CHAPTER 7 THE CLASSICAL MODEL THE KEYNESIAN REJOINDER

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Oct 28, 2013 (3 years and 11 months ago)

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45

CHAPTER
7

THE CLASSICAL MODEL




THE KEYNESIAN REJOINDER



There are several alternative theories or models available to explain the way macro
-
economies
function with different implications for government economic policy. There is far more
disagreement in

this area of macroeconomics than we ever saw in microeconomics


this is why
different analysts in government and the media say completely contradictory things about what
the government should do even if they agree about the current state of the economy.

We will
examine each of the major economic theories that has influenced economic thought and/or
government policy in the US over the course of the last 100 years.


In the late 1800s and early 1900s American economic theory in both microeconomics and
macro
economics was dominated by Classical theory. Classical economic theory largely came
from the study of individual market behavior in microeconomics and its macroeconomic theory
was based on the contention that market based economies are just an amalgamatio
n of individual
markets and, therefore, the same behavioral patterns prevail. Classical economics viewed
markets as incredibly powerful and efficient mechanisms that could not be improved upon by any
intervention; as a consequence, they strongly urged
lai
ssez
-
faire
policy by the government


that
the government should leave the economy alone and let it work properly.



The Assumptions of the Classical Model



An economic model is based on certain conditions or assumptions; it is important to examine
these
to understand why the theory makes the conclusions that it does. The assumptions of a
model function as its foundation and flaws in the foundation undermine the structural integrity of
the building. Flaws in a model’s assumptions undermine the accuracy o
f the model itself. The
main assumptions of the Classical model are as follows.


Markets are highly competitive:
If markets are highly competitive, than no one can hold a
market off its full employment equilibrium. Firms competing with each other will h
ave to make
the best product they can for the lowest acceptable price


any firm trying to take advantage of
consumers by selling an inferior product for an inflated price will just lose its customers to other
firms. Price will, therefore, always reflect
the minimum efficient cost of making the good. As
long as consumer benefit is high enough to justify paying for the good, they will keep buying it
and we will keep making it. Consequently, if individual markets do this, all the markets together
will
-

we

will make the socially optimal level of production, i.e. full employment.


Wages and prices are completely flexible:
Wages and prices will rapidly adjust to reflect
supply and demand in the labor and goods markets. If producers are making more output th
an
consumers want, price will simply fall until the quantity demanded and quantity supplied for
goods are equal. If workers are unable to find enough jobs, wages will simply fall until the
quantity demanded and quantity supplied for labor are equal. Wage
s and prices adjust to keep the
full employment level of goods selling and the full employment level of labor working.
Furthermore, this adjustment is so rapid that an economy left alone will not experience any
significant period of unemployment or fallin
g production. This adjustment process is one of the
powerful self
-
correcting mechanisms in the Classical model.


46

Savings will always equal investment:
The act of producing national output also generates
national income and the national income is used to b
uy the national output. These two values
must be equal since the value produced always belongs to someone (consider them GDP by the
expenditures approach and GDP by the cost/income approach


with no measurement error the
two would always be equal). So a
s long as the national income spent is equal to the national
output available, there will not be unsold goods or unfulfilled demand. The Classical economists
said that it always will, a belief presented as
Say’s Law



supply creates its own demand


the
act
of making national output will always generate the right amount of income to buy the output. We
can, therefore, sustain the economy at full employment.






=






Some people pointed out a potential problem


consumers do not spend their enti
re income they
save part of it


won’t that cause the amount of national income spent to be too small to buy all
the output we have made? No, the Classical economists said, because businesses don’t intend to
sell all their output to consumers anyway. To
keep the analysis simple, imagine the economy
only has consumers and businesses in it so there is only consumer spending or consumption(C)
and business spending or investment (I). When businesses invest, what they are actually doing is
withholding goods a
nd services from the household sector


they are keeping part of national
output to themselves. When consumers save, they are withholding purchasing power from the
business sector


they are keeping part of national income to themselves. As long as busin
ess
investment is equal to consumer saving, we will still see the economy maintain equilibrium at full
employment.







Suppose that business withhold 10% of the value produced for their own uses, leaving 90%
available for co
nsumers. If consumers withhold 10% of value earned for savings, leaving 90%
available to buy goods and services, then we have a balance between quantity of national output
demanded and quantity supplied. Consumers will buy all the output available to the
m and
businesses take the remaining


both sides achieved the share of national output they were trying
to acquire. There is no reason for production or employment to shift.

Nat’l
=
lutput
=
=
Nat’l
=
䥮come
=

47

This sets up the situation where consumption and investment automatically correct

for each other,
maintaining the economy at the natural rate of output. Suppose that full employment equilibrium
is at $100 billion dollars which initially is comprised of $10 billion in investment and $90 billion
in consumption. Now, what would happen i
f consumers for some reason reduced their spending
to $80 billion dollars? When consumers spend less they must be saving more


we can examine
this in a supply and demand analysis of the credit market.


In a simple economy the supply of loanable
funds i
n the credit market is the net savings
of households (amount households save
minus what they borrow). Higher levels of
interest can encourage households to save
more since they will earn more income on
each dollar saved.


The demand for loanable funds is
the
investment borrowing of businesses (since
we have already netted out household
borrowing). Higher levels of interest
discourage investment since fewer projects
will be profitable when the company must
pay more for the loans.



Consumer spending fell t
o $80 billion so savings must have risen to $20 billion. A rise in
consumer saving shifts the supply curve to the right, depressing interest rates until firms are
willing to borrow the same level of funds that households are providing. Investment borrowi
ng
will then rise to $20 billion as well. Remember, savings must equal investment.



Here we see the original level of
consumption ($90B) and investment ($10B)
where the economy was at full employment.
After consumers drop their spending
businesses MUST

borrow an amount equal
to savings which means that investment rises
to make up for the missing consumption.
The economy remains at full employment.
Since all markets rapidly adjust to
equilibrium, including the credit market,
there is only the shortest
period of time until
investment has reestablished the natural rate
of output. Consumption and investment
corrected for each other.


Velocity of money is constant:
As we saw in chapter seven, the velocity of money is the speed
at which money circulates in

the economy and is equal to the nominal GDP divided by money
supply. This can be rearranged into the following:



Money Supply x V = Nominal GDP


48

Nominal GDP can be further broken down into its component parts


the price level and real
GDP. Nomina
l GDP is the actual output made (real GDP) times the prices it sells at.



Money Supply x V = P x Y



If the velocity of money is a constant, then the only way nominal GDP can change is if the money
supply changes first. This is known as the
q
uantity theory of money



the quantity or supply of
money determines nominal GDP. Attempts to use fiscal policy to change real GDP (Y) will fail
since fiscal policy cannot change the value of the left
-
hand side of the equation. If the public
sector tak
es a larger slice of an economic pie that is not changing in value, then the private sector
must take a smaller piece. Fiscal policy is cancelled by opposite changes in private sector
spending


perfect

crowding out.
Note that when the government increas
ed its share of national
output from $15 billion to $30, billion the private sector share fell equal to that increase.


Furthermore
,
monetary is also ineffective at adjusting real GDP; if the economy adjusts so rapidly
that the real GDP is continually at
the natural rate of output, then the only effect of a change in
the money supply is a change in the price level. We can see this another way using the aggregate
supply and demand model.



Implications of Assumptions


If all markets are competitive while
wages
and prices are flexible, then the economy
will be rapidly pushed to full employment
just as a single market is rapidly pushed to
equilibrium. When there are unsold
goods, output prices will fall; when there
are unemployed workers, wages will fall
un
til the natural rate of output is reached.


This means the aggregate supply curve in
the economy is a vertical line (completely
inelastic) set at the natural rate of output


any deviation in the economy is very
temporary and is fixed quickly by our self
-
correcting mechanisms.

70


49

Since aggregate supply is perfectly inelastic for all but the shortest time, what happens to
aggregate demand is irrelevant for any real variables. No matter aggregate demand is in this
graph, no matter how many times it moves, the

economy makes the natural rate of output and
employs the full employment level of workers (i.e. unemployment will be at the natural rate of
unemployment). All aggregate demand can do is establish the price level. So not only does a
change in the money s
upply only affect the price level, but any variable that shifts aggregate
demand will have no long run consequences for the economy.


Since the economy has powerful self
-
correcting mechanisms that work reliably and rapidly, the
government has no need to
intervene. In fact, government intervention will make things worse by
preventing the adjustment process or slowing it down. For example, if government tried to raise
income and reduce poverty by raising wages it would create unemployment and make it hard
er to
achieve the full employment level of production. Prices would rise reducing real wages until we
eliminate the unemployment and boosted production back up to the natural level, at which time
the government might raise wages again to make up for the i
nflation. If government tried to raise
aggregate demand to increase production beyond full employment, it would only raise the price
level. The more the government keeps trying to keep the temporary changes in production or
income going the more the econo
my keeps having to work to achieve full employment. The
appropriate course of action for the government would then be to do nothing


laissez
-
faire
policy
.


Historically, we know that the economy had a business cycle and sometimes spent extended
periods
off full employment. How is this explained in the Classical model? The Classical model
explains how an economy
would

work if there were no intervention; since the economy does not
work that way, intervention must have occurred. Unions which prevent the
free functioning of
labor markets and the adjustment of wages were a favorite factor that Classical economists used
to explain persistent unemployment. Inflation was blamed on the excessive production of money
shifting aggregate demand to the right and pu
shing the price level up. Trade protection was
viewed as a government interference that protected inefficient domestic producers at the expense
of efficient foreign ones. Countries protect their firms that have difficulty competing with foreign
competito
rs but the efficient firms lose the chance to export as other countries do the same. Since
there was never any period without some level of outside intervention in the economy, the
Classical economists were able to continue claiming that their model accur
ately predicted how
the economy would work if this intervention did not exist.


It is no surprise that the Classical economists started losing influence during the Great Depression
considering how severe that economic downturn was and how long it lasted.
It is difficult to
justify a model of rapidly adjusting self
-
correcting mechanisms when the economy struggles for
over a decade. At first, Classical economists were able to explain the situation given the unusual
nature of the stock market crash, bank fai
lures and a growing trade war among developed
countries. In 1930, soon after the October crash on Wall Street, the US government passed the
Smoot
-
Hawley Tariff Act

dramatically raising the tariffs on foreign goods. Other countries
retaliated raising thei
r tariffs on US goods and a major trade war resulted. Since the US was a net
exporter at this time, we actually lost more jobs than we protected and employment shrank.


However, we would expect the economy to bounce back if the Classical model were correc
t.
Even if we have interfered with the reliable and rapid self
-
correcting mechanisms, they still
should work to some degree once the economy has absorbed the initial problem. For years we do
not see the kind of automatic stabilization ever kicking in that

would be predicted under the
Classical model. This led to a growing number of economists and economic students questioning
the accuracy and applicability of Classical theory.


50

The Keynesian Answer



During the 1930s a British economist, John Maynard Keyne
s, answered the assumptions of the
Classical model point by point. His position was that the Classical model was flawed from the
beginning by inappropriate assumptions; if you can deny the assumptions, the model falls apart.
Let’s examine the Keynesian r
ejoinder to each of the Classical assumptions. Bear in mind that
some of the arguments presented may not have been the work of John Maynard Keynes himself,
but rather that of some of his students and later followers. The Keynesian model evolves over a
nu
mber of years from the publication of Keynes original work.


Many markets are not very competitive:
Keynes argued that there are powerful oligopolies
and monopolies in an industrial economy and that their domination was growing. Companies
with this kind
of market power can artificially restrict production in order to boost price. As a
larger and larger part of the economy is found in these industries, a larger and larger part of the
economy will not demonstrate a full employment level of production. Fur
thermore, some
employers will not be in competitive labor markets and can hold wages artificially low
withholding income from consumers so that they are unable to buy full employment output.


Wages and prices are not flexible


they are “sticky”


particul
arly downward:
Wages and
prices do not rapidly adjust to reflect supply and demand for a variety of reasons.


Contracts:


Companies often sign contracts with employees and suppliers


these contracts mean that the company cannot lower the prices it
pay
s for inputs and is, therefore, unwilling to cut the price of
their output. It is harder to lower wages and prices since the
seller is more motivated to fight a downward move than an
upward one.


Menu Costs:

It costs a company money to change its prices


someone has to
change the information in the computer, someone has to change
the prices on the shelf or the individual tags, any “hard copy”
that contains prices has to be reprinted, etc. These are called
menu costs (when a restaurant changes prices it m
ust reprint the
menu). These make a company reluctant to change prices unless
they feel the change is not temporary. Obviously, companies are
less reluctant to raise price than lower it.


Implicit Agreements
:

Whether in the labor market or a goods market
, both buyers and
sellers have an interest in stability over volatility. Workers want
a dependable level of income not one that fluctuates with every
shift in supply and demand. Firms want a predictable level of
cost not one that fluctuates with every sh
ift in supply and
demand. Firms don’t want to constantly fluctuate price because
consumers will learn to wait for the price drops. Consumers
want predictable prices both so they can anticipate expenses and
to save time


they don’t want to constantly be
looking at where
prices are best this week. Consequently, we tend to accept that
wages and prices stay up somewhat when business is weak, but
don’t rise that much when business is strong.


51

If wages and prices are somewhat “sticky” and rise more easily than

they fall, then we will have
at least a temporary problem in the economy, especially in the downward direction. Firms
change production and employment rather than wages and prices. When there is a drop in
aggregate demand, far from self
-
correcting, the
trend intensifies


falling demand for goods and
services leads to layoffs and production cuts. As workers lose jobs they cut their spending


even
the workers who are still employed will spend less out of concern for future job cuts. As
consumer spendin
g drops, more companies layoff even more workers. The economy will come
to an equilibrium far below full employment and remain there for an extended period of time.
Since wages and prices are most sticky in the downward direction, the economy is more pro
ne to
entering recessions than booms.


There are no forces to make supply equal intended investment at full employment levels:
While savings must equal investment, Keynes pointed out that there is no reason that savings will
equal intended investment at l
evels necessary to support full employment.
Intended investment

refers to what businesses planned to invest in their business


desired changes in asset levels.
Let’s see why the difference is important.


When we looked at Classical economics, we had a s
ituation where full employment was $100
billion, made up of $90 in consumer spending (savings is $10 billion) and $10 billion in business
investment. When consumer spending fell to $80 billion (saving rose to $20 billion), business
investment rose to $20
billion and we remained at full employment. Now let’s break investment
down into intended and unintended levels and see the effect it has on economic events.


Suppose businesses at full employment intend to invest $10 billion in the following way: $3
bill
ion on replacing old equipment and facilities, $6 billion in expansion and $1 billion in new
inventory (this desired inventory is part of their expansion plans). Now consumer spending falls,
catching businesses by surprise. Keynes assumed that their inve
stment plans would proceed
because of contractual commitments (actually we know today intended investment is more
volatile than this) so that businesses continue to allocate this $10 billion in the same way. If
consumers are spending $80 billion and busin
esses are spending $10 billion, then there are $10
billion worth of unsold goods. Since unsold goods are in inventory and the value of inventory is
an asset to the company, these unsold goods constitute investment. Actual investment does equal
$20 billio
n ($10 billion in intended investment plus the $10 billion in unintended investment as
undesired inventory changes occur) but there is obviously a problem. Companies will not
continue to produce full employment output when they cannot sell it and we have
already seen
that they will not cut price in order to sell it


they will cut production instead.


Even though actual investment was equal to savings, the economy will not remain at full
employment. When savings are greater than intended investment, the r
emaining amount of
national income spent is less than the remaining amount of national output available
-

unsold
goods will pile up in inventory. This situation cannot continue.












52

Consumption and investment no
longer correct for each other, e
ven
if intended investment doesn’t
fall. When C originally fell,
businesses saw no reason to
increase intended investment
since they can’t sell current
output. We will see layoffs and
drops in production, but as
households lose income, they cut
consumpti
on more and the
economy moves further away
from full employment.


If anything, firms will cut
intended investment as the
economy worsens which would
increase the drop off seen in the
graph to the left.



For full employment to exist saving and intended inv
estment must be equal when GDP is at full
employment levels and the Keynesians said there is no reason to expect that to happen. In the
Classical model interest rates brought savings and investment together, but the Keynesians
believe that interest rates
largely lose their power as the economy moves off full employment. If
the economy has dropped significantly below full employment so that companies cannot sell all
their output and workers are losing jobs, low interest rates will be relatively powerless t
o
encourage either group to increase their borrowing and spending. If the economy has sped up
significantly above full employment so that companies are seeing continually rising revenue and
profits while workers are able to get good jobs and overtime, hig
h interest rates may not be
sufficient to discourage either to slow their borrowing and spending.


The velocity of money fluctuates:
The Keynesians believe that the velocity of money moves
with the economy and against the money supply all other things e
qual. When the economy is
strong, people, businesses and financial institutions move money more rapidly and aggressively


they are less inclined to hold it for long periods of time. When the economy is weak, people,
businesses and financial institution
s move money more slowly and cautiously


they are more
inclined to hold it for long periods of time.


Money Supply x V = P x Y


Since V fluctuates with Y, if the Fed pumps additional money into the financial system, it will
have little affect on

real GDP (Y) unless people, businesses and financial institutions have the
confidence and opportunities to lend, borrow and spend. If the money supply rises, but banks are
reluctant to lend it while people and businesses have little incentive to borrow a
nd spend, then the
velocity of money will just slow down, negating the effect of the policy. Fiscal policy on the
other hand will now work


since V fluctuates a change in fiscal policy can cause both sides of
the equation to rise. Fiscal stimulus can ra
ise real GDP (Y) on the right hand side of the equation
because as the fiscal policy works the velocity of money on the left hand side is rising as well.


53

Crowding out will no longer be a problem since when government takes a larger piece of the
economic
pie, it causes total output to rise as well and there is more pie to go around. Private
sector spending may drop by a very small amount (by $1 billion below) but for the most part, the
additional government consumption of goods and services is filled by t
he expanded production.














The nature of the velocity of money is one of the main differences between Keynesian policy and
those that hold opposing theories


it drives the controversies over the nature of monetary and
fiscal policy. If veloci
ty is constant or almost constant, then fiscal policy is very weak while
monetary policy has a lot of power, at least over nominal measures. If velocity is variable, then
fiscal policy is very powerful while monetary policy is fairly weak. We are not abl
e to answer
this by examining the historical data


the velocity of money is not completely constant but its
variability is limited. The analysis is further complicated by the fact that the stability of V varies
depending on the time period looked at and
the money aggregate used. V is less stable for M1
and more stable for M2.


How much variation is needed for the Keynesian view to still work? Keynesians argue that even
small variations in V are sufficient since the money supply is so enormous (even a sm
all change
multiplied against a large base can have a significant effect). Some other economists say that
variations in V are too small and that crowding out will be a significant problem.



Implications of Assumptions



If many markets are not competi
tive while
wages and prices are not flexible for an
extended time, then the economy can
remain off the natural rate of output for
prolonged periods of time. When there are
unsold goods, production rather than output
prices will fall, employment rather tha
n
wages will fall.


This gives us the aggregate supply curve
we saw in chapter four


the shape is
driven by the fact that some wages and
prices are less sticky than others and, in
general, are less sticky upward than
downward.


54

This aggregate supply curv
e is a more sophisticated and realistic version of the original
Keynesian AS curve and contains three distinct areas. In the horizontal range we see that as the
economy contracts, the price level drops very little and the main impact is on production (and
,
therefore, employment). Since wages and prices are more prone to downward stickyness, the
economy has room to fall far below full employment. In the vertical range we see that as the
economy booms, the price level starts changing much faster


this is
because wages and prices
are less sticky in the upward direction. There is still a little stickyness so that the economy can
rise above full employment production.


Since the economy lacks rapid and reliable self
-
correcting mechanisms, it is possible for
the
economy to become “stuck” far off full employment (especially
below

full employment) for very
long periods of time. It is clear why this model gained acceptability during the Great Depression
since it reflected the economy of the time


one far below
full employment for years. If the
private sector does not have the ability to turn the economy around, then it is the necessary role of
the government to do so. Government not only has the ability to stabilize the economy, it has the
responsibility to do

so. It is unacceptable to allow people, households, businesses to suffer long
period of falling income, sales, profits


a financial blow from which many will never recover


when the government can shift aggregate demand in order to restore the natural
rate of output
more quickly and reliably than the economy could on its own.


We will develop the extended technical Keynesian model and use it for predicting the necessary
government policy to achieve full employment in the next chapter.



Journal Topics:

Complete the following assignment:



Write a 3 page paper comparing the two theories using at least two sources.


























55

CHAPTER 8

THE KEYNESIAN CROSS



The technical Keynsian model, known as the
Keynesian cross
, can be presented in diffe
rent
formats


tabular, graphical or algebraic


but is always going to show the relationship between
the components of aggregate demand and the final equilibrium output of an economy. The
Keynesian cross is used to estimate how changes in aggregate deman
d affect the final equilibrium
level of production and, therefore, the necessary government action to achieve full employment.
The model comes in more and less sophisticated versions


we will use only the basic model
which is based on: 1) a closed econo
my, i.e. no exports or imports, 2) “sticky” wages and
prices, 3) only consumption is affected by GDP, and 4) Real GDP is both national output and
the income of households.


Aggregate Demand or Aggregate Expenditures represents the value spent on goods

and services
in an economy, and since this economy is closed will equal C + I + G (consumption plus
investment plus government purchases). We will start by modeling consumption


the main
determinant of consumer spending is consumer income (more sophisti
cated models include other
variables but the largest determinant is income). When the government gathers spending and
income data for consumers, we observe a pattern or correlation between the two variables
-

consumption and income have a positive correla
tion


the more income consumers have the
higher their spending will be. We can summarize the typical or general relationship between
income and spending either as a line or a formula (remember from math any line can be
represented as a formula in slope/i
ntercept form). This “summary” is known as the

consumption function
.



The Consumption Function



The points on the graph to the left
represent the differing observations of
consumer spending found at different
income levels. A graph showing this
kin
d of set of points is known as a
scattergram
.


When given a set of such
observations, a computer can calculate
the “typical” relationship between the
two variables by fitting a line into the
scattering of points. This line
minimizes the total distance bet
ween
the line and all the points. This line is
the consumption function.


Since we have assumed that national income (GDP) is also the income of households, this
consumption data also tells us something about savings. What households do not spend must
h
ave been saved. Therefore, if a GDP of $700 billion is associated with a consumption level of
$680 billion, then net household savings must have been $20 billion.


56

The consumption function is typically graphed but it could also be represented in a table
or as an
algebraic formula.



Here we see some points along the
consumption function which represent
the typical level of consumption to be
expected at certain GDP levels. For
example, when GDP is $400 billion,
consumption averages $410 billion;
since
consumers are spending more than
their income, savings is negative.


These points could also be represented
as entry in a table. The five individual
points to the left are also represented in
the table below. We could add a line to
the table and calculat
e household
savings as well.




GDP

300

400

500

600

700

C

320.00

410.00

500.00

590.00

680.00

Sn

-
20

-
10

0

10

20



Note that we have no observations for extremely low levels of GDP


even in the depths of the
Great Depression GDP was no where near 0. In

order to find the algebraic formula for the
consumption function, we need to extrapolate from the relationship we do see. Imagine that the
existing data does not vary in pattern as we work backwards to non
-
observed GDP levels


this
can be thought of as
extending the line or table back to the left.


When we extend the consumption
function to the left, we see that when the
line intersects the Y axis (in other words
GDP is zero), there is still some
consumption occurring. This level of
consumption is
inde
pendent

of the level
of income and is known as
autonomous
consumption
.


Consumers also spend a percent of
income in addition to the autonomous
consumption. This spending is
determined

by the level of income and is
known as
induced consumption
. This
propo
rtion of income spent in addition is
the slope of the consumption function
and is known as the
marginal
propensity to consume
.


57

We can also work backwards with the tabular information and in fact this is usually more
accurate given the difficulties of preci
sion with a graph.



GDP

0

100

200

300

400

500

600

700

C

50.00

140.00

230.00

320.00

410.00

500.00

590.00

680.00



Since every column demonstrates a $100 billion dollar difference in GDP, we just add columns
backward until GDP reaches 0. Since each colum
n represents a $90 billion dollar difference in
consumption, we just continue that relationship until we reach the GDP of 0. This starting level
of consumption is our autonomous consumption. To derive the formula for the consumption
function we need both

autonomous and induced consumption


to find induced consumption we
need the marginal propensity to consume.


MPC =

or


In our problem we see that this equals:


MPC =

=

or .9


People are spending 90% of their income in addition to the starting level of autonomous
consumption. In fact, this is close to the traditional historical MPC for American consumers (in
the last generation it is a bit
higher than in previous years). Since any line can be represented as a
formula in slope/intercept form and autonomous consumption is the intercept while the MPC is
the slope, the formula for the consumption function is:


C = 50 + .9Y



Aggregate Expen
ditures



Keynes, himself, did not really use aggregate supply and demand to model the behavior of a
market economy. He did not use GDP and the price level as his axes, instead he uses GDP and
spending or aggregate expenditures. In a closed economy (no n
et exports) spending would be C
+ I + G; note that this is the closed economy version of the aggregate demand model. Since we
are not using the price level as a variable (prices and wages are sticky)and aggregate demand
relates spending to the price level
, Keynes named this measure aggregate expenditures.


Keynes treated the other two components of aggregate expenditures or aggregate demand as
completely autonomous


independent of the level of GDP. Lacking good information on
investment, Keynes assumed t
hat businesses would be caught by surprise when consumers
fluctuated their spending


in other words, that intended investment would tend to remain the
same, at least for awhile, as businesses were contractually tied to investment projects. Likewise,
the
government would have its spending already budgeted and contracted, therefore, would not
change its policies without the passage of new legislation. While these are not accurate

58

assumptions, using them does not undermine the validity of the model’s conclu
sions


if Keynes’
model shows the economy is unstable with stable investment, then if business investment actually
fluctuates with the economy as consumption does, the economy is even more unstable, not less.
Keynes’ assertion about the short
-
run instabi
lity of the economy is not challenged by the
observation that business investment is not stable. If government policy is necessary to stabilize
the economy, it does not matter that some of that policy is actually built into the system to run
automatically
, government policy is still necessary. For the moment, we will continue to hold the
simple Keynesian assumptions.


To calculate aggregate expenditures (AE), we need to add our autonomous investment and
government purchases to consumption. Again, this ca
n be done on the table, the graph or in the
formula. Let us start with no government participation.


GDP

0

100

200

300

400

500

600

700

C

50.00

140.00

230.00

320.00

410.00

500.00

590.00

680.00

I

10

10

10

10

10

10

10

10

G

0

0

0

0

0

0

0

0

AE

60

150

240

3
30

420

510

600

690


Equilibrium is found where aggregate demand equals aggregate supply


here where the amount
people are trying to buy equals what is available to be purchased. Only at a GDP level of 600 is
the value being made (GDP or Aggregate Supply
) equal to the value being bought (AE or
Aggregate Demand). This is our equilibrium, but we were only able to see it because it occurred
on the table


if equilibrium had been between our observations, we would not be able to find it.


The AE curve start
s at at
the autonomous spending
(here 60) and rises at the
rate of the MPC (here .9).


The gray line is the 45
-
degree line and represents
all the points where AE
equals GDP. Every one
of these points is a
potential equilibrium.


Any economy must be on
the

45
-
degree line. This
economy is on its AE
curve. The only place
where both is true is
where the lines intersect


that is equilibrium. This
is the Keynesian Cross.



Notice that it can be
difficult to see the
equilibrium point on the
graph.


59

It is ea
siest to calculate the equilibrium level of GDP, changes in the equilibrium GDP and the
effect of government policies using the algebraic model. We have the formula for consumption
as well as the autonomous levels of investment and government purchases.
This will allow us to
find the formula for AE.



C = 50 + .9Y






AE = 60 + .9Y

I = 10








Y = 60 + .9Y

G = 0







.1Y = 60






Y = 600

AE = 60 + .9Y



Once we have the formula for AE we want to solve for the value of national
income (Y) where
aggregate demand (AE) equals aggregate supply (GDP). Very quickly, we can find that this
occurs when GDP or Y is 600.



Changes in Equilibrium


The Multiplier



When one of the components of AE changes its spending behavior, then the equ
ilibrium level of
GDP will also change. Suppose that a new technology is invented and businesses raise their
investment to 15 as they buy the new equipment.



C = 50 + .9Y






AE = 65 + .9Y

I = 15








Y = 65 + .9Y

G = 0







.1Y =

65






Y = 650

AE = 65 + .9Y



Notice that equilibrium output rose by much more than the initial change in investment. This is
because of induced consumption. When businesses spent $5 billion more, it meant $5 billion
more in income for some househo
lds who then raised their spending by 90% of that $5 billion,
causing consumer spending to rise by $4.5 billion. But this means that other households have
now seen their income rise by $4.5 billion and will raise their spending by 90% of that or $4.05
bil
lion. This causes a further rise in household income and yet another rise in consumer
spending, and so forth. We have set off a chain reaction of spending


a self
-
perpetuating cycle.
Note that each time consumers raise their spending they increase it b
y a smaller amount since
only 90% of the change in income goes to spending. Eventually, the cycle breaks down and we
can see the final effect on total spending. This can be represented in a flow chart.










S

Initial

Chang
e in





Final Effect

Autonomous

Y


C

on Eq. GDP

Spending



60

Anytime there is a cycle similar to the one on the previous page, we can see the total effect of the
cycle as pumping up the size of the initi
al change, be it negative or positive. In effect, the cycle
multiplies the initial force that sets the process off; hence the power of the cycle is reflected in a
number known as a multiplier. Since this was the first multiplier developed in economics, i
t is
just known as
the multiplier:
the amount we multiply times the initial change in spending to get
the final effect on equilibrium GDP. Any multiplier can be calculated as one divided by the rate
at which energy “leaks” from the system. In this case,

the leakage is represented by consumer
savings


each time the cycle turns over, consumers remove power from the system by
withholding savings. The savings rate is what is left over after we take out the rate at which
consumers are spending


in other wo
rds one minus MPC. For example, if consumers are
spending 90% of every new dollar they receive (MPC = .9), then they must be saving 10% of
every new dollar they receive (MPS = .1).



The Multiplier or M =

or

or








=

=

=

= 10



In this model, using the numbers from before, we see that any initial change in autonomous
spending

will be pumped up by a factor of 10. This is consistent with our previous result when an
increase in investment spending of $5 billion resulting in a rise in equilibrium spending of $50
billion or 10 times as much.



Counter
-
cyclical Fiscal Policy using
G



Since we have seen that monetary policy is relatively weak in the Keynesian model but that fiscal
policy can be effective without crowding out, fiscal policy is the stabilization tool of choice to
Keynesian economists. To the Keynesians, the governmen
t has the responsibility to use fiscal
policy to shift aggregate demand back to full employment levels by running the opposite kind of
policy to what the private sector is doing that cause the inappropriate aggregate demand in the
first place


this is kno
wn as
counter
-
cyclical fiscal policy
. (The word counter means opposite,
so this is policy that runs opposite the cycle which is the business cycle). So if the private sector
is underspending (saving too much), then the government needs to overspend (spen
d more than
their “income”); if the private secotr is overspending, then the government needs to underspend.


The question now becomes how much fiscal policy to run? Remember there are three ways the
government could be expansionary or contractionary with

fiscal policy. It can change taxes,
change government transfers or change government purchases. Taxes and transfers work
indirectly on aggregate demand mainly through consumption (C). Any change in taxes or
transfers does not change C by the same dolla
r amount


consumers do not spend every cent of
any dollar they gain or lose. The last of these is the easiest to calculate since government
purchases are a direct component of aggregate demand (G). Any change in G goes dollar for
dollar into the AD form
ula. Therefore, we will start by calculating the necessary change in G to
achieve full employment.


61

C + I + G + Xn = AD and each of these components has an autonomous level of spending. In the
simple Keynesian model Xn does not exist while both I and G ar
e completely autonomous. The
relationship between autonomous spending is:


Autonomous spending x multiplier = equilibrium Y


Which means that a change in autonomous spending will translate to a change in equilibrium Y
by the formula:


Δ Autonomous spending x multiplier = Δ equilibrium Y


If we know what equilibrium Y is, in other words, we know the actual level of GDP the economy
is stuck at, and we have a target GDP we want the economy to achieve


our estimate of full
employme
nt, then we know the amount by which we need equilibrium Y to change. Plug that
number in on the right hand side of the equation, plug the multiplier in and you can solve for the
necessary change in autonomous spending. In the case of government purchase
s that is your
answer, since G is part of autonomous spending.


Back in the first example of calculating equilibrium GDP, we had an equilibrium Y of $600
billion and a multiplier of 10. Suppose that full employment GDP is at $700 billion. How much
woul
d government purchases (G which is currently zero) have to change to achieve full
employment?


Δ Autonomous spending x multiplier = Δ equilibrium Y




ΔG



x 10


= $100 billion







ΔG


=


$ 10 billion


Let’
s test that and see if it works. If we change government purchases by 10 when they were
originally 0 then G will now be 10. This gives us a new AD or AE formula of:


C = 50 + .9Y






AE = 70 + .9Y

I = 10








Y = 70 + .9Y

G = 10







.1Y = 70






Y = 700

AE = 70 + .9Y


The new level of government purchases supports a level of economic activity consistent with full
employment, i.e. the policy worked. Notice that when we increased government purchases
nothing happened to the formu
las for either C or I. In other words, there was no crowding out.
This is because the Keynesians believe that the velocity of money changes; since spending by the
private sector has slowed, the velocity of money has slowed. As the government taps the sl
uggish
flow of money, borrowing funds that are unused or slow in being used, the government speeds up
the velocity of money and, therefore, there is no reason for the C or I functions to change. This is
true as long as the government borrows to fund its e
xpansionary fiscal policies


debt/bond
financing
. The situation will be different if the government uses
tax financing



raises taxes to
pay for its fiscal policies. Tax financing will change the consumption function (assuming we use
income taxes) since

consumers now have less income to spend.


62

Suppose the government consistently runs a balanced budget so that increases in G require
increases in taxes and decreases in G require decreases in taxes. Now we are changing two
components of aggregate demand an
d changing them in the opposite direction


if G rises causing
a tax increase, C will fall. The fall in C will cancel out the rise in G to some degree. Let’s
identify how much of the original rise in G actually impacts the economy using the number in the

current example. We just raised G by $10 billion when we used debt/bond financing. What
would happen if we raised G by $10 billion when using tax financing?


Increase G by



$10 billion

Increase Taxes by


$10 billion

Household income falls


$10 billio
n

Consumption falls


$ 9 billion

(Δ income times the MPC =
-
$10 billion x .9)

Δ autonomous spending


$ 1 billion

(G up $10 billion while C down $9 billion)


90% of the change in G was cancelled by an opposite change in C so that only 10% actually
makes i
t through to affect autonomous spending. The MPC represents the proportion of the
change in G that is cancelled by the opposite change in C; 1
-
MPC represents the proportion of
the change in G that is NOT cancelled by the opposite change in C and makes it

to autonomous
spending.


multiplier x
Δ Auto. spending


= Δ equilibrium Y

multiplier x (1
-
MPC) Δ G


= Δ equilibrium Y

1/(1
-
MPC) x (1
-
MPC) Δ G


= Δ equilibrium Y

(1
-
MPC)/(1
-
MPC) x Δ G



= Δ equilibrium Y


Δ G



= Δ equilibrium Y


I
n the simple Keynesian model, (1
-
MPC)/(1
-
MPC) is sometimes referred to as the
balanced
budget multiplier

since it is what we multiply by the change in G to get the change in
equilibrium output. The balanced budget multiplier in the simple Keynesian model
is always
equal to one


whatever the government wants to happen to equilibrium Y that’s what they have
to do to government purchases.

Since tax financing results in crowding out
and means the government has to fluctuate
its tax and spending programs more

from
year to year, the Keynesians reject tax
financing. Instead they want the
government to balance the budget over the
business cycle


running deficits and
borrowing the money during recessions
while running surpluses and paying the
debt off during boo
ms. The surpluses
should roughly cancel the deficits
-

this is
known as
balancing the budget over the
business cycle
. (It does not quite work
that well, because of downward sticky
wages and prices the economy is more
prone to recessions than booms so
surp
luses will not be large enough and
frequent enough to pay the deficits off).


63

Counter
-
cyclical Fiscal Policy using Taxes and Transfers



What if the government wishes to change taxes or transfers instead of government purchases? As
we have said before, tax
es and transfers work indirectly on aggregate demand through
consumption. This means we need to do a two
-
stage calculation


first, find the necessary change
in consumption to achieve full employment; second, find the necessary tax or transfer change to
a
chieve that change in consumption.


Calculating the necessary change in consumption in no different than finding the necessary
change in government purchases


we need to find the change in autonomous spending that when
maginified by the multiplier results

in the desired change in equilibrium output. Literally, the
only difference is that we use the symbol for C instead of G.


In the first example of calculating equilibrium GDP that we used for finding the necessary change
in G, we had an equilibrium Y of

$600 billion and a multiplier of 10 when full employment GDP
was at $700 billion. How much would consumption (C) have to change to achieve full
employment?


Δ Autonomous spending x multiplier = Δ equilibrium Y




ΔC



x 10


=

$100 billion







ΔC


=


$ 10 billion


Consumption has to change by the same $10 billion that G needed to change by for the same
reason. Where the tax/transfer problem become different is that we now need to calculate the
relationship

between the tax/transfer change and the change in consumption. We use the formula
for the MPC here. Since we have an estimate for the MPC in the US at any time and we now
know the desired change in consumption, we need only solve for the necessary chang
e in income.


MPC =

ΔC = MPC x ΔY ΔY =


ΔY =

=

= $11.11 billion


Government would have to raise transfers $11.11 billion or cut taxes $11.11 billion in order to
raise ho
usehold income by that amount; when household income rises $11.11 billion, then
consumers will increase their spending by 90% of the $11.11 billion or $10 billion dollars. When
C rises by $10 billion and is magnified by the multiplier of 10, equilibrium n
ational income will
rise by $100 billion taking us to full employment.


These are the simple versions of the kinds of techniques used by Keynesian economists in the
government for years to calculate the necessary government policies to stabilize the econom
y.
How well did those policies work? That depends in part on who is doing the interpretation and
what time period the data comes from. Over several decades the historical experience in the
short
-
run business cycle seems to support the Keynesian model.
This is not always true even in
the short
-
run and many economists will challenge the Keynesians in the long run.


64

The Historical Perspective



During the 1930s the US government started using fiscal policy to try to improve the economy
during the Great Depr
ession


we spent money on government projects to provide jobs, such as
the TVA building dams, the WPA constructing government buildings, the National Park system
buying land and building lodges, paths, bridges, etc. Although large by standards of the day
, the
spending of the 1930s was woefully modest relative to the depths of the economic downturn


the
Keynesian model recommended far larger fiscal policies than government was willing to enact
during that time. As the Keynesian model would predict the ec
onomy improved but extremely
slowly. During the Presidential campaign of 1936, Roosevelt promised to start moving back to a
balanced budget since the economy was modestly improving, raising taxes and cutting spending.
As the Keynesian model would predict
, in 1937 the economy took another drop as did the stock
market. Finally, in the early days of WWII, the US government had the justification it needed to
run the size of spending programs the Keynesians advocated


military spending for the war. As
the g
overnment spent millions that it borrowed from the public in the form of war bonds, the
economy soared out of the Depression the way the Keynesian model predicted. This convinced
most of a generation of young economists that the Keynesian model had solved

the riddle of the
business cycle and had handed government the policy tools it needed to stabilize the economy.


Over the next couple of decades the US government used the appropriate Keynesian fiscal policy
whenever the economy seemed to be developing a
problem and it appeared to be successful. In
addition, we set up our tax and transfer programs to rise and fall with economic activity which
results in some Keynesian policy being run without the need for new legislation


these are
known as
automatic sta
bilizers
. Since we have tied taxes to the level of income, sales and
profits, when the economy is weak, tax revenue automatically falls. Since we have tied most
transfer programs to the level of income, when the economy is weak, spending on transfers
aut
omatically rises. This eliminates much of the lag problem with fiscal policy. There is fairly
good data during this time period to support the Keynesian contention that the business cycle had
improved


that economic downturns were milder and less freque
nt compared to the days before
government intervention. As we will see in the next chapter, opposing economists argue that
other factors could cause this and that the pattern of stability is missing in the 1970s and early
1980s. They also argue that what

appears to be true in the short
-
run does not occur in the long
-
run, especially the relationship between AD and real GDP as well as unemployment and inflation.


Aggregate demand in the short
-
run pushes real GDP up and down


this is the heart of the
busine
ss cycle. While Keynes believed that consumption was the volatile component of
aggregate demand, modern Keynesians are more likely to blame investment. Investment
spending is much more responsive to
changes

in economic activity than the
level

of economic

activity. While consumers keep spending if their income is high but slowing down in growth,
businesses tend to slow down their spending if not cut it when their sales and profits slow even if
they are still high. After all, business investment spending
builds future capacity so we need
increasing sales to support creating more capacity than we are using now. Businesses pick up
changes in economic activity and adjust their spending accordingly, which intensifies the initial
small economic trend. A slowd
own in growth becomes slower and slower and possibly a
downturn. This is known as the
accelerator principle



business investment takes the beginning
of a trend and “speeds” it up


often providing the turning point of the business cycle. Other than
adju
sting the mechanism that causes the instability of aggregate demand, the basic conclusions
remain the same


fluctuating aggregate demand in an environment of sticky wages and prices
will push the economy off full employment and cause short
-
run ups and dow
ns in real GDP.


65

Just as there is very good
short
-
run

data that real GDP fluctuates with Aggregate Demand, there
is very good
short
-
run

data that unemployment and inflation move in the opposite direction.
There appears to be a short
-
run trade
-
off between
the two economic problems in that events that
raise production and income thus lowering unemployment also tends raise the price level. Events
that lower production and income tend to raise unemployment but lower the price level. There is
a great deal of
data over many decades and many countries that this short
-
run trade
-
off exists. An
economist by the name of Phillips popularized this idea and summarized it in a famous graph


the
Phillips curve
.


The shape of the Phillips curve is drawn
from the shap
e of the Aggregate Supply
curve. The short
-
run AS has the
horizontal range where production (GDP)
can rise a lot with only small increases in
the price level. This corresponds with an
area where the unemployment rate falls
significantly with rising GDP a
nd inflation
only rises a bit. (Zone A)


The intermediate range on the AS curve is
where there a significant change in both
GDP and the price level; this corresponds
with a Phillips curve area where
unemployment and inflation move
significantly against

each other (Zone B).


The vertical range on the AS curve is
where GDP changes by very little while
the price level changes significantly; this
corresponds with a Phillips curve area
where inflation changes a lot and
unemployment by very little (Zone C).




Journal Topics: Complete the following assignment:



GDP

C

I

G

AD






400

380

50

60

?

500

460

50

60

?

600

540

50

60

?

700

620

50

60

?



1. Fill in the missing data wherever there is a question mark.

2.

Find the MPC and the multiplier for the ab
ove data. Show work!

3. Find the equilibrium level of output for the above data. Show work!

4. If full employment is $700, what is the necessary
ΔG to achieve this? Show work!

A

B

C


66

CHAPTER
9
: THE MONETARISTS




Just as Keynesian economics began to supersede Classical theory as the latter appeared unable to
explain the events of the 1930s, Keynesian economics was challenged when it appeared not to fit

the economy of the 1970s. The Keynesian model claimed that an unstable aggregate demand
caused the instability of market economies; excessive aggregate demand and inflation causing
booms and insufficient aggregate demand and unemployment causing recessio
ns. The solution
was then to correct the fluctuations of the private market with the opposite government policy


slowing aggregate demand during a boom and raising aggregate demand during a recession.


In the 1970s the US experienced a period of rising
inflation and unemployment simultaneously;
this did not fit the Keynesian model. Shifts in aggregate demand cause inflation and
unemployment to move in the opposite direction, not together. Keynesian policy had no
suggestions for the current economic woe
s either; one uses expansionary policy to fight
unemployment at the cost of worsening inflation or one uses contractionary policy to fight
inflation at the cost of worsening unemployment. Since the Keynesians did not seem to have an
immediate explanation
or solution, people began to explore other options. Since the 1950s a
small group of macroeconomists, led by Milton Friedman, had challenged Keynesian economic
thought, but since the latter appeared to work so well, they had not been able to influence
eco
nomic theory or government policy significantly. Now the theory seemed worth a closer look.



The Assumptions of the Monetarist Model



Markets are competitive enough:
The Classical economists had said that if markets were
highly competitive, then no one

could hold a market off its full employment equilibrium. Price
will, therefore, always reflect the minimum efficient cost of making the good. As long as
consumer benefit is high enough to justify paying for the good, they will keep buying it and we
will

keep making it. Consequently, if individual markets do this, all the markets together will
-

we will make the socially optimal level of production, i.e. full employment. The Keynesians had
claimed that does not occur because there are many noncompetitiv
e markets dominated by
powerful oligopolies and monopolies. The Monetarists claimed that while markets are not as
competitive as the Classical economists had assumed, they are more competitive than the
Keynesians were willing to admit, particularly with a
nti
-
trust law and a more open international
trade adding competition. In general, a firm will only be temporarily able to hold a market off its
potential production level and then new firms will enter pushing production up and prices down.


Wages and pric
es are flexible enough:
The Classical economists said that wages and prices
will rapidly adjust to keep the full employment level of goods selling and the full employment
level of labor working. Furthermore, this adjustment is so rapid that an economy le
ft alone will
not experience any significant period of unemployment or falling production. The Keynesians
countered that wages and prices are inflexible particularly in the downward direction,
undermining this self
-
correction mechanism. The Monetarists a
sserted that while wages and
prices are “sticky” in the short
-
run, they become flexible in a reasonable period of time. They
point out that many wages and prices are not hampered by contracts and that most contracts are
open for renegotiation within a 12
to 18 month period. Consequently, the economy will start
correcting itself in this time, which is about the same time it takes stabilization policy to work.


67

Savings will generally equal intended investment at full employment levels
if

the
government maint
ains the appropriate quantity of money:
The monetarists argued that
money is an asset that competes with other assets like land, stocks, gold etc. Money has the
advantages of being liquid


so it’s available for emergencies


and stable in value


it doe
s not
go up and down each day in worth like the other assets mentioned can (it only erodes over time
with inflation). Money has the disadvantages that it does not appreciate in value over time like
the others and it generates little or no income


money i
n the bank earns little interest if any and
cash earns none. Consequently, Friedman claimed that people wish to keep only a portion of
their wealth in money form and that this portion remains relatively constant over time. If this is
correct, then if gov
ernment maintains the appropriate level of money people can be depended on
to convert approximately the needed amount into either goods and services or other assets. Even
if someone were to buy gold, stock or land they have now given someone else more mon
ey than
they wish to hold in money form and they will have to convert it. Eventually, enough will be
converted into goods and services.


Changes in spending on goods and services by one component of aggregate demand will shift the
allotment of money asset
s so that someone is holding more money than they wish. Some other
component of aggregate demand will end up correcting for the initial shift in spending. This
process can take awhile, so once again, the Monetarists are looking at a 12 to 18 month period

for
the economy to start stabilizing itself unlike the Classical economists who saw this process
operating almost immediately. The Monetarist contention is that the economy’s self
-
correcting
mechanisms work reliably, although not rapidly, and since gover
nment fiscal and monetary
policy also take 12
-
18 months to work, we are better off letting the market economy correct itself.


Velocity of money is relatively stable:
As we have seen, the velocity of money is the speed at
which money circulates in the econ
omy and is equal to the nominal GDP divided by money
supply. Nominal GDP is the price level times real GDP.



Money Supply x V = Nominal GDP = P x Y



If the velocity of money is relatively stable, then nominal GDP is primarily driven by the

money
supply. This is a modified version of the
quantity theory of money



the quantity or supply of
money determines nominal GDP. Attempts to use fiscal policy to change real GDP (Y) will not
be significant in shifting aggregate demand since fiscal p
olicy cannot change the value of the left
-
hand side of the equation by any significant amount. If the public sector takes a larger slice of an
economic pie that is not changing much in value, then the private sector must take a smaller
piece. Fiscal poli
cy is still largely cancelled by opposite changes in private sector spending


crowding out
just as it was in the Classical model.


68

In contrast
,
monetary policy has important implications for real GDP and unemployment.


Money Supply x V = Nominal GDP

= P x Y


Since the price level is “sticky” in the short
-
run Monetarist model, it is important that the
government maintain the appropriate level of money in order to insure that real GDP (Y) is as
stable as possible. Remember that potential GDP grow
s over time with new technology,
population growth, new resources etc. While we do not know the growth of potential GDP per
se, we do know that actual real GDP grows at a 2
-
3% rate per year, therefore, the potential must
be growing at that rate or higher.

This is only the
average

annual growth, actual potential GDP
growth will vary from year to year since technology and new resource discoveries are irregular in
pace. This suggests that the money supply needs to grow at a similar rate in order to maintain

full
employment. If the money supply grows faster, then we will see inflation in the long run equal to
the excess growth of the money supply. If the money supply grows slower, then we will see real
GDP slow from its growth path or even fall causing unemp
loyment in the short run. While prices
and wages are flexible in the long run and will adjust until whatever money supply we have is
sufficient to support the natural rate of output, there will be a lag period before this adjustment
occurs. Both of these

outcomes are undesirable and avoidable.


Since we will not be able to even estimate the actual growth in the natural rate of output until
after the fact, and monetary policy takes 12
-
18 months to work beyond that, Friedman claimed
the government should no
t use
feedback policy



where policy is set by economic conditions and
then adjusted as the economy reacts to the policy. Friedman claimed that this will create a
situation where the government was causing tomorrows problem today by fighting yesterday’s
d
ilemma. Instead, Friedman claims that the most stable policy would be to use a
fixed
-
rule
policy



where policy is set once at a regular rate that never varies with the state of the economy.
In the case of monetary policy the Monetarist fixed rule was th
e
monetary rule



that the Fed
should increase the money supply at a set rate (Friedman said 3% per year) every year regardless
of economic conditions. When the economy steams ahead a bit faster than its average long
-
run
growth path, there will be too li
ttle money in the economy and production will slow for a while;
when the economy lags behind a bit from its average long
-
run growth path, there will be too
much money in the economy and prices will rise for a while, but no other strategy keeps the
money su
pply as close to the necessary level as much of the time. Friedman said that the
monetary rule would not eliminate the business cycle but would make recessions less frequent,
shorter and milder when they do occur.



Implications of Assumptions



If all ma
rkets are competitive enough while wages and prices are sticky in the short run though
flexible enough in the long run, then the economy will be pushed to full employment, but only in
about 12
-
18 months. This means that a Keynesian style Aggregate Supply
curve can exist in the
short
-
run
-

there will be a business cycle.


Short
-
run shifts in aggregate demand result in temporary and unsustainable changes in real GDP,
eventually as wages and prices adjust to the new aggregate demand conditions, the short
-
run

aggregate supply curve shifts to push the economy back to the natural rate of output. In a
reasonable period of time, the economy will face the vertical AS curve set at the natural rate of
output just as in the Classical model


the difference is the tim
e delay.


69

First, Aggregate Demand rises, perhaps because of a rise in the money supply. Businesses see
orders and sales increasing while the price of their inputs, especially labor, are not rising as fast,
so extra production appears profitable and we mo
ve along the short
-
run aggregate supply. But as
time goes on, more and more wages and prices are flexible and businesses realize that extra
production costs in the form of higher wages and other input prices are undermining the
profitability of the extra
production. Production cost is a major determinant of supply and with
higher production costs the aggregate supply curve shifts back to the left moving the economy
back to the natural rate of output


where we started. In the long run the economy ends up

at the
natural rate of output and the long run doesn’t take all that long.




Since aggregate supply is perfectly inelastic in the
long run, what happens to aggregate demand is
irrelevant for any real variables in the long run.
No matter aggregate dem
and is in this graph, no
matter how many times it moves, the economy
makes the natural rate of output and employs the
full employment level of workers (i.e.
unemployment will be at the natural rate of
unemployment). All aggregate demand can do is
establis
h the price level.




We saw in the Keynesian model that the shape of the aggregate supply curve determined the
relationship between unemployment and inflation, therefore, the shape of the Phillips curve.
Since the short
-
run aggregate supply curve in th
e Monetarist’s model can be the Keynesian
supply curve, the short
-
run Phillips curve in the Monetarist’s model can mirror that of the
Keynesians. However, the Monetarists felt that the long
-
run was achieved in a moderate period
of time and in the long run

the aggregate supply curve is vertical and the natural rate of output.
Since the economy produces natural rate of output level of GDP with only the price level
varying, the economy must also produce the natural rate of unemployment with only inflation
v
arying


the Phillips curve is also a vertical line


this time set at the natural rate of
unemployment.

AD1

AD2

AS2

AD1

AD2


70

Since the economy has reliable self
-
correcting mechanisms to push us to the natural rate of output
and the natural rate of unemployment, and these mech
anisms while not rapid, work at least as
quickly as government policy, the government has no need to intervene. In fact, government
intervention could make things worse by continually setting up the next economic problem. For
example, if the economy were

experiencing a short
-
run contractionary gap and government tried
to raise aggregate demand and lower unemployment, by the time the government policy would be
working the economy has already started to correct itself The government policy on top of the
s
elf
-
correcting mechanisms would end up pushing the economy too far in the other direction,
setting off a short
-
run expansionary gap. By the time the government realizes that inflation has
become a problem and enacts contractionary policy, the economy’s se
lf
-
correcting mechanisms
are again beginning to work. The government policy on top of the economy’s adjustments would
push the economy too far back in the opposite direction into another recession. Friedman claimed
that the government’s attempt to use fe
edback stabilization policy, in fact, destabilizes the
economy. The appropriate course of action for the government would then be to follow a neutral
fixed policy rule conducive to the support of the natural rate of output.



The Keynesian/Monetarist deba
te: So who’s right anyway?



During the 1970s and into the 80s, the field of economics was dominated by the debate between
the Keynesians and Monetarists over the nature of the economy. By the mid80s a pair of journal
articles appeared each written by a k
ey supporter of one of the theories conceding that the other
side had some valid points (“We are all Keynesians now” and “We are all Monetarists now”). It
appears that the economy is more stable than the original Keynesian model suggested


that most
wage
s and prices do become more flexible in a reasonable period of time and the quantity of
money is highly correlated with the price level of an economy. Most recessions last 2 years or
less from top to bottom and back up again; however, we do know that the
economy has
occasionally remained significantly off full employment far longer than the Monetarist model
would suggest possible or reasonable (over 10 years during the Great Depression). We also know
that the economy reacted to changes in fiscal policy du
ring the Great Depression in a manner
consistent with the Keynesian model and that the economy appears to respond faster to fiscal
policy than monetary when the economy is far below full employment. Monetary policy appears
far more successful than fiscal
at controlling the problem of inflation. The velocity of money is a
tricky subject, since the velocity of M1 shows far less stability than the velocity of M2, while
even the velocity of M2 has been less stable in the last 20 years than in the several deca
des before
that. When velocity fluctuates, it does so as predicted by the Keynesian model.


In general, there is a certain amount of support for each theory. The Monetarists appear to be
more successful at explaining the long run economic patterns of t
he US economy, as well as how
the economy behaves in the more usual times of being
close

to the natural rate of output. The
Keynesians appear to be more successful at explaining how an economy responds to being
pushed
far
off full employment, suggesting t
hat the self
-
correction mechanisms may stall once a
certain critical level of economic activity has been reached. Some Keynesians have claimed that
the US economy has been more stable since the government started using stabilization policy;
however, that
could also be the result of a better regulated banking and financial system, the shift
of the US economy from manufacturing to a more service and information processing economy
(the first is more prone to large shifts in production and employment) and the
greater international
economy providing a stabilizing force (in a global economy weak demand in the US can be
countered by stronger demand from abroad).


71


If we look at of unemployment and
inflation over the years, we see an
interesting pattern


the Key
nesians
Phillips curve does not hold, but neither
does there appear to be a vertical one.
The Phillips curve seems to shift, with
each subsequent curve resembling the
Keynesian model.


PC1

represents the US during the 1960s
and late 1990s. PC2 represents

the US
in the early 1970s, late 1980s and early
1990s. PC3 represents the US for most
of the 1970s and the early 1980s.



The Monetarists argue that changing expectations caused the short
-
run aggregate supply curve to
shift and when that happens the Phi
llips curve automatically shifts as well, but in the opposite
direction. Shifts in aggregate demand move us along the Phillips curve because production and
employment are moving in the same direction as prices, therefore, unemployment and inflation
are mo
ving in the opposite direction. Shifts in aggregate supply move the entire Phillips curve
because production and employment are moving in the opposite direction as prices, therefore,
unemployment and inflation are moving in the same direction.



Since pr
oduction is rising when aggregate demand shifts to the right, employment is rising and
unemployment falling. Since the price level is rising when aggregate demand shifts to the right,
inflation is rising. When we move along the supply curve to the right,

we move along the Phillips
curve to the
left



lower levels of unemployment and higher levels of inflation.


This gives us the classic Keynesian Phillips curve, but in the Monetarist model as businesses
learn that production costs are rising


wages and i
nput prices are rising


they cut production
back, in other words there is a leftward shift of the aggregate supply curve.

AD1

AD2


72


Since production is falling when aggregate supply shifts to the left, employment is falling and
unemployment rising. Since the p
rice level is rising when aggregate supply shifts to the left,
inflation is rising. When we move the supply curve to the left, we move the Phillips curve to the
right



higher levels of unemployment and higher levels of inflation at the same time.


Accord
ing to the Monetarists, we are seeing the adjustment of expectations to the new higher
level of production costs. After a rise in aggregate demand, businesses eventually learn that they
will have to pay more for labor and other inputs as wages and prices
become more flexible. The
rise in production costs will cause a leftward shift of aggregate supply


all other things equal, the
economy will be restored to the natural rate of output and the natural rate of unemployment. In
the real world all other thin
gs are never equal


the government keeps conducting policies that
move us along the short
-
run Phillips curve


so that we don’t see the long run vertical Phillips
curve we just see the new short
-
run curves.


On the other hand, the Keynesians can explain t
he shifts in the short
-
run Phillips curve with other
variables


there is a high correlation between oil prices and the placement of the Phillips curve.
Years associated with low Phillips curves tend to have low oil prices and years associated with
high P
hillips curves tend to have high oil prices regardless of government fiscal and monetary
policy. Basically, the real world Phillips curve data can be interpreted to support either theory


both are able to explain the shifts in the short
-
run Phillips curv
e. The only way to really settle
these policy debates would be to run the economy through exactly the same circumstances
multiple times changing one variable each time and see what happens. Since we can never do
this, we can never really establish whose
theory is correct or not.


While the Keynesian
-
Monetarist debate dominated economics for 20 years, they are not the only
theories to have been discussed. We will look at another couple of theories in the next unit.



Journal Topics: Complete the followin
g assignment:


Write a two page paper on Monetarism based on at least two references (give them). Do not
repeat material from the text, but you can use a reference that compares Monetarism and
Keynesian economics.




73

CHAPTER 10 RE and Supply
-
side Theories




Rational Expectations (RE) Theory



Rational expectations, or the New Classical Theory or economics is very similar to Classical
economics. Associated with John Muth and Robert Lucas, this theory became a hot topic in
academic economics during the 198
0s and into the 1990s. RE theory, like Classical theory, sees
the economy as adjusting to the natural rate of output incredibly quickly, this time not because of
market forces operating in the background but rather because of the understanding the
partici
pants have in the economy. Because we all know the economy will end up at full
employment and we understand the implications of government policies, we eliminate all the
short
-
term adjustment mechanisms and simply go straight to the long run equilibrium.

The
assumptions of the RE theory are:


Information, although imperfect, is widely available and will be fully incorporated in
decision making:
Rational expectations theory gets its name from their belief that people
eliminate any consistent source of err
or from their predictions and behavior. For example, if
every month you budget an inadequate amount for your gas bill you will learn to raise the amount
you put aside for the gas bill until this is no longer true. Your bill continues to fluctuate each
mo
nth according to weather and the number of billing days so there are times your prediction is
not correct but there is no longer any pattern to the error. Businesses do not know what the
demand for their goods and services will be next week let alone next

year


but they will
eliminate any pattern to their error such as consistently over or underproducing. Households may
not know exactly what the future holds for their jobs, investments or income, but they will
eliminate any pattern to their error such as

consistently under or overestimating income or risk.
Since everyone has access to roughly the same information the decisions made by people vary
randomly by interpretation. For example, if everyone has access to the same financial data
released by corpo
rations, then over time we adjust what we are willing to pay for a stock so that
we eliminate overpayments and underpayments. These analysts claim that winners and losers in
the stock market are then random since any pattern will be incorporated into exis
ting stock prices.


Markets are highly competitive and collusion is essentially impossible:
As has been said
before
if markets are highly competitive than no one can hold a market off its full employment
equilibrium. The RE model goes farther even than t
he Classical economists by saying that
collusion and market dominance are almost impossible in the long run. Firms that try to
cooperate to reduce production and raise price will simply result in cheating on the agreement


every firm knows that it can in
crease its short
-
run profits by raising production back up so they
will. If firms try to use expensive strategies such as predatory pricing to drive other competitors
out of the market, they will simply weaken their own financial position and make it easi
er for new
competitors to enter and drive
them
out of the market. Since firms know this, they refrain from
attempting these strategies. Note, that participants understand the ways markets work and take
this information into consideration in their decisio
n making.


People understand the relationships among economic variables and learn the implications
of any government policies that try to manipulate those variables:
This is the main difference
between the Classical and New Classical (RE) models. The C
lassical economists thought that the
unseen forces of supply and demand (“the invisible hand of the marketplace”) would steer the

74

economy to socially optimal outcomes in micro markets and full employment in macro markets
as individuals pursued their indivi
dual interests. This happens without the understanding of the
participants who are unknowingly pushed by competition and self
-
interest. The RE theorists felt
that we achieved socially optimal outcomes in micro markets and full employment in macro
markets

because as individuals we understand the economic forces at work and that this
understanding plays an important role in the rapid achievement of these outcomes. Remember,
that people incorporate any information in their decision making


the RE theorists

feel that
individuals in an economy learn the processes at work and then anticipate them. For example,
since people “know” that a current deficit means the government will need more money in the
future to pay the interest on the national debt in addition

to repaying the bonds they “know” that
this will mean the need for higher taxes or lower spending in the future. Consequently, they will
not increase their spending today, rather they will save more money to cover the future problems
they anticipate. Th
e policies used by the government will not even stimulate aggregate demand
in the short
-
run because we understand their consequences.


Wages and prices are completely flexible:

RE theorists argue that buyers and sellers of goods,
services and labor will c
onstantly renegotiate prices based upon their understanding of economic
forces. For example, since people “know” that excessive money growth causes future inflation as
soon as they see excessive money growth they start raising their prices and wage demand
s to
compensate for the coming inflation. Wages and prices do not display any “stickyness” they are
rapidly renegotiated. If there is inadequate money to support full employment at the current price
level everyone knows that the price level will fall in
the future so they renegotiate wages and
prices today to preserve jobs and sales. Since we “know” that in the long run the economy will
end up at the natural rate of output we agree to adjust wages and prices today to keep the
economy there in the short
-
r
un as well. Only unanticipated events or events with unknown
consequences (because we have never seen them before) will be able to disrupt the economy even
in the short
-
run.



Implications of Assumptions



Since all markets are operating on the fir
ms’
knowledge that excessive prices through
market dominance or cooperation merely
brings in new competitors, said excessive
prices will not occur. Firms will knowingly
set production at the socially optimal level.
As long as outside factors remain equal
, the
firms and, therefore, the economy, will
deviate from the natural rate of output only
by random error.


Short
-
run shifts in aggregate demand result
in immediate adjustments in aggregate
supply that push the economy back to the
natur
al rate of output, as everyone
immediately adjusts wages and prices to
support full employment. Even in the short
-
run, the aggregate supply curve is vertical as

75

long as there are no unanticipated changes in outside variables. By this logic the Phillips c
urve is
also vertical with only random variations from the natural rate of unemployment, again, as long
as there are no unanticipated changes in outside variables.


If this is true then how do we explain the business cycle? Clearly, there are times in the

economy
that the economy moves farther and farther away from full employment, stabilizes and then
moves back closer and closer to full employment. That is not a random pattern of economic
activity. A group of RE theorists derived their explanation of th
e cyclical pattern of economic
activity


the
real business cycle model
.


The real business cycle model states that changes in exogenous factors that temporarily or
permanently shift the natural rate of output are responsible for the ups and downs of GDP.

Mainly, it is shifts in technology or resource availability that create the short
-
run fluctuations in
economic activity. A rise in the availability of resources such as oil and/or a rise in technology
would shift aggregate supply to the right
-

resulting

in lower prices and a higher natural rate of
output while the Phillips curve would shift to the left


resulting in lower inflation and a lower
natural rate of unemployment. A disruption in the availability of resources such as oil and/or a
drop in capac
ity due to loss of technology or facilities would shift aggregate supply to the left
-

resulting in higher prices and a lower natural rate of output while the Phillips curve would shift to
the right


resulting in higher inflation and a higher natural rate

of unemployment.


The problem is that relatively few business cycle phases in US history can be linked to exogenous
factors shifting


the booming economy of the late 1990s and the stagnant economy of the late
1970s are relatively rare examples of cycles
created by shifts in resource availability and/or
technology. Most business cycles in US history clearly originate with aggregate demand not
aggregate supply. If aggregate supply is shifting then unemployment and inflation will move in
the SAME direction



if aggregate demand is shifting then they will move in the OPPOSITE
direction. In most business cycles we see them clearly move in the opposite direction.


In my opinion, RE theory is too dependent on the technical development of their models and the
m
athematics involved and too unresponsive to empirical data and experiences. We do not see
rapid renegotiations of wages and prices in the real world, we do not see consumers taking the
future consequences of current government economic policies into consi
deration when making
decisions, and we do not see random variations on GDP, employment and prices in the absence of
real world variables shifting. I believe the Monetarists have a much more defensible conservative
macroeconomic model.



Supply
-
side Econom
ics



A relatively small group of economists in the late 1970s and 1980s also suggested that the
business cycle was the result of fluctuating aggregate supply, however, their opinion was that
government policies were responsible for disrupting the aggregat
e supply of the economy. They
argued that the government had created a environment that was hostile to business and success
and encouraged waste and inefficiency, resulting in a leftward shift of the aggregate supply curve.
A leftward shift in aggregate
supply results in higher unemployment and inflation at the same
time and this was their explanation of the stagflation of the 1970s. This theory was never widely
accepted in economics, although it was embraced by conservative politicians and served as the

foundation of Ronald Reagan’s economic policies (
Reaganomics
).


76

According to the supply
-
siders, liberal government policies during the late 1960s and early 1970s
reduced production and employment in the US by over
-
taxation (especially of businesses) and
ov
er
-
regulation. These excessive taxes and regulations raise the cost of production for American
businesses and cause them to reduce their production and hiring. Individuals who worked hard,
acquired additional training or education and raised their wages
found themselves in higher tax
brackets where they lost a larger percent of their income to the government. This discouraged
people from pursuing these activities which are valuable to the economy and society. In addition,
the government was said to enco
urage waste and inefficiency by rewarding nonproductive
behavior


the tax code gave big write
-
offs for excessive costs and entitlement programs
“rewarded” people for choosing not to work or acquire skills by giving them benefits such as
welfare and food s
tamps. In general, the government was said to have created a skewed incentive
system with productive behavior being punished and discouraged while unproductive behavior
was reward and encouraged.


The Supply
-
side solution to this was to reduce taxes, espe
cially on businesses and upper income
groups, reduce government regulations on industry and reduce entitlement spending. I’m sure
you can see why this theory resonated with political conservatives. While many conservative
economists were sympathetic to s
ome of the claims of the supply
-
siders, their theory was largely
rejected in the field of economics because of the extremes they took their claims to. The most
controversial aspect of the supply
-
side model was their view of the relationship between
govern
ment tax rates and tax revenue.



The Laffer Curve



Arthur Laffer was the predominate supply
-
side economist at this time, and he made the rather
extreme claim that the government could cut tax rates without losing any money, in fact, if
anything, they wer
e likely to receive higher tax revenue
after

cutting tax rates. This view was
NOT supported by the empirical evidence on tax elasticity at the time. Tax revenue is the product
of the tax rate and the number of units being taxed (
tax base
).


Tax Rev =

Tax Rate x Tax base


So that if the government has a 40¢ a gallon tax on gasoline and 10 million gallons of gas are
sold, then the government will collect $4 million dollars in tax revenue. All other things equal,
the tax rate and the tax base will m
ove in the opposite direction


if the government raises the tax
rate it discourages the production or consumption of the good being taxed. The degree to which
production or consumption falls depends on the responsiveness of the people being taxed.


The

more consumers keep buying a product even though it is now more expensive, the more
producers will keep making it. Consequently, the tax base will decrease less than the tax rate went
up and the tax revenue will move with the tax rate. If people tend to
keep working even though
their income tax has risen then the tax base falls less than the tax rate went up and the tax revenue
will again move with the tax rate.


The less consumers keep buying a product because it is now more expensive, the less produce
rs
will keep making it. Consequently, the tax base will decrease more than the tax rate went up and
the tax revenue will move with the tax base. If people tend not to keep working because their

77

income tax has risen then the tax base falls more than the ta
x rate went up and the tax revenue
will again move with the tax base.

When the tax rate is 0%, then clearly the
government will take in $0. But, notice
that the government also takes in $0 when
the tax rate is 100%. Will people work or
open businesses

if the government took
100% of their income or profits? No!


At lower tax rates the tax base does not
shrink very much as tax rates rise. People
will not change behavior very much when
very low tax rates rise to low tax rates.


At higher tax rates the
tax base shrinks
significantly as tax rates rise. People will
change behavior a lot when high tax rates
become very high tax rates. These are
known as
prohibitive taxes



tax rates so
high they reduce tax revenue.


In the late 1970s, Laffer claimed that
the US was on the right hand side of this graph


that our
tax rates were prohibitive. If this were true, then a cut in government taxes would eventually
raise

tax revenue or at least leave it about the same. The stimulus does not work immediately,
becau
se it will take time for businesses to expand their productive capacity; it takes time to build
new factories, order new equipment, hire and train new workers, etc. The supply
-
siders claimed
that in about 3
-
5 years the government tax cut would pay for its
elf or better. Mainstream
economists denied that the US was in the zone of prohibitive taxes; all our data suggested that we
were somewhere to the left of the graph, perhaps approaching the maximum tax revenue at worst.


The Reagan tax cuts in the early
1980s were largely influenced by the supply
-
siders though the
final version of the tax cuts was more of an across the board cut than originally proposed. Given
that the US economy was in a severe recession at the time, economists and politicians argued ho
w
much the tax cut operated as a Keynesian tax cut and how much it operated as a Supply
-
side one.
The same groups argued over how much the large budget deficits of the 1980s were a result of the
recession and how much the result of Reagan’s economic polic
ies.



A Tax Cut By Any Other Name



The Keynesians wanted a tax cut during the recession of 1980
-
82, the Supply
-
siders wanted a tax
cut during the recession of 1980
-
82


how are the two positions different? Supply
-
side
economists saw large differences be
tween their tax cuts and those of their theoretical


To whom do we give the tax cut?
Keynesian tax cuts were either across the board (for political
purposes) or aimed at the lower 50% of the income distribution (because these are the people that
respond
most to an income change). Supply
-
side tax cuts were aimed primarily at businesses and
upper income households because those are the individuals most likely to invest the money in the
business sector thus creating new production capacity.


78

Which curve shif
ts?
Keynesian tax cuts were aimed at increasing the aggregate demand curve
by shifting consumption


an increase in aggregate demand, aote, raises both real GDP and the
price level. A supply
-
side tax cut is aimed at increasing the aggregate supply curve
by increasing
investment to build more capacity


an increase in aggregate supply, aote, raises real GDP but
lowers the price level. Since investment is also part of the aggregate demand curve, aggregate
demand will also rise, but the supply
-
siders said t
hat it will not rise more than aggregate supply,
therefore, the most that will happen is the price level will remain constant


a supply
-
side tax cut
is non
-
inflationary.


Effect on the national debt:
A Keynesian tax cut creates a ongoing deficit that w
ill persist until
the economy overheats and the government reverses policy raising taxes. Since recessions are
more frequent and more severe that booms, this means that the national debt over time gradually
increases. A supply
-
side tax cut, it was claime
d, would only create a very temporary deficit that
lasts until the business sector expands production sufficiently to move us up and to the left on the
Laffer curve. At this point the deficit disappears, in fact, the economy is likely to move into a
surpl
us that can be used to pay off past debt or used to spend on other government programs.


The supply
-
side economists felt that their policy was clearly superior to that of the Keynesians.
This entire argument is based upon two principles both working


tha
t businesses and high
income households invest their tax cut in building productive capacity (as opposed to CEO
bonuses or European vacations) and that tax elasticity is elastic


i.e. tax revenue moves with the
tax base not the tax rate. Our real world e
xperience suggests that the former is only partially true
and that the latter has not been true at all for the US at any time.


Many economists concluded that our experiences during the 1980s have proven supply
-
side
theory wrong but this overstates the cla
rity of the evidence. During the 1980s the government ran
enormous budget deficits that remained high even after the US economy started recovering from
the recession of 1980
-
82. Part of this was due to the severity
of the recession and how long it
took to climb back to previous production levels, part was due to the increases in military
spending, part was due to the extremely high interest rates coming from the contractionary policy
of the Federal Reserve and part t
o the tax cuts themselves. While economists disagree over how
much of the resulting government debt was due to the tax cut, one thing is clear


there was a

79

large shift in aggregate demand because of this tax cut


much larger than the shift in aggregate
supply. The lesson is not clear, however, since the Reagan tax cuts were not entirely supply side


they were much more across the board than the supply
-
siders had wanted


more across the
board then the Reagan administration had wanted.


The US economy

started booming in the mid 1990s and some supply
-
siders have claimed that
this is the result of the tax cuts during the 1980s. If the lag time for capacity is more like 5 years
instead of 3
-
5 years and the creation of capacity was delayed because of the
Fed’s high interest
rates and then the recession of 1990
-
91, it would be possible that the supply
-
side stimulus did not
significantly impact the US economy until the mid 1990s. Most economists believe that the
boom of the 1990s was really the result of lo
w oil prices, high productivity coming from
technology and greater efficiency due to rising international trade, but proving it is another
matter.



Journal Topics: Complete the following assignment


Find two web pages on each theory and write a one page
summary of the 2 web pages for each
theory.