule for monetary policy.
INSTRUCTIONAL OBJECTIVES
"fter completing this chapter, students should %e a%le to&
1. Contrast the classical and 'eynesian views of the aggregate supply curve.
(. Compare the classical and 'eynesian views of the sta%ility of the aggregate demand curve.
). *ive two reasons for macroeconomic insta%ility according to mainstream economists.
4. +!plain the e,uation of e!change.
-. .dentify the single most important cause of macroeconomic insta%ility according to the monetarists.
/. +!plain the main reasons for macro economic insta%ility according to the real0%usiness0cycle theory.
7. Construct an e!ample to demonstrate a coordination failure.
1. +!plain the view of self0correction held %y mainstream economists.
2. #ist three reasons why a higher wage could result in greater efficiency.
13. +!plain how insider0outsider relationships contri%ute to downward wage infle!i%ility.
11. 4escri%e the monetary rule and e!plain why monetarists prefer it to discretionary monetary policy.
1(. Compare the views of mainstream economists with monetarists and R+T economists regarding the
use of discretionary fiscal policy and the need for an annually %alanced %udget.
1). Compare and contrast Taylor Rule with 5onetary Rule advocated %y monetarists.
14. 4efine and e!plain the terms and concepts listed at the end of the chapter.
((7
Disputes in Macro Theory and Policy
COMMENTS AND TEACHING SUGGESTIONS
1. This chapter illuminates %asic disagreements and controversies in macroeconomic theory. 6tress
that, despite the disagreements, there is considera%le agreement a%out the %asic macro concepts, the
tools of analysis, and the framewor7 for discussion.
(. This may %e a good time to reemphasi8e the difference %etween positive and normative economics.
Remind students that value 9udgments a%out the economy, that is, which economic goals are most
important, influence opinions a%out a particular economic policy, as much as any empirical data.
). "s7 students to evaluate the last presidential election. Can they identify the school of thought most
closely associated with each candidate for president: Consider the candidates for local elective
office; is there enough information availa%le to ma7e a 9udgment a%out the candidates< opinions
a%out economic policies:
4. 5ainstream economists %elieve that nominal wages are infle!i%le downward %ecause of la%or
contracts, efficiency wages, and insider0outsider relationships. =ave students interview a %usiness
manager with first0hand e!perience in this area; or as7 students to consider what 7ind of empirical
data they would need to collect to evaluate the fle!i%ility or infle!i%ility of wages.
-. "rthur O7un pu%lished a wor7 in the 12/3s that is still a good %asis for discussion, 0'uality and
0fficiency the 1ig !radeoff.
STUDENT STUMBLING BLOCK
This is not easy material. 6tudents may %ecome frustrated when they consider more than one point of view.
.t may %e helpful to point out that acceptance or re9ection of a theory depends on opinions a%out which
economic goals are most important for the country.
LECTURE NOTES
I. Introduction: Disagreements about Macro Theory and Policy
". This chapter contrasts the classical and 'eynesian macroeconomic theories.
>. Contemporary disagreements on three inter0related ,uestions are considered.
1. $hat causes insta%ility in the economy:
(. .s the economy self0orrecting:
). 6hould government adhere to rules or use discretion in setting economic policy:
II. Some History: Classical Economics
". Classical economics dominated the discipline from "dam 6mith ?177/@ until the 12)3s. .t
maintained that full employment was normal and that a laisse80faire ?let it %e@ policy %y
government is %est.
>. 'eynes o%served in the 12)3s that laisse80faire capitalism is su%9ect to recurring recessions or
depressions with widespread unemployment, and contended that active government
sta%ili8ation policy is re,uired to avoid the waste of idle resources.
C. Classical Aiew.
1. The aggregate supply curve is vertical and located at the full0employment level of real
output.
(. 6tress that classical economists %elieved that real output does not change in response to
changes in the price level %ecause wages and other input prices would %e fle!i%le.
((1
Disputes in Macro Theory and Policy
). The economy would operate at its full employment level of output %ecause of&
a. 6ay<s law ?6ee Chapter 2@ which states supply creates its own demand.
%. responsive, fle!i%le prices and wages in cases where there might %e temporary over0
supply.
4. 5oney underlies aggregate demand. Classical economists theori8e that aggregate demand
will %e sta%le as long as the supply of money is controlled with limited growth.
-. The downward sloping demand curve is sta%le and is solely responsi%le for setting the
price level. ?6ee Bigure 1201a@
/. Changes in the money supply would shift "4 right for an increase and left for decrease,
%ut responsive, fle!i%le prices and wages will insure that full employment output is
maintained.
4. 'eynesian Aiew.
1. The core of 'eynesianism is that product prices and wages are downwardly infle!i%le
?don<t fall easily@. This is graphically represented as a hori8ontal aggregate supply curve.
?6ee Bigure 1201%@
(. " decline in real output will have no impact on the price level. Once full employment is
reached at Cf, the aggregate supply curve is vertical.
). 'eynesian economists view aggregate demand as unsta%le from one period to the ne!t,
even without changes in the money supply.
4. The investment component of aggregate demand is especially li7ely to fluctuate and the
sole impact is on output and employment, while the price level remains unchanged. ?6ee
shift "41, to "4( in Bigure 1201@
-. "ctive government policies are essential to increase aggregate demand and move the
economy %ac7 toward full employment.
III. What Causes Macro Instability such as reat Depression! "ecessions! In#lationary Periods$
". 5ainstream Aiew& This term is used to characteri8e prevailing perspective of most economists.
1. 5ainstream macroeconomics is 'eynesian0%ased, and focuses on aggregate demand and
its components. C?a@ D .?g@ D E?n@ D * F *4G ?"ggregate e!penditures@ F ?real output@
(. "ny change in one of the spending components in the aggregate e!penditure e,uation shifts
the aggregate demand curve. This, in turn, changes e,uili%rium real output, the price level
or %oth.
a. .nvestment spending is particularly su%9ect to variation.
%. .nsta%ility can also arise from the supply side. "rtificial supply restriction, wars, or
increased costs of production can decrease supply, desta%ili8ing the economy %y
simultaneously causing cost0push inflation and recession.
>. 5onetarist Aiew& This la%el is applied to a modern form of classical economics.
1. 5oney supply is the focus of monetarist theory.
(. 5onetarism argues that the price and wage fle!i%ility provided %y competitive mar7ets
cause fluctuations in product and resource prices, rather than output and employment.
). Therefore, a competitive mar7et system would provide su%stantial macroeconomic sta%ility
if there were no government interference in the economy.
((2
Disputes in Macro Theory and Policy
a .t is government that has caused downward infle!i%ility through the minimum wage
law, pro0union legislation, and guaranteed prices for some products as in agriculture.
%. 5onetarists say that government also contri%utes to the economy<s %usiness cycles
through clumsy, mista7en, monetary policies.
4. The fundamental e,uation of monetarism is the e,uation of e!change. 5A F GC
a. The left side, 5A, represents the total amount spent H5, the money supply ! A, the
velocity of money, ?the num%er of times per year the average dollar is spent on final
goods and services@I
%. The right side, GC, e,uals the nation<s nominal *4G HG is the price level or more
specifically, the average price at which each unit of output is sold ! C is the physical
volume of all goods and services produced.I
c. 5onetarists say that velocity, A, is sta%le, meaning that the factors altering velocity
change gradually and predicta%ly. Geople and firms have a sta%le pattern to holding
money.
d. .f velocity is sta%le, the e,uation of e!change suggests there is a predicta%le
relationship %etween the money supply and nominal *4G ?GC@.
-. 5onetarists say that inappropriate monetary policy is the single most important cause of
macroeconomic insta%ility. "n increase in money supply will increase aggregate demand.
/. 5ainstream economists view insta%ility of investment as the main cause of the economy<s
insta%ility. They see monetary policy as a sta%ili8ing factor since it can ad9ust interest rates
to 7eep investment and aggregate demand sta%le.
C. Real >usiness Cycle Aiew& " third perspective on macroeconomic sta%ility focuses on a
aggregate supply. ?6ee Bigure 120(@
1. The view that %usiness cycles are caused %y real factors affecting aggregate supply such as
a decline in productivity, which causes a decline in "6.
(. .n the real0%usiness cycle theory declines in *4G mean less demand for money. =ere, the
supply of money is decreased after the demand declines. "4 falls, %ut price level is the
same %ecause "6 also declined.
4. Coordination Bailures& " fourth view relates to so0called coordination failures.
1. 5acroeconomic insta%ility can occur when people do not reach a mutually %eneficial
e,uili%rium %ecause they lac7 some way to 9ointly coordinate their actions.
(. There is no mechanism for firms and households to agree on actions that would ma7e them
all %etter off if such a failure occurs. The initial pro%lem may %e due to e!pectations that
are not 9ustified, %ut if everyone %elieves that a recession may come, they reduce spending,
firms reduce output and the recession occurs. The economy can %e stuc7 in a recession
%ecause of a failure of households and %usinesses to coordinate positive e!pectations.
I%. Does the Economy &Sel#'Correct($
". Jew Classical Aiew of 6elf0Correction
1. 5onetarist and rational e!pectation economists %elieve that the economy has automatic,
internal mechanisms for self0correction.
(. Bigure 12a0% demonstrates the ad9ustment process, which retains full employment output
according to this view.
()3
Disputes in Macro Theory and Policy
). The disagreement among new classical economists is over the speed of the ad9ustment
process.
a. 5onetarists usually hold the adaptive e!pectations view of gradual change. The
supply curve shifts, show in figure 120) may ta7e ( or ) years or longer.
%. Rational e!pectations theory ?R+T@ holds that people anticipate some future outcomes
%efore they occur, ma7ing change very ,uic7, even instantaneous.
i. $here there is ade,uate information, people<s %eliefs a%out future outcomes
accurately reflect the li7elihood that those outcomes will occur.
ii. R+T assumes that new information a%out events with 7nown outcomes will %e
assimilated ,uic7ly.
4. .n R+T unanticipated price0level changes do cause temporary changes in real output.
Birms mista7enly ad9ust their production levels in response to what they perceive to %e a
relative price change in their product alone. "ny change in *4G is corrected as prices are
fle!i%le and firms read9ust output to its previous level.
-. .n R+T fully anticipated price0level changes do not change real output, even for short
periods. Birms are a%le to maintain profit and production levels.
>. 5ainstream Aiew of 6elf0Correction
1. There is ample evidence that many prices and wages are infle!i%le downward for long
periods of time. =owever, some aspects of R+T have %een incorporated into the more
rigorous model; of the mainstream.
(. *raphical analysis shown in Bigure 120)% demonstrates the ad9ustment process along a
hori8ontal aggregate supply curve.
). 4ownward wage infle!i%ility may occur %ecause firms are una%le to cut wages due to
contracts and the legal minimum wage. Birms may not want to reduce wages if they fear
pro%lems with morale effort, and efficiency.
4. "n efficiency wage is one that minimi8es the firm<s la%or cost per unit of output. Birms
may discover that paying higher than mar7et wages lowers wage cost per unit of output.
a. $or7ers have an incentive to retain an a%ove0mar7et wage 9o% and may put forth
greater wor7 effort.
%. #ower supervision costs prevail if wor7ers have more incentive to wor7 hard.
c. "n a%ove0mar7et wage reduces 9o% turnover.
-. 6ome economists %elieve wages don<t fall easily %ecause already employed wor7ers
?insiders@ 7eep their 9o%s even though unemployed outsiders might accept lower pay.
+mployers prefer a sta%le wor7 force. ?'ey Cuestion 7@
%. "ules or Discretion$
". 5onetarists and other new classical economists %elieve that policy rules would reduce insta%ility in
the economy.
1. " monetary rule would direct the Bed to e!pand the money supply each year at the same
annual rate as the typical growth of *4G. ?6ee Bigure 1204@
a. The rule would tie increases in the money supply to the typical rightward shift of
long0run aggregate supply, and ensure that aggregate demand shifts rightward along
with it.
()1
Disputes in Macro Theory and Policy
%. " monetary rule, then, would promote steady growth of real output along with price
sta%ility.
(. " few economists favor a constitutional amendment to re,uire the federal government to
%alance its %udget annually.
a. Others simply suggest that government %e passive in its fiscal policy and not
intentionally create %udget deficits of surpluses.
%. 5onetarists and new classical economists %elieve that fiscal policy is ineffective.
+!pansionary policy is %ad %ecause it crowds out private investment.
c. R+T economists re9ect discretionary fiscal policy for the same reason they re9ect active
monetary policy. They don<t %elieve it wor7s %ecause the effects are fully anticipated
%y private sector.
>. 5ainstream economists defend discretionary sta%ili8ation policy.
1. .n supporting discretionary monetary policy, mainstream economists argue that the velocity
of money is more varia%le and unpredicta%le, in short run monetary policy can help offset
changes in "4 than monetarists contend.
(. 5ainstream economists oppose re,uirements to %alance the %udget annually %ecause it
would re,uire actions that would intensify the %usiness cycle, such as raising ta!es and
cutting spending during recession and the opposite during %ooms. They support
discretionary fiscal policy to com%at recession or inflation even if it causes a deficit or
surplus %udget.
C. The K.6. economy has %een a%out one0third more sta%le since 124/ than in earlier periods.
4iscretionary fiscal and monetary policy were used during this period and not %efore. This
ma7es a strong case for its success.
4. " summary of alternative views presents the central ideas and policy implications of four main
macroeconomic theories& 5ainstream macroeconomics, monetarism, rational e!pectations
theory and supply side economics. ?6ee Ta%le 1201 @
%I. )ast Word: The Taylor "ule: Could a "obot "eplace *lan reenspan$
". 5acroeconomist Lohn Taylor of 6tanford Kniversity calls for a new monetary rule that would
institutionali8e appropriate Bed policy responses to changes in real output and inflation.
>. Traditional monetarist rule is passive. .t re,uired Bed to e!pand money supply at a fi!ed
annual rate regardless of economic conditions.
C. 4iscretion is associated with the opposite& an active monetary policy where Bed changes the
money supply and interest rates in response to changes in the economy or to prevent
undesira%le results.
4. Taylor<s policy proposal would dictate active monetary actions that are precisely defined. .t
com%ines monetarism and the more mainstream view.
+. Taylor<s rule has three parts&
1. .f real *4G rises 1M a%ove potential *4G, the Bed should raise the Bederal funds rate %y
3.-M relative to the current inflation rate.
(. .f inflation is 1M a%ove its target of (M, the Bed should raise Bederal funds rate %y 3.-M
a%ove the inflation rate.
). .f real *4G e,uals potential *4G and inflation is (M, the Bederal funds rate should %e
a%out 4M implying real interest rate of (M.
()(
Disputes in Macro Theory and Policy
B. Taylor would retain Bed<s power to override rule, so a ro%ot really couldn<t replace the >oard.
>ut a rule increases predicta%ility and credi%ility.
*. Critics of the proposal see no reason for this rule given the success of monetary policy in the
past decade.
ANSWERS TO END-OF-CHAPTER QUESTIONS
1201 ?&ey 2uestion@ Kse the aggregate demand0aggregate supply model to compare classical and
'eynesian interpretations of ?a@ the aggregate supply curve, and ?%@ the sta%ility of the aggregate
demand curve. $hich of these interpretations seems more consistent with the realities of the *reat
4epression:
?a@ Classical economists envisioned the "6 curve as %eing perfectly vertical. $hen prices fall,
real profits do not decrease %ecause wage rates fall in the same proportion. $ith constant real
profits, firms have no reason to change the ,uantities of output they supply. 'eynesians
viewed the "6 curve as %eing hori8ontal at outputs less than the full0employment output and
vertical only at full employment. 4eclines in aggregate demand do not change the price level
%ecause wages and prices are assumed to %e infle!i%le downward.
?%@ Classical economists viewed "4 as sta%le so long as the monetary authorities hold the money
supply constant. Therefore inflation and deflation are unli7ely. 'eynesians viewed the "4
curve as unsta%leNeven if the money supply is constantNsince investment spending is
volatile. 4ecreases in "4 can cause a recession; rapid increases in "4 can cause demand0pull
inflation.
?c@ The 'eynesian view seems more consistent with the facts of the *reat 4epression; in that
period, real output declined %y nearly 43 percent in the Knited 6tates and remained low for a
decade.
120( "ccording to mainstream economists what is the usual cause of macroeconomic insta%ility: $hat
role does the spending0income multiplier play in creating insta%ility: =ow might adverse aggregate
supply factors cause insta%ility, according to mainstream economists:
The mainstream view of macroeconomic insta%ility is 'eynesian0%ased and focuses on aggregate
spending and its components. Garticularly significant are changes in investment spending, which
change aggregate demand and, occasionally, adverse supply shoc7s which change aggregate supply.
.nvestment spending is su%9ect to wide variations, and a multiplier effect magnifies these changes
into even greater changes in aggregate demand, which can cause demand pull inflation in the
forward direction or a recession if investment spending falls.
.n the mainstream view, a second source of insta%ility could arise on the supply side. $ars or
artificial supply restrictions %oost may raise per unit production costs. The result is a si8a%le
decline in a nation<s aggregate supply, which could desta%ili8e the economy %y simultaneously
causing cost0push inflation and recession.
120) 6tate and e!plain the %asic e,uation of monetarism. $hat is the ma9or cause of macroeconomic
insta%ility, as viewed %y monetarists:.
The fundamental e,uation of monetarism is the e,uation of e!change. 5A F GC. The left side,
5A, represents the total amount spent H5, the money supply E A, the velocity of money, ?the
num%er of times per year the average dollar is spent on final goods and services@I. The right side,
GC, e,uals the nation<s nominal *4G HG is the price level or more specifically, the average price at
which each unit of output is soldI. C is the physical volume of all goods and services produced.
5onetarists %elieve changes in the money supply, in particular, inappropriate monetary policy, is
the single most important cause of macroeconomic sta%ility.
())
Disputes in Macro Theory and Policy
1204 ?&ey 2uestion@ 6uppose that the money supply and the nominal *4G for a hypothetical economy
are O2/ %illion and O))/ %illion, respectively. $hat is the velocity of money: =ow will
households and %usinesses react if the central %an7 reduces the money supply %y O(3 %illion: >y
how much will nominal *4G have to fall to restore e,uili%rium, according to the monetarist
perspective:
Aelocity F ).- or ))/P2/. They will cut %ac7 on their spending to try to restore their desired ratio
of money to other items of wealth. Jominal *4G will fall to O(// %illion ?F O7/ %illion remaining
money supply ! ).-@ to restore e,uili%rium.
120- >riefly descri%e the difference %etween a so0called real %usiness cycle and a more traditional
spending %usiness cycle.
.n the real0%usiness0cycle theory, %usiness fluctuations result from significant changes in
technology and resource availa%ility. These changes affect productivity and thus the long0run
growth trend of aggregate supply. The changes in aggregate supply then induce changes in the
demand for money, which in this controversial scenario then leads to a change in the money supply,
which allows ad9ustment without changes in the price level. The conclusion of the real0%usiness0
cycle theory is that macro insta%ility arises on the aggregate supply side of the economy, not on the
aggregate demand side as %oth mainstream economists and monetarists generally say.
120/ "ndrew and 'ris were wal7ing directly toward each other in a congested store aisle. "ndrew
moved to his left to avoid 'ris, and at the same time 'ris moved to his right to avoid "ndrew.
They %umped into each other. $hat concept does this e!ample illustrate: =ow does this idea
relate to macroeconomic insta%ility:
This e!ample illustrates a coordination failure which occurs in macroeconomics, when people do
not reach a mutually %eneficial e,uili%rium %ecause they lac7 some way to 9ointly coordinate their
actions.
+!pectations of households and %usiness firms can create an undesira%le outcome. .f individuals
e!pect others to cut spending and anticipate e!cess capacity, they will cut their own investment and
consumption as well. "ggregate demand will decline and the economy will e!perience a recession
due to self0fulfilling prophecy. Once the economy is depressed, producers and households have no
individual incentive to increase spending. .f all participants would agree to simultaneously increase
spending, then aggregate demand would rise and real output and real income would e!pand. +ach producer
and consumer would %e %etter off. >ut this mutually %eneficial outcome will not occur %ecause there is no
mechanism %y which to coordinate their actions.
1207 ?&ey 2uestion@ Kse an "40"6 graph to demonstrate and e!plain the price0level and real0output
outcome of an anticipated decline in aggregate demand, as viewed %y R+T economists. ?"ssume
that the economy initially is operating at its full0employment level of output.@ Then, demonstrate
and e!plain on the same graph the outcome, as viewed %y mainstream economists.
6ee the graph and the decline in aggregate demand from "4
1
to "4
(
. R+T view& The +conomy
anticipates the decline in the price level and immediate moves from a to d. 5ainstream view& The
economy first moves from a to % and then to c. .n view of historical evidence, the mainstream view
seems more plausi%le to us than the R+T view; only when aggregate demand shifts from "4
(
to
"4
1
will full0employment output 2
1
%e restored in the mainstream view.
()4
Disputes in Macro Theory and Policy

1201 $hat is an efficiency wage: =ow might payment of an a%ove0mar7et wage reduce shir7ing %y
employees and reduce wor7er turnover: =ow might efficiency wages contri%ute to downward
wage infle!i%ility, at least for a time, when aggregate demand declines:
"n efficiency wage is one that minimi8es the firm<s la%or cost per unit of output. Jormally, we
could assume that the mar7et wage for the particular type of la%or would %e efficient, since it is the
lowest wage that could %e paid to o%tain wor7ers in the classification. Birms may discover,
however, that paying a wage that is higher than the mar7et wage will lower their wage cost per unit
of output. There are a num%er of reasons for this possi%le outcome&
Birst, the a%ove average wage raises the opportunity cost of losing the 9o% and gives wor7ers
an incentive to retain their relatively high0paying 9o%. $or7er productivity is li7ely to %e
higher and in a sense the higher wage more than pays for itself.
6econd, motivated wor7ers re,uire less supervision. .f the firm needs fewer supervisory
personnel to monitor wor7 performance, the overall wage cost per unit of output can %e lower.
Third, the a%ove0mar7et pay discourages wor7ers from voluntarily leaving their 9o%s and the
lower turnover rate reduces the firm<s cost of hiring and training new wor7ers. .t also gives the
firm a %etter selection of potential wor7ers, since the a%ove0mar7et wage would increase
applications. $ith a high retention rate and a good pool of applicants, the firm is li7ely to
maintain a more e!perienced and productive wor7force.
+fficiency wages are li7ely to contri%ute to downward wage infle!i%ility. $age cuts may
encourage shir7ing, re,uire more supervising personnel and increased turnover. $age cuts that
reduce productivity and raise per0unit la%or costs are self0defeating.
1202 =ow might relationships %etween so0called insiders and outsiders contri%ute to downward wage
infle!i%ility:
.nsiders are wor7ers who retain employment even during recession. Outsiders are wor7ers laid off
from a particular firm and other unemployed wor7ers who would li7e to wor7 at that firm. .nsider0
outsider theory suggests that wages will %e infle!i%le downward even when aggregate demand
declines. +mployers seem to %elieve that hiring unemployed wor7ers at a reduced wage is not
worth the disruption it could cause the %usiness. .nsiders are already trained, 7now their 9o%s and
may wor7 in teams. Replacing them with outsiders may cost more than the saving in reduced
wages.
12013 Kse the e,uation of e!change to e!plain the rationale for a monetary rule. $hy will such a rule
run into trou%le if A une!pectedly falls %ecause of, say, a drop in investment spending %y
%usinesses:
()-
Disputes in Macro Theory and Policy
5A F GC. .f we assume that A ?velocity@ is constant, increasing the money supply at the same rate
as the anticipated increase in real output ?C@ would leave the price level ?G@ unchanged. .f velocity
is not sta%le and changes une!pectedly, a steady rate of growth of the money supply may not %e
sufficient to 7eep the economy on the desired path of non0inflationary growth of real output.
12011 "nswer ,uestions ?a@ and ?%@ on the %asis of the following information for a hypothetical economy
in year 1& money supply F O433 %illion; long0term annual growth of potential *4G F ) percent;
velocity F 4. "ssume that the %an7ing system initially has no e!cess reserves and the reserve
re,uirement is 13 percent. "lso assume that velocity is constant and the economy initially is
operating at its full0employment real output.
?a@ $hat is the level of nominal *4G in year 1:
?%@ 6uppose the Bed adheres to a monetary rule through open0mar7et operations. $hat amount of
K.6. securities will it have to sell to, or %uy from, %an7s or the pu%lic %etween years 1 and ( to
meet its monetary rule:
The e,uation of e!change 5A F GC allows us to calculate nominal *4G %y multiplying 5?433
%illion@ times A?4@.
?a@ nominal *4G is 1,/33 %illion in year 1
?%@ to achieve a )M growth rate, an increase in nominal *4G of 41 %illion, the money supply
would have to increase %y O1( %illion.
5A F 1,/41 ?41( 4@ F 1,/41.
"ssuming a 13M reserve re,uirement and all money in the form of %an7 deposits, a money
multiplier of 13 would suggest that the Bederal Reserve would need to purchase O1.( %illion in
K.6. *overnment securities in order to achieve the re,uired monetary growth over the course of the
year.
1201( +!plain the difference %etween active discretionary fiscal policy advocated %y mainstream
economists and passive fiscal policy advocated %y new classical economists. +!plain& The
pro%lem with a %alanced0%udget amendment is that it would, in a sense, re,uire active fiscal policy
N%ut in the wrong directionNas the economy slides into recession.
"ctive discretionary fiscal policy entails the use of deficit spending during recessions, that is,
increasing government spending, andPor cutting ta!es to e!pand aggregate demand and to use
contractionary fiscal policy, running a %udget surplus, all to ward off inflationary pressures when
necessary.
Jew classical economists, monetarists and rational e!pectationlists see the economy as
automatically self0correcting when distur%ed from its full0employment level of real output. They
are opposed to using discretionary fiscal policy to create %udget deficits or %udget surpluses.
5ainstream economists vigorously defend the use of %oth discretionary fiscal and monetary
policies. They %elieve that %oth theory and empirical data support the use of countercyclical
measures. Re,uiring an annually %alanced %udget would re,uire the use of fiscal policy that would
intensify the swings in the %usiness cycle, rather than help reduce variations in output.
1201) ?&ey 2uestion@ Glace 5OJ, R+T, or 5".J %esides the statements that most closely reflect
monetarist, rational e!pectations, or mainstream views, respectively.
a. "nticipated changes in aggregate demand affect only the price level; they have no effect on real
output.
%. 4ownward wage infle!i%ility means that declines in aggregate demand can cause long0lasting
recession.
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Disputes in Macro Theory and Policy
c. Changes in the money supply M increase 32; at first only 2 rises %ecause nominal wages are
fi!ed, %ut once wor7ers adapt their e!pectations to new realities, 3 rises and 2 returns to its
former level.
d. Biscal and monetary policy smooth out the %usiness cycle.
e. The Bed should increase the money supply at a fi!ed annual rate.
?a@ R+T;
?%@ 5".J;
?c@ 5OJ;
?d@ 5".J;
?e@ 5OJ.
12014 Qou have 9ust %een elected president of the Knited 6tates, and the present chairman of the Bederal
Reserve >oard has resigned. Qou need to appoint a new person to this position, was well as a
person to chair your Council of +conomic "dvisers. Ksing Ta%le 1201 and your 7nowledge of
macroeconomics, identify the views on macro theory and policy you would want your appointees to
hold. Remem%er, the economic health of the entire nationNand your chances for reelectionNmay
depend on these selections.
The appointments to chair the Bederal Reserve >oard and the Council of +conomic "dvisors would
depend on what coalition of interest groups contri%uted to my campaign and helped put me in
office.
" 4emocratic president is li7ely to appoint economists with a mainstream approach and who are in
favor of active fiscal and monetary policies. 6ince la%or unions may have contri%uted, supply
siders need not apply.
4uring the Reagan administration ?121101211@ supply side policies were implemented. One of the
first actions ta7en was to fire stri7ing air traffic controllers. #a%or unions were sha7en %y the
action, since they are usually most successful representing highly s7illed wor7ers and air traffic
controllers are among the most speciali8ed and s7illed wor7ers in the nation. This ris7y %ut
successful move set the tone for supply side policies which were designed to reduce the costs of
production, increase wor7er productivity and shift aggregate supply to the right. .n addition to
reducing the power of la%or unions the Reagan administration tried to reduce government
regulation of %usiness in many areas and cut marginal ta! rates in an effort to increase saving and
investment.
Conservative Repu%lican candidates for president are most li7ely to surround themselves with
economic advisers who are monetarists or rational e!pectationalists since %oth favor a reduced role
for government and would %e against the use of discretionary fiscal policy to manage aggregate
demand. >oth would favor the use of a monetary rule and reliance upon the mar7et system to %e
self0ad9usting.
12.1- ?4ast $ord@ Compare and contrast the Taylor Rule for monetary policy with the older, simpler
monetary rule advocated %y 5ilton Briedman.
The monetary rule advocated %y Briedman, the monetarist rule, is passive. .t re,uires consistent
e!pansion of money supply regardless of economic conditions. The Taylor rule is activist and
counter cyclical. .t allows the Bed to ad9ust the money supply and interest rates in e!pansionary or
contractionary fashion depending on economic conditions. =owever, it is similar to the monetarist
prescription %y stating the Bed<s policy changes precisely in response to a variety of economic
conditions.
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