I.Overview of Current theories
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 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 economicsstated emphasizes increasing aggregate supply rather than increasing aggregate demand.
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) A slow down to use excess inventory, which causes unemployment, was not necessary.
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
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.
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 due to uncertainty (when a recession is expected).
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: prices would adjust downward insuring all resources are fully employed.
a. Resource prices are inflexible downward meaning resource prices may not adjust and unemployment may persist.
b. Wages are sticky downward because of unions, monopoly power of corporations, and government policies.
4. As a result, government involvement may be required to keep AD high enough to maintain full employment.
Keynes argued against a return to the gold standard after the war.
wikipedia.org John_Maynard_Keynes
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.
VI. 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 Velocity of Money = Average Price Level X Number of Transactions
1. Velocity of money is how often the money supply is spent.
2. Number of transactions is 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 therefore 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.
1. Quantity Theory of Money? is a concise narrative.
2. Quantity theory of money - Wikipedia, explores the algebra.
3. The money-inflation connection: It's baaaack! from macroblog of the Atlanta Federal Reserve
VII. 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 Monetarism from The Concise Encyclopedia Of Economics and Monetarism
from the History of Economic Thought Website.
F. PRIVATIZE THE GAINS, SOCIALIZE THE LOSSES is a concise history of our 20th century monetary system.
from new school/money
VIII. New classical macroeconomics- wiki
A. Lead by Milton Friedman - wiki , these economists revived the quantity theory of money.
1. Milton Friedman Video on Greed from You Tube
2. Milton Friedman Video 30 minute interview on Open Mind
B. They rely on market forces and not government manipulation of aggregate demand and the money supply to 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. Instead, it assumes market participants will learn from experience and use current information to predict and
adjust to the 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 a moral problem and lower 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 visit New Classical Macroeconomics, by Robert King: The Concise
IX. 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, this theory is discussed in chapter 16.
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