Monetarism vs. Keynesian Economics: Comparing Output and Employment Determinants - Prof. M, Study notes of Economics

Download Monetarism vs. Keynesian Economics: Comparing Output and Employment Determinants - Prof. M and more Study notes Economics in PDF only on Docsity! Chapter 9: The Monetarist Counterrevolution 9.1: Monetarist Propositions Below are listed four propositions that characterize the monetarist position 1. The supply of money is the dominant influence on nominal income 2. In the long run, the influence of money is primarily on the price level and other nominal magnitudes. In the long run real variables, such as output and employment, are determined by real, not monetary, factors 3. In the short run , the supply of money does influence real variables. Money is the dominant factor causing cyclical movements in output and employment 4. The private sector is inherently stable. Instability in the economy is primarily the result of government policies The central policy that follows from these propositions is that stability in the growth of money supply is crucial for a stable economy. Monetarists believe that such stability is best achieved by adopting a rule for monetary policy The second monetarist proposition from above asserts that, in the long run, economic activity measured in real dollars does not depend on the quantity of money. In the long run, real output is determined by real factors such as stock of capital goods, the size and quality of the labor force, and the state of technology The third proposition from above states that, in the short run, output and employment ARE strongly influenced by changes in the supply of money 9.2: the Reformulation of the Quantity Theory of Money The monetarist are showing how the Velocity of money is not constant as is was before with Keynes model. (page 194) They are showing how VELOCITY VARIES POSITIVELY WITH THE INTEREST RATE 1. Contrary to the early Keynesians, Friedman argued that the demand for money was stable 2. Contrary to the near liquidity trap characterization, Friedman maintained that the interest elasticity of money demand was certainly not infinite and was in fact "rather small" 3. "The quantity of money, far from being unimportant, was the dominant influence on the level of economic activity PAGE 198 HAS THE EXPLANATION OF ALL THE DIFFERENCED BETWEEN FREIDMANS THEORY AND THE OTHER ONES BUT IT IS KIND OF CONFUSING Friedman's money demand function can be written as follows Md = L(P,Y, rb, re, rd) P = price level Y = real income Rb = nominal interest rate on bonds Re = nominal return on equities Rd = nominal return on durable goods Money demanded is assumed to depend on nominal income, the product of the first two arguments in the demand function. An increase in nominal income would increase money demanded. FOR A GIVEN LEVEL OF NOMINAL INCOME, FRIEDMAN ASSUMES, AS DID KEYNES, THAT THE AMOUNT OF MONEY DEMENDED DEPENDS ON THE RATE OF RETURN OFFERED ON ALTERNATIVE INVESTMENTS These other assets are 1. Bonds 2. Equities 3. And durable goods The difference between Friedman and Keynes 1. Friedman views the money demand function as stable 2. Friedman does not segment money demand into components representing transaction balances, speculative demand, and precautionary demand. Money like other "goods," had attributes that make it useful, but Friedman does not find it helpful to specify separate demands based on each of the uses of money 3. Friedman includes separate yields for bonds, equities, and durable goods Friedman's money demand theory can be used to restate the Cambridge equation as follows Md = k(rb, re, rd)PY In Friedman's view a quantity theorist belivies the following 1. The money demand function is stable 2. This demand function plays an important role in determining the level of economic activity 3. The quantity of money is strongly affected by money supply factors With a stable money demand function, an exogenous increase in the money supply must either lead to a rise in PY or cause declines in rb, re, and rd (which will cause k to rise), with indirect effects on PY Friedman's equation can again be rewritten as PY = (1/k)(m) Chapter 10 Output, Inflation, and unemployment In chapter 9 we analyzed the monetarist proposition that short-run changes in the money supply are the primary determinant of fluctuations in output and unemployment In the long run the influence of money is primarily on the price level and other nominal magnitudes. In the long run, REAL variables, such as real output and employment, are determined by real, not monetary, factors. Hysteresis - it property that when a variable is shocks away from an initial value, it shows no tendency to return even when the shock is over. Persistently high unemployment rates in many European countries have led economists to argue that unemployment exbits hysteresis Chapter 11 Keynesian really wants the government to be stabilized by aggregate demand management The central policy of the NEW CLASSICAL economics is that the stabilization of real variable, such as output and employment, cannot be achieved by aggregate demand management New Classical Policy Ineffectiveness Proposition - asserts that systematic monetary and fiscal policy actions that change aggregate demand will NOT affect output and employment even in the short run. This is the exact opposite of what the Monetarist believe Pretty much all that Keneysians said was that in the short run you can increase output and labor but in the long run it is all just going to stay the same Keynesians and Monetarists have said that labor suppliers form and expected price by looking at past behavior of prices. New classical economists say that is stupid NCE say people choose based on rational expectations I think later n he mentions that this is bullshit because there is no way that the average citizen uses all information to make an informed descion because that would take up way too much time Rational Expectations - expectations formed on the basis of all available relevant information concerning the variable being predicted. Moreover economic agents are assumed to use available information intelligently: that is they understand the relationships between the variables they observe and the variables that they are trying to predict The crucial difference between the new classical case and the Keynesian case concerns the variables that determine the positions of the labor supply and aggregate supply schedules Increases in the expected price level will shift both schedules to the left The expected price level depends on the expected level of the variables in the model that actually determine the price level. These include the expected levels of the money supply (Me), government spending (Ge) and tax collections (Te), and autonomous investment (Ie) In the Keynesian or monetarist analysis, the increase in the money supply leads to an increase in employment and output in the short run - that is, until labor suppliers correctly perceive the increase in the price level that results from the monetary policy action Says that any set of systematic policy actions will be anticipated and will not affect the behavior of output or employment. There was some other random stuff in that section but it can really just be seen by looking at the graph 11.2 A broader View of the New Classical Position New classical economists are critical of Keynesian economies as a whole Say that the Keynesian system was based off individual optimizing behavior. The Keynesian model is, in their view, made up of ad hoc elements, which were failed attempts to explain the observed behavior of the economy in the aggregate. As we learned in Speech class ad hoc means that one event occurred after another, and claiming that the first event cause the second event, even though that might not be true. An example is saying that pickles cause death. The fact is that yes, everybody that has ever eaten a pickle has died or will die, but just because a person eats a pickle does not mean that they will die New classicalist do not think that the market has sticky wages. I that the markets do have sticky wages though because there are tings like contracts that ensure people money. They favor the classical view that markets, including the labor market, clear, that is, prices, including the money wage rate, move to equate supply and demand 1. Agents optimize 2. Markets clear This is a pretty stupid view Recall that the classical AS curve is vertical Classicalist believed in perfect information but New classicalist believe in rational expectations. In this case systematic, and hence anticipated, changes in AD will not affect output and employment, but unanticipated changes in aggregate demand will 11.3 The Keynesian Counter critique Keynesians argue that although unanticipated declines in AD might be plausible for brief departures from potential output and employment, it is not adequate to explain persistent and substantial deviations that we have experienced Says that yes over a period of a year these changes would be anticipated, but by the next year decline in AD would be apparent and not longer unanticipated Keynesian also argues the assumption that individuals use all available relevant information in making their forecasts. Such assumption ignores the costs of gathering information Auction market - In the classical view the money wage is assumed to adjust quickly to clear the labor market Contractual view - In the Keynesian labor market wages are not set to clear markets in the short run, but rather are stronglt conditioned by londer term considerations involving employer - worker relations Keynesians view te labor market as one in which long-term arrangments are made between buyers and sellers. In general such relationships fix the money wage while leaving the employer free to adjust hours worked over the course of contracts Chapter 12 Real business cycle theory is an outgrowth of the new classical theory, which in turn built on the original classical economics. In fact, real business cycle models are sometimes referred to as second generation of nre calssical models Recall that new classical economists believe macroeconomic models should have two characteristics 1. Agents optimize 2. Markets Clear Real Business Cycle theorists agree RBC focuses on individual optimization Keynesian - has involuntary unemployment New Classical and RBC - All unemployment is voulantary Where RBC differ with NC is on the causes of fluctuations in output and employment RBC see these fluctuations as arising from variations in the real opportunities of the private economy. Factors that cause such change include shocks to technology, variations in environmental conditions, changes in the prices of imported raw materials and changes in tax rates. Fluctuation's in output also occur with changes in individuals preferences. These are the same factors that determined output in the classical model RBC says that supply side variables are also the source of short run changes in output and employment Monetary Policy The defining fwture of RBC models is that real, not monetary, factors are responsible for fluctuations in outputand employment. In BBC models, the role of money is to determine the price level, much the same as in the original classical model. Changes in the quantity of money result in proportionate changes in the price level with no change in output or employment. This means that monetary policy should focus on controlling the price level Many fiscal policy actions will affect output and employment in a RBC. The effect will be caused by supply side Outsiders (those who want jobs) do not. Recessions cause insiders to become outsiders. After the recession, with fewer insiders, the real wage rises and unemployment persists. It is a hypothesis that present unemployment is strongly influenced by past unemployment. Economies can get stuck in EMPLOYMENT TRAPS Hysteresis - just another term for EMPLOYMENT TRAPS A variable exhibits hysteresis if, when shocked away from an initial value, it shows no tendency to return even when the shock is over It is a trap because once insiders become outsiders, they have no bargaining power over the real wage and the people on the inside have no real reason to help them since the people on the inside are now getting paid more money. Chapter 13: Macroeconomic Models: A Summary There are some great graphs on page 265 Classical Model  Views output as completely determined by supply factors  Has a vertical aggregate supply schedule  Both labor supply and labor demand depend only on the real wage, which is known to all market participants  The money wage is perfectly flexible and moves to equate demand and supply in the labor  Increases in AD cause the price level to rise  The price rise spurs production  To clear the labor market the money wage has to rise proportionally with the price level  This causes the real wage to be unchanged in the new equilibrium  The role of AD is to determine the price level  They use the quantity Theory of money o Cambridge form is M = kPY  If there is an excess supply of money, a corresponding excess demand for commodities will drive up the aggregate price level Real Business Cycle  Is a modern version of the classical theory  Output and employment are determined by real variables  The labor market is always in equilibrium  All unemployment is voluntary  Role of money is to determine the price level Keynesian model  This is the antithesis of the classical model and RBC  Supply plays no role in output determination  The aggregate supply schedule is horizontal, indicating that supply is no constraint on the level of production  On the demand side the model concentrates on the determinants of autonomous expenditures: government spending, taxes, and autonomous investment demand  Money factors are neglected  Aggregate Demand is important for determining employment  The modern Keynesian model allows for the influence of both supply factors on output and monetary factors on aggregate demand  Keynesian aggregate supply slopes upward to the right  In the short run, an increase in the price level will cause firms to supply a higher level of output because the money wage will not rise proportionally with price.  They say that there is wage and price stickiness There are two important differences between the Keynesian and Classical frameworks 1. In the classical model, output and employment are completely supply - determined, whereas in the Keynesian theory in the short run, output and employment are determined jointly by aggregate supply and demand. In the Keynesian system, aggregate demand is an important determinant of output and employment 2. Aggregate demand in the classical model is determined soely by the quantity of money. In the Keynesian system, money is only one of several factors the determine aggregate demand Monetarists  Have taken the Cambridge version of the quantity equation  Both monetarist and Keynesians have the AS sloping upward to the right in the short run New Classical  Believe that systematic, and therefore predictable, changes in aggregate demand will not affect real output. Such changes will be anticipated by rational economic agents  Unanticipated changes in AD, for example an increase ein the money supply that could not have been predicted will shift the AD schedule without shifting the AS schedule  Unanticipated changes in AD will cause labor suppliers to make price forecast effors and will therefore affect output and employment Keynesians seem to be the only ones who like policy interventions Might want to take another look at page 268 and 269 If every single food is the same color, I have fucked up. Itlatin and Irish Chapter 14: Exchange Rates and the International Monetary System The U.S economy has become much more open in the sense of having more extensive trade and financial dealings with other economies Balance of Payments Accounts - records economic transactions between U.S and foreign residents, both in goods and assets 14.1 Balance of Payments Accounts Export = credit Import = Debit Merchandise trade balance - measures exports minus imports in the U.S balance of payments. RIGHT NOW IT IS A DEFICIT Current Account - In the U.S balance of payments this is a record of U.S merchandise exports and imports as well as trade in services and foreign transfer payments. Capital Account - in the balance of payments is a record of purchases of U.S assets by foreign residents and purchases of foreign assets by U.S residents Statistical discrepancy - Because not all international economic transactions are properly recorded, the statistical discrepancy is the amount that must be added to make the total balance of payments balance of payments balance Official reserve assets - holdings of gold, special drawing rights, and foreign currency holdings 14.2 Exchange rates and the market for Foreign Exchange Foreign Exchange - a general term to refer to an aggregate of foreign currencies To see the link between the balance of payments accounts and transactions in the foreign exchange market, we begin by recognizing that all expenditures by U.S residents on foreign goods, services, or assets and all foreign transfer payments also represent demands for foreign currencies - that is demand for FOREIGN EXCHANGE Thus the total U.S residents expenditure abroad represents a demand for foreign exchange. The primary determinants of capitla flows between nations are expected rates of return on assets in each of the countries. With a fixed exchange rate system, the effects of expected exchange rate movements on asset returns can be ignored Interest rates in the various countries will be measures of realtive rates of return. If we take the rate of return in other countries as given, the level of the capital flow into a particular country will depend positively on the level of its interest rate ®; that is F = F® F = net capital inflow ( a negative value of of F represents a net outflow of deficit on capital account. This means that the capital account will therefore depend on how the interest rate varies with the change in economic activity Expansionary monetary policy  Lowering rate of interest  Unfavorable to the balance on the capital account  Investment in U.S by foreigners will decline  U.S investment abroad will increase  TB and capital account will deteriorate Expansionary fiscal policy  Interest rate will rise  Increase in capital inflow  Whether the overall effect on the BoP is favorable or unfavorable depends on the relative strength of these two effects of the fiscal policy - induced expansion: the favorable effect on the capital account or the unfavorable effect on the trade balance UNLESS THE ECONOMY IS FAR FROM FULL EMPLOYMENTEXPANSIONARY AGGREGATE DEMAND POLICIES WILL CAUSE THE PRICE LEVEL TO RISE Exchange Rate Flexibility and Insulation from Foreign Shocks A foreign recession results in a fall in exports and a shift to the left in the supply of foreign exchange. With a fixed exchange rate system, there will be a BoP deficit. In a flexible exchange rate system, the exchange rate will rise to clear the foreign exchange market Arguments for Fixed Exchange Rates  Provide a more stable environment for growth in world trade and international investment  More macroeconomic stability Here are some flaws in a fluctuating exchange rate However there is volatility in a fluctuating exchange rate poses a risk to a domestic exporter or an investor who plans a foreign investment, such as a plant in another country People also argue that a fluctuating exchange rate swings, and adjustment costs - exchange rate fluctuations would cause resources to be shifted into and out of export industries, with consequent adjustment cost, including frictional unemployment Last argument against is that a fluctuating exchange rate would lead to destabilizing speculation in foreign exchange markets. The last couple of sections dealt with certain years that the dollar has fluctuated in and did not really focus on any theory and again the class notes did not show any reference to this. Chapter 15 Monetary and Fiscal Policy in the Open Economy 15.1 the Mundell-fleming This chapter just has a few equations that suck The BP schedule will be upward sloping in the case of the imperfect capital mobility If domestic and forigen assets were perfect substitutes a situation called pefect capital mobility , investors would move to equalize interest rates among countries