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Chapter 19 – Current Issues in Macro Theory and Policy

CHAPTER NINETEEN

CURRENT ISSUES IN 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 don’t 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. This is true

in economics.

In this chapter we examine some of contemporary disagreements in macroeconomic theory and policy

design in the context of three interrelated questions: 1) What causes instability in the economy? 2) Is the

economy self-correcting? 3) Should government adhere to rules or use discretion in setting economic

policy?

WHAT’S NEW

There is a minor revision to the Learning Objectives.

There is a new Quick Review (QR 19.3) to help the students retain the appropriate information.

All relevant tables and graphs have been updated with current data.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to:

1. Give two reasons for macroeconomic instability according to mainstream economists.

2. Explain the equation of exchange.

3. Identify the single most important cause of macroeconomic instability according to the monetarists.

4. Explain the main reasons for macro economic instability according to the real-business-cycle

theory.

5. Construct an example to demonstrate a coordination failure.

6. Explain the view of self-correction held by mainstream economists.

7. List three reasons why a higher wage could result in greater efficiency.

8. Explain how insider-outsider relationships contribute to downward wage inflexibility.

9. Describe the monetary rule and explain why monetarists prefer it to discretionary monetary policy.

10. Compare the views of mainstream economists with monetarists and RET economists regarding the

use of discretionary fiscal policy and the need for an annually balanced budget.

11. Compare and contrast Taylor Rule with Monetary Rule advocated by monetarists.

12. Define and explain the terms and concepts listed at the end of the chapter.

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COMMENTS AND TEACHING SUGGESTIONS

1. This chapter illuminates basic disagreements and controversies in macroeconomic theory. Stress

that, despite the disagreements, there is considerable agreement about the basic macro concepts, the

tools of analysis, and the framework for discussion.

2. This may be a good time to reemphasize the difference between positive and normative economics.

Remind students that value judgments about the economy (i.e., which economic goals are

perceived to be most important) influence opinions about a particular economic policy, as much as

any empirical data.

3. Ask students to evaluate the last presidential election, or the views of new candidates vying for the

presidency. 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

available to make a judgment about the candidates’ opinions about economic policies?

4. Mainstream economists believe that nominal wages are inflexible downward because of labor

contracts, efficiency wages, and insider-outsider relationships. Have students interview a business

manager with first-hand experience in this area; or ask students to consider what kind of empirical

data they would need to collect to evaluate the flexibility or inflexibility of wages.

5. Arthur Okun published a work in the 1960s that is still a good basis for discussion, Equality and

Efficiency, the Big Tradeoff.

6. In discussing Rational Expectations Theory, the following “Concept Illustration” may be useful. It

appeared on the website for the previous edition in the “Analogies, Anecdotes, and Insights”

section.

Concept Illustration … Rational Expectations

The following story illustrates forward-looking behavior, which is part of the theory of rational

expectations.

When Lucas Sargent declared his college major, he sketched out a plan for his courses for the next

two or three years. He based his plan on the course requirements set out in the university catalog

and his expectation that these requirements would continue.

Also suppose that a very difficult, poorly designed course is required in Lucas’s major. Everyone is

complaining about the course, but since it is required, Lucas decides to stay with his plan and

Next, suppose that the word gets out that the faculty has voted to eliminate this requirement for the

major. This curriculum change, however, must go through university procedures and thus will not

be finalized until next year. Lucas visits with other students and concludes that this change will

most likely happen. He therefore changes his registration for the second term, substituting another

course for the one in question. Because many other students also opt out, registration for the

course plummets for the second term, surprising the faculty.

Lucas and the other students initially registered for this course based on a particular expectation

about the future: that the course would be required. The policy change produced a new expectation

about the future: that the course would no longer be required. This new expectation led students to

alter their present behavior. Lucas and his fellow students changed their current behavior based on

rational expectations.

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STUDENT STUMBLING BLOCK

This is not easy material for many students. Students may become frustrated when they consider more

than one point of view; many are looking for the “right” way to solve macroeconomic problems. It may

be helpful to point out that acceptance or rejection of a theory depends in part on 1) assumptions made

about economic behavior, and 2) opinions about which economic goals are most important for the

country.

LECTURE NOTES

I. Introduction:

A. Learning objectives – After reading this chapter, students should be able to:

1. Describe alternative perspectives on the causes of macroeconomic instability, including

views held by mainstream economists, monetarists, real-business cycle advocates, and

proponents of coordination failures.

2. Discuss why new classical economists believe the economy will “self-correct” from

aggregate demand and aggregate supply shocks.

3. Identify and describe the variations on the debate over “rules” versus “discretion” in

conducting stabilization policy.

4. Summarize the fundamental ideas and policy implications of mainstream

macroeconomics, monetarism, and rational expectations.

B. Contemporary disagreements on three inter–related questions are considered.

1. What causes instability in the economy?

2. Is the economy self-correcting?

3. Should government adhere to rules or use discretion in setting economic policy?

II. What Causes Macro Instability such as Great Depression, Recessions, Inflationary Periods?

A. Mainstream View: This term is used to characterize the prevailing perspective of most

economists.

1. Mainstream macroeconomics is Keynesian-based, and focuses on aggregate demand and

its components. C(a) + I(g) + X(n) + G = GDP (Aggregate expenditures) = (real output)

2. Any change in one of the spending components in the aggregate expenditure equation

shifts the aggregate demand curve. This, in turn, changes equilibrium real output, the

price level or both.

a. Investment spending is particularly subject to variation.

b. Instability can also arise from the supply side. Artificial supply restriction, wars, or

increased costs of production can decrease supply, destabilizing the economy by

simultaneously causing cost-push inflation and recession.

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B. Monetarist View: This label is applied to a modern form of classical economics.

1. Money supply is the focus of monetarist theory.

2. Monetarism argues that the price and wage flexibility provided by competitive markets

cause fluctuations in product and resource prices, rather than output and employment.

3. Therefore, a competitive market system would provide substantial macroeconomic

stability if there were no government interference in the economy.

a It is government that has caused downward inflexibility through the minimum wage

law, pro-union legislation, and guaranteed prices for some products as in agriculture.

b. Monetarists say that government also contributes to the economy’s business cycles

through clumsy, mistaken, monetary policies.

4. The fundamental equation of monetarism is the equation of exchange. MV = PQ

a. The left side, MV, represents the total amount spent [M, the money supply x V, the

velocity of money, (the number of times per year the average dollar is spent on final

goods and services)]

b. The right side, PQ, equals the nation’s nominal GDP [P is the price level or more

specifically, the average price at which each unit of output is sold x Q is the physical

volume of all goods and services produced (real output)].

c. Monetarists say that velocity, V, is stable, meaning that the factors altering velocity

change gradually and predictably. People and firms have a stable pattern to holding

money.

d. If velocity is stable, the equation of exchange suggests there is a predictable

relationship between the money supply and nominal GDP (PxQ).

5. Monetarists say that inappropriate monetary policy is the single most important cause of

macroeconomic instability. An increase in money supply will directly increase aggregate

demand, causing inflation during periods of full-employment.

6. Mainstream economists view instability of investment as the main cause of the

economy’s instability. They see monetary policy as a stabilizing factor since it can adjust

interest rates to keep investment and aggregate demand stable.

C. Real Business Cycle View: A third perspective on macroeconomic stability focuses on

aggregate supply. (See Figure 19.1)

1. The view that business cycles are caused by real factors affecting aggregate supply such

as a decline in productivity, which causes a decline in AS.

2. In the real-business cycle theory declines in GDP mean less demand for money. Here,

the supply of money is decreased after the demand declines. AD falls, but price level is

the same because AS also declined.

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D. Coordination Failures: A fourth view relates to so-called coordination failures.

1. Macroeconomic instability can occur “when people do not reach a mutually beneficial

equilibrium because they lack some way to jointly coordinate their actions.”

2. There is no mechanism for firms and households to agree on actions that would make

them all better off if such a failure occurs. The initial problem may be due to

expectations that are not justified, but if everyone believes that a recession may come,

they reduce spending, firms reduce output and the recession occurs. The economy can be

stuck in a recession because of a failure of households and businesses to coordinate

positive expectations.

E. Consider This…Too Much Money?

1. Mainstream view argues the recession of 2007 – 2008 was caused by AD shocks due to

the financial crisis which decreased investment and consumption spending.

2. Monetarists argue the recession was caused by too much money which contributed to low

interest rates and led to the housing bubble. The bursting of the housing bubble

decreased AD.

3. Most economists agree that the housing bubble led to the recession, but many factors

contributed to the housing bubble like loose monetary policy, foreign savings into the

U.S., “pass the risk” lending practices, etc.

III. Does the Economy “Self-Correct”?

A. New Classical View of Self-Correction

1. Monetarist and rational expectation economists believe that the economy has automatic,

internal mechanisms for self-correction.

2. Figure 19.2 demonstrates the adjustment process, which retains full employment output

according to this view.

3. The disagreement among new classical economists is over the speed of the adjustment

process.

a. Monetarists usually hold the adaptive expectations view of gradual change. The

supply curve shifts shown in figure 19.2 may take 2 or 3 years or longer.

b. Rational expectations theory (RET) holds that people anticipate some future

outcomes before they occur, making change very quick, even instantaneous.

i. Where there is adequate information, people’s beliefs about future outcomes

accurately reflect the likelihood that those outcomes will occur.

ii. RET assumes that new information about events with known outcomes will be

assimilated quickly.

4. In RET unanticipated price-level changes do cause temporary changes in real output.

Firms mistakenly adjust their production levels in response to what they perceive to be a

relative price change in their product alone. Any change in GDP is corrected as prices are

flexible and firms readjust output to its previous level.

5. In RET fully anticipated price-level changes do not change real output, even for short

periods. Firms are able to maintain profit and production levels.

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B. Mainstream View of Self-Correction

1. There is ample evidence that many prices and wages are inflexible downward for long

periods of time. However, some aspects of RET have been incorporated into the more

rigorous model of the mainstream.

2. Graphical analysis shown in Figure 19.2b demonstrates the adjustment process along a

horizontal aggregate supply curve.

3. Downward wage inflexibility may occur because firms are unable to cut wages due to

contracts and the legal minimum wage. Firms may not want to reduce wages if they fear

problems with morale effort, and efficiency.

4. An efficiency wage is one that minimizes the firm’s labor cost per unit of output. Firms

may discover that paying higher than market wages lowers wage cost per unit of output.

a. Workers have an incentive to retain an above-market wage job and may put forth

greater work effort.

b. Lower supervision costs prevail if workers have more incentive to work hard.

c. An above-market wage reduces job turnover.

5. Some economists believe wages don’t fall easily because already employed workers

(insiders) keep their jobs even though unemployed outsiders might accept lower pay.

Employers prefer a stable work force.

IV. Rules or Discretion?

A. Monetarists and other new classical economists believe that policy rules would reduce

instability in the economy.

1. A monetary rule would direct the Fed to expand the money supply each year at the same

annual rate as the typical growth of GDP. (See Figure 19.3)

a. The rule would tie increases in the money supply to the typical rightward shift of

long-run aggregate supply, and ensure that aggregate demand shifts rightward along

with it.

b. A monetary rule, then, would promote steady growth of real output along with price

stability.

c. The Taylor rule, introduced in Chapter 16, specifies how and when the Fed should

change the Federal funds rate (see Last Word for further discussion).

2. A few economists favor a constitutional amendment to require the federal government to

balance its budget annually.

a. Others simply suggest that government be “passive” in its fiscal policy and not

intentionally create budget deficits of surpluses.

b. Monetarists and new classical economists believe that fiscal policy is ineffective.

Expansionary policy is bad because it crowds out private investment.

c. RET economists reject discretionary fiscal policy for the same reason they reject

active monetary policy. They don’t believe it works because the effects are fully

anticipated by private sector.

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B. Mainstream economists defend discretionary stabilization policy.

1. In supporting discretionary monetary policy, mainstream economists argue that the

velocity of money is more variable and unpredictable, in short run monetary policy can

help offset changes in AD than monetarists contend.

2. Mainstream economists oppose requirements to balance the budget annually because it

would require actions that would intensify the business cycle, such as raising taxes and

cutting spending during recession and the opposite during booms. They support

discretionary fiscal policy to combat recession or inflation even if it causes a deficit or

surplus budget.

C. The U.S. economy has been about one-third more stable since 1946 than in earlier periods.

Discretionary fiscal and monetary policies were used during this period and not before. This

makes a strong case for its success.

D. A summary of alternative views presents the central ideas and policy implications of four

main macroeconomic theories: Mainstream macroeconomics, monetarism, rational

expectations theory and supply side economics. (See Table 19.1)

E. Consider This … On the Road Again

Keynesian Abba Lerner compared the economy to a car without a steering wheel, and that the

prudent addition and use of a steering wheel (discretionary fiscal and monetary policy) would

stabilize the macroeconomy. Monetarist Milton Friedman argued that the steering wheel

already exists, and that discretionary use of monetary policy by the Fed keeps jerking on it,

causing the car (the macroeconomy) to swerve. If the Fed would just hold the steering wheel

steady, the macroeconomy would be stable.

V. LAST WORD: The Taylor Rule: Could a Robot Replace Ben Bernanke?

A. Macroeconomist John Taylor of Stanford University calls for a new monetary rule that would

institutionalize appropriate Fed policy responses to changes in real output and inflation. (We

first saw the Taylor rule in Chapter 16)

B. Traditional “monetarist rule” is passive. It required Fed to expand money supply at a fixed

annual rate regardless of economic conditions.

C. “Discretion” is associated with the opposite: an active monetary policy where Fed changes

the money supply and interest rates in response to changes in the economy or to prevent

undesirable results.

D. Taylor’s policy proposal would dictate active monetary actions that are precisely defined. It

combines monetarism and the more mainstream view.

E. Taylor’s rule has three parts:

1. If real GDP rises 1% above potential GDP, the Fed should raise the Federal funds rate by

0.5% relative to the current inflation rate.

2. If inflation is 1% above its target of 2%, the Fed should raise Federal funds rate by 0.5%

above the inflation rate.

3. If real GDP equals potential GDP and inflation is 2%, the Federal funds rate should be

about 4% implying real interest rate of 2%.

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F. Taylor would retain Fed’s power to override rule, so a robot really couldn’t replace the Board.

But a rule increases predictability and credibility.

G. Critics of the proposal see no reason for this rule given the success of monetary policy in the

past decade. A monetary rule would unnecessarily constrain Fed action.

QUIZ

1. The idea that business fluctuations are primarily caused by factors affecting aggregate supply

rather than aggregate demand is a central tenet of:

A. Efficiency wage theory

B. Real-business-cycle theory

C. Mainstream economics

D. Monetarism

2. The equation of exchange indicates that:

A. MQ equals VP

B. The velocity of money and the supply of money vary proportionately with one another

C. Other things being equal, an increase in V will increase P and/or Q

D. Other things being equal, M and P are inversely related

3. According to mainstream economists, which will contribute to the downward inflexibility of

wages when aggregate demand declines?

A. A monetary rule

B. Price-level surprises

C. Insider-outsider relationships

D. Changes in the velocity of money

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4. From a monetarist perspective, a contractionary fiscal policy might be offset by:

A. The buying of government securities by the Federal Reserve

B. The selling of government securities by the Federal Reserve

C. An increase in reserve ratios

D. An increase in the discount rate

5. Monetarists believe that:

A. prices and wages are inflexible or sticky.

B. both product and resource markets are monopolistic.

C. velocity is relatively stable.

D. the economy is more stable when active fiscal and monetary policy is used.

6. The velocity of money is the:

A. relationship between the money supply and the price level.

B. number of times per year the average dollar is spent on final goods and services.

C. relationship between asset and transactions demands for money.

D. price level divided by aggregate supply.

7. According to real business cycle theory:

A. monetary factors affecting aggregate demand cause macroeconomic instability.

B. recessions result from declines in long-run aggregate supply, rather than decreases in

aggregate demand.

C. when real wages fall during recessions, “real” unemployment rates rise.

D. the net long-run costs of business fluctuations are severe.

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8. In new classical economics, the change in output caused by a “price-level surprise”:

A. is shown as a shift of the long-run aggregate supply curve.

B. does not alter the rate of unemployment, even in the short-run.

C. is soon reversed through a shift of the short-run aggregate supply curve.

D. permanently changes the rate of unemployment.

9. The crowding-out effect refers to the possibility that:

A. when used simultaneously, expansionary fiscal and monetary policies are counterproductive.

B. the asset demand for money varies inversely with the interest rate.

C. deficit financing will increase the interest rate and reduce investment.

D. an increase in the supply of money will result in a decline in velocity.

10. Mainstream economists contend that, as stabilization tools:

A. discretionary fiscal policy is effective, but discretionary monetary policy is not.

B. discretionary monetary policy is effective, but discretionary fiscal policy is not.

C. both discretionary fiscal policy and monetary policy can be effective if appropriately used.

D. discretionary fiscal policy and discretionary monetary policy cause more instability than they

cure.

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