Macroeconomic Viewpoints: ClassicalKeynesianMonetaristNew ClassicalNew Keynesian

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Classical Economics: Laissez - Faire

Real GDP is determined by aggregate supply

The equilibrium price level is determined by the money supply.

Full employment is the normSupply creates its own demand

– The classical view prevailed before the Great Depression.

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The Classical Model

•Real GDP is determined by aggregate supply

•The price level is determined by aggregate demand.

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Keynesian Economics: Economic ActivismJohn Maynard Keynes, The General Theory of Employment, Interest, and Money (1936)

Emphasizes aggregate demand in determining GDP and employment.

Assumes fixed prices (horizontal AS) at relevant levels of GDP. inflation is not a risk when unemployment is

high. Government must stabilize an inherently

unstable macroeconomy – Use demand management policies

• Fiscal policy• Monetary policy

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The Fixed-Price Keynesian Model

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Monetarism: Return to Laissez - FaireMilton Friedman, Studies in the Quantity Theory of Money (1956) _______________, The Role of Monetary Policy (1968)

Emphasizes role of money supply in determining real GDP and price level.

Business cycles are largely the result of discretionary monetary policy

Monetary mischiefActivist policy is wrong:

Too Much Too Late

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Monetarism: Return to Laissez-Faire

Efforts to increase real GDP through expansionary monetary policy

Accelerating Inflation. “Inflation is everywhere and at all

times a monetary phenomenon.”Economic policy operates with long and

variable lagsaccurate timing nearly impossible.

Don’t mess with the macroeconomy

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Long and Variable Policy Lags

– 1. Recognition Lag: policymakers need time to realize that there is a problem.

– 2. Reaction Lag: they need time to formulate an appropriate policy response.

– 3. Effect Lag: policy takes time to implement and work through the economy.

Countercyclical policies can become procyclical policies, worsening fluctuations

Don’t mess with the macroeconomy

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New Classical Economics: Policy IneffectivenessArose in the 1970s in response to

stagflation.Wages and prices are perfectly flexible.

Markets are always in equilibrium.Markets work!

Expectations are rational only unexpected changes in policy

can affect output and employment.– Changes in real GDP result from

unexpected changes in the prices level.

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New Classical “Policy”Most observed unemployment is

voluntary.Only unanticipated policies can have any

effect. “policy ineffectiveness proposition”.

Therefore, attempt no activist policy. Follow predictable and stable monetary and

fiscal policies for long run employment and price stability.

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New Classical Economics

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New Keynesians: Policy Can Work Incorporate rational expectations But prices and wages are “sticky” in short run.

Disequilibrium prevails.– Price-wage stickiness: impediments to

adjustment exist (contracts, adjustment costs, etc.)

Activist policies can work – Stabilize the economy/make things better!– The private sector is an important source of

shifts in aggregate demand.– Monetary and fiscal policies should be used to

offset drops in private sector spending.

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The Modern Keynesian Model