Disputes over Macro Theory and Policy [ Internet-Only chapter ]
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- In classical economics the aggregate supply curve is vertical and establishes the level of real output, while
the aggregate demand curve is generally stable and establishes the price level. In this view the economy is
- In Keynesian economics the aggregate supply curve is horizontal at less-than-full-employment levels of
real output, while the aggregate demand curve is inherently unstable. In this view the economy is highly
- The mainstream view is that macro instability is caused by the volatility of investment spending, which
shifts the aggregate demand curve. If aggregate demand increases too rapidly, demand-pull inflation may
occur; if aggregate demand decreases, recession may occur. Occasionally, adverse supply shocks also cause
- Monetarism focuses on the equation of exchange: MV = PQ. Because velocity is thought to be stable,
changes in M create changes in nominal GDP (= PQ). Monetarists believe that the most significant cause of
macroeconomic instability has been inappropriate monetary policy. Rapid increases in M cause inflation;
insufficient growth of M causes recession. In this view, a major cause of the Great Depression was inappropriate
monetary policy, which allowed the money supply to decline.
- Real-business-cycle theory views changes in resource availability and technology (real factors), which alter
productivity, as the main causes of macroeconomic instability. In this theory, shifts in the economy's longrun
aggregate supply curve change real output. In turn, money demand and money supply change, shifting
the aggregate demand curve in the same direction as the initial change in long-run aggregate supply. Real
output thus can change without a change in the price level.
- A coordination failure is said to occur when people lack a way to coordinate their actions in order to achieve
a mutually beneficial equilibrium. Depending on people's expectations, the economy can come to rest at
either a good equilibrium (non-inflationary full-employment output) or at a bad equilibrium (less-than-fullemployment
output or demand-pull inflation). A bad equilibrium is a result of a coordination failure.
- The rational expectations theory (RET) rests on two assumptions: (1) With sufficient information, people's
beliefs about future economic outcomes accurately reflect the likelihood that those outcomes will occur; and
(2) markets are highly competitive, and prices and wages are flexible both upward and downward.
- New classical economists (monetarists and rational expectations theorists) see the economy as automatically
correcting itself when disturbed from its full-employment level of real output. In RET, unanticipated
changes in aggregate demand change the price level, which in the short run leads firms to change output.
But once the firms realize that all prices are changing (including nominal wages) as part of general inflation
or deflation, they restore their output to the previous level. Anticipated changes in aggregate demand produce
only changes in the price level, not changes in real output.
- Mainstream economists reject the new classical view that all prices and wages are flexible downward. They
contend that nominal wages, in particular, are inflexible downward because of several factors, including
labour contracts, efficiency wages, and insider-outsider relationships. This means that declines in aggregate
demand lower real output, not only wages and prices.
- Monetarist and RET economists recommend a monetary rule according to which the central bank is directed
to increase the money supply at a fixed annual rate equal to the long-run growth of potential GDP. They also
support maintaining a "neutral" fiscal policy, as opposed to using discretionary fiscal policy to create budget
deficits or budget surpluses. A few monetarists and RET economists favour a constitutional amendment that
would require the federal government to balance its budget annually.
- Mainstream economists oppose a monetary rule and a balanced-budget requirement and vigorously defend
discretionary monetary and fiscal policies. They say that both theory and evidence suggest that such policies
are helpful in achieving full employment, price stability, and economic growth.