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```									CHAPTER 19
Disputes over Macro Theory and Policy

1. Compare and contrast the classical and Keynesian views of aggregate demand and
supply.

2. The following questions refer to graphs A and B below. In the graphs, Qf represents
full-employment output and Qu1 and Qu2 represent less-than-full-employment levels of
output.

(a) Which of the two graphs best illustrates the Keynesian view of the macroeconomy,
and which best illustrates the classical view? Explain.

(b) When demand shifts from AD1 to AD2, explain what happens to output and price
level in graph A.

(c) When demand shifts from AD1 to AD2, explain what happens to output and price
level in graph B.

3. Describe two basic differences between the Keynesian and monetarist economic
theories.

4. Give the basic symbolic equations for the mainstream view of the economy. Identify
each symbol in the equation with a brief explanation. Using this equation, what is one
major explanation for instability in the economy from a mainstream perspective?

5. Explain the equation of exchange.

6. Assume that M is \$500 billion and V is 5. What is the level of nominal GDP according
to the monetarist equation? If V rises by 10%, then according to the monetarist
equation, what will be the new level of nominal GDP?

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Chapter 19

7. Assume that M is \$200 billion and V is 6. If V increases by 15%, what will be the
change in nominal GDP?

8. If nominal GDP is \$848 billion, and velocity of money is 4, how much is the money
supply? If the GDP price index is 200, what is real GDP here?

9. Assume that M is \$300 billion and V is 10. What is the level of nominal GDP according
to the monetarist equation? If V rises by 10%, then according to the monetarist
equation, what will be the new level of nominal GDP?

10. Assume that M is \$250 billion and V is 8. If V increases by 15%, what will be the
change in nominal GDP?

11. If nominal GDP is \$1344 billion, and velocity of money is 6, how much is the money
supply? If the GDP price index is 160, what is real GDP here?

12. Define the velocity of money. Explain the monetarist view with regard to the stability
of velocity.

13. Does velocity change in response to changes in the money supply according to
monetarists?

14. What are the four different views of the causes of macroeconomic instability in the
economy?

15. Use aggregate supply and demand analysis to explain real business cycle theory.

16. Explain the new classical view of self-correction in the economy.

17. Compare and contrast the new classical and the mainstream view of self-correction in
the economy.

18. Describe the mainstream view of self-correction in the economy.

New 19. How can paying workers an above-market wage result in greater efficiency? What are
the implications for the flexibility of wages?

New 20. What is insider–outsider theory? How does it explain the downward inflexibility of
wages?

21. Answer the following questions for a hypothetical economy whose situation in year 1
was as follows: M = \$800 billion; long-term annual growth of real GDP = 3%; V = 4.

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Disputes over Macro Theory and Policy

The banking system has no excess reserves and the reserve requirement is 10%.
Assume that V is constant and the economy is at full employment.

(a) What is the nominal GDP in year 1?

(b) If the Federal Reserve adheres to the monetarist rule of increasing the money supply
by a constant 5% using open-market operations, explain whether it will have to buy or
sell bonds and by how much between years 1 and 2 in order to meet the rule.

(c) Based on the information given above and calculated in (b) above, what will be the
nominal GDP in year 2?

(d) Is this change greater or less than the change in real GDP? Explain.

22. How do new classical economists view the importance of policy rules and discretion in
macroeconomic policy?

23. What reasons do monetarists give for downgrading the importance of fiscal policy
relative to monetary policy?

24. Distinguish between discretionary monetary policy and monetary “rules.” How do the
mainstream economists and monetarists differ on their recommendations for the use of
rules or discretionary policy?

25. Compare and contrast the views of new classical economists and mainstream
economists on the issue of policy rules versus the use of discretionary monetary and
fiscal policy.

26. Below are price level (PL) and output (Q) combinations to describe aggregate demand
and aggregate supply curves: (1) PL and Q1 is AD1. (2) PL and Q2 is AD2. (3) PL and
Q3 is ASLR1. (4) PL and Q4 is ASLR2.

PL            Q1                Q2                Q3                Q4
50             0               100               200               300
40           100               200               200               300
30           200               300               200               300
20           300               400               200               300
10           400               500               200               300

(a) Use the graph below to graph AD1, AD2, ASLR1, and ASLR2. Label the vertical axis
as the price level and the horizontal axis as real output (Q).

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(b) If the economy is initially in equilibrium where AD 1 and ASLR1 intersect, what will
the price level and real output be?

(c) If over time, the economy grows from AS LR1 to ASLR2, what will be the equilibrium
price level and real output?

(d) Assume a monetary rule is adopted that increases the money supply proportionate to
the increase in aggregate supply. Aggregate demand will increase from AD 1 to AD2, so
what will the equilibrium price level and real output be?

(e) Mainstream economists would argue that velocity is unstable, so a constant increase
in the money supply might not shift AD1 all the way to AD2. It might also be the case
that the constant increase in the money supply might shift AD 2 beyond its expected level
of output. For both cases, explain what mainstream economists think will happen to the
price level.

27. What rationale does rational expectations theory provide for the ineffectiveness of
discretionary policies?

28. Explain the mainstream economists’ justification for the use of discretionary fiscal and
monetary policy and their criticisms of policy rules.

29. Identify how ideas from monetarism and rational expectations have been incorporated

30. Which aspects, if any, of monetarist or rational expectations theory have been integrated
into mainstream macroeconomics?

31. Mainstream and new classical view are compatible perspectives on macroeconomic
issues and policies. Do you agree? Explain.

New 32. (Last Word) Describe three major features of the Taylor rule.

New 33. (Last Word) What is the basic purpose of the Taylor rule?

270
Disputes over Macro Theory and Policy

1. Compare and contrast the classical and Keynesian views of aggregate demand and
supply.

The classical view is that the aggregate supply curve is vertical and that it alone
determines the level of real output. The level of real output (and employment) does not
change as aggregate demand changes because there is perfect flexibility in wages and
prices. Thus it is not possible for the economy to remain at less than the full-
employment level of output for any length of time. Also, the aggregate demand curve is
downsloping and it alone determines the price level. The aggregate demand curve,
however, will be stable if monetary authorities maintain a constant money supply.

The Keynesian view is that the aggregate supply curve is horizontal up to the full
employment level of real output because there is downward inflexibility in prices and
wages. Therefore, a decline in real output will have no effect on the price level.
Keynesian economists also think that the aggregate demand curve is unstable and
subject to periodic fluctuations, in large part because of the instability of the investment
component of aggregate demand. If aggregate demand decreases in the horizontal range
of aggregate supply, then real output will decrease, but the price level remains constant.
In this case, it is possible for the economy to achieve equilibrium at less than the full-
employment level of output, a result that is not possible in the opinion of classical
economists. [text: E pp. 355-357; MA pp. 355-357]

2. The following questions refer to graphs A and B below. In the graphs, Qf represents
full-employment output and Qu1 and Qu2 represent less-than-full-employment levels of
output.

(a) Which of the two graphs best illustrates the Keynesian view of the macroeconomy,
and which best illustrates the classical view? Explain.

(b) When demand shifts from AD1 to AD2, explain what happens to output and price
level in graph A.

(c) When demand shifts from AD1 to AD2, explain what happens to output and price
level in graph B.

(a) Graph A represents the classical view and Graph B represents the Keynesian view.
In Graph A full employment is the norm and any change in demand is reflected in
changing price levels. This is the classical perspective. However, in Graph B a change
in demand has an impact on real output and may or may not affect the price level.
(b) Output remains at full employment but price level rises.

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(c) Output declines but price level remains the same. [text: E pp. 355-357; MA pp.
355-357]

3. Describe two basic differences between the Keynesian and monetarist economic
theories.

Keynesians believe that the capitalist economy is inherently unstable and that business
cycle fluctuations could lead to periodic inflation or unemployment. As a result they
support government intervention to assist in stabilizing the economy.

Monetarists believe that capitalist markets are highly competitive and that this
competition makes the economy very stable. Prices and wages fluctuate to equilibrate
the economy at a level of full employment. [text: E pp. 355-357; MA pp. 355-357]

4. Give the basic symbolic equations for the mainstream view of the economy. Identify
each symbol in the equation with a brief explanation. Using this equation, what is one
major explanation for instability in the economy from a mainstream perspective?

The basic equation for Keynesian theory is the aggregate expenditures equation: C + I g
+ Xn + G = GDP where C is aggregate consumption, I g is gross investment spending, Xn
stands for net exports (exports minus imports), and G is government spending on goods
and services. The instability in the economy arises from the instability in investment
spending. The sharp increases or decreases in investment spending lead to changes in
aggregate demand that result in demand-pull inflation or recession. [text: E p. 358; MA
p. 358]

5. Explain the equation of exchange.

The fundamental monetarist equation is MV = PQ. In this equation M is the money
supply and V is the velocity at which the average income dollar is spent in a year, MV
represents the total amount spent by purchasers. P is the price level and Q is the
physical volume of goods and services produced. PQ, therefore, is the value of nominal
GDP. [text: E pp. 359-360; MA pp. 359-360]

6. Assume that M is \$500 billion and V is 5. What is the level of nominal GDP according
to the monetarist equation? If V rises by 10%, then according to the monetarist
equation, what will be the new level of nominal GDP?

5 times \$500 billion = \$2500 billion GDP. If V rises by 10% to 5.5, then the new level
of GDP should rise by 10% to \$2750 billion or 5.5 times \$500 billion = \$2750 billion.
[text: E pp. 359-360; MA pp. 359-360]

7. Assume that M is \$200 billion and V is 6. If V increases by 15%, what will be the
change in nominal GDP?

The nominal GDP should rise by 15%. The arithmetic is as follows: original GDP =
\$1200 billion; after V rises to 6.9, GDP = \$1380 billion. [text: E pp. 359-360; MA pp.
359-360]

8. If nominal GDP is \$848 billion, and velocity of money is 4, how much is the money
supply? If the GDP price index is 200, what is real GDP here?

\$848 billion/4 = \$212 billion = PQ, where Q is real GDP. If P = 2.00, then real GDP =
\$848/2.00 = \$424 billion. [text: E pp. 359-360; MA pp. 359-360]

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Disputes over Macro Theory and Policy

9. Assume that M is \$300 billion and V is 10. What is the level of nominal GDP according
to the monetarist equation? If V rises by 10%, then according to the monetarist
equation, what will be the new level of nominal GDP?

10 x \$300 billion = \$3000 billion GDP. If V rises by 10% to 11%, then the new level of
GDP should rise by 10% to \$3300 billion or 11 x \$300 billion = \$3300 billion. [text: E
pp. 359-360; MA pp. 359-360]

10. Assume that M is \$250 billion and V is 8. If V increases by 15%, what will be the
change in nominal GDP?

The nominal GDP should rise by 15%. The arithmetic is as follows: Original GDP =
\$2000 billion; after V rises to 9.2, GDP = \$2300 billion. [text: E pp. 359-360; MA pp.
359-360]

11. If nominal GDP is \$1344 billion, and velocity of money is 6, how much is the money
supply? If the GDP price index is 160, what is real GDP here?

\$1344 billion/6 = \$224 billion = PQ, where Q is real GDP. If P = 1.60, then real GDP =
\$1344/1.60 = \$840 billion. [text: E pp. 359-360; MA pp. 359-360]

12. Define the velocity of money. Explain the monetarist view with regard to the stability
of velocity.

The velocity of money is the number of times per year that the average dollar is spent.
It can be viewed as the rate at which money turns over in a year. The monetarists look
at the value of V over the long run and conclude that it is stable. By stable the
monetarist does not mean “constant.” Rather, the monetarist thinks that the factors
changing velocity over time occur gradually and are predictable. Any year-to-year
changes in velocity can be easily anticipated. [text: E pp. 358-359; MA pp. 358-359]

13. Does velocity change in response to changes in the money supply according to
monetarists?

No. People have a stable desire to hold money relative to other financial assets, real
assets, or for buying goods and services. How much money the public wants to hold
depends primarily on the level of nominal GDP. Monetarists reason that the money
supply is the causal force in determining nominal GDP. [text: E pp. 358-359; MA pp.
358-359]

14. What are the four different views of the causes of macroeconomic instability in the
economy?

First, the mainstream view is Keynesian based and holds that instability in the economy
arises from: (a) the volatility in investment spending that makes aggregate demand
unstable; and (b) occasional aggregate supply shocks which cause cost-push inflation
and recession. Second, monetarists focus on the money supply, think markets are highly
competitive, and that government intervention destabilizes the economy. Monetarists
see macroeconomic instability as a result of inappropriate monetary policy. An increase
in the money supply will increase aggregate demand, output, and the price level; it will
also reduce unemployment. Eventually, nominal wages rise to restore real wages, and
real output and the unemployment rate falls back to its natural level at long-run
aggregate supply. Third, real-business cycle theorists see macroeconomic instability as
being caused by real factors influencing aggregate supply instead of monetary factors
causing shifts in aggregate demand. Changes in technology and resources will affect
productivity, and thus the long-run growth rate of aggregate supply. Fourth, another

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view of instability in the macro economy attributes the reasons to coordination failures.
These failures occur when people are not able to coordinate their actions to achieve an
optimal equilibrium. A self-fulfilling prophecy can lead to recession because if
households and firms expect it, they individually cut back on spending and employment.
If, however, they were to act jointly, they could take actions to counter the recession
expectations to achieve an optimal equilibrium. [text: E pp. 359-361; MA pp. 359-361]

15. Use aggregate supply and demand analysis to explain real business cycle theory.

Real business cycle theorists focus on real factors that affect aggregate supply rather
than monetary or spending factors that affect aggregate demand. Significant changes in
technology or resource prices will affect productivity and also the long-term growth of
the economy.

If aggregate supply should increase due to an improvement in productivity, then real
output will increase but the price level will remain the same. The reason the price level
does not change is that aggregate demand will shift outward to accommodate the shift in
aggregate supply. The reason that aggregate demand shifts is that there is an increase in
the demand for money and it brings forth an increase in the supply of money. [text: E p.
360; MA p. 360]

16. Explain the new classical view of self-correction in the economy.

The new classical view of economics, held by monetarists and rational expectation
economists, is that the economy may deviate from the full-employment level of output,
but it eventually returns to this output level because there are self-corrective
mechanisms in the economy. Graphically, if aggregate demand increases, it temporarily
raises real output and the price level. Then, nominal wages rise and productivity falls,
so short-run aggregate supply decreases, thus bringing the economy back to its long-run
output level. There is disagreement about the speed of adjustment. The monetarists
adopt the adaptive expectations view that there will be a slower, temporary change in
output, but in the long-run it will return to its natural level.

Other new classical economists adopt the rational expectations theory (RET) that there
will be a rapid adjustment with little or no change in output. RET is based on two
assumptions: people understand how the economy works so that they quickly anticipate
the effect on the economy of an economic event; all markets in the economy are so
competitive that equilibrium prices and quantities quickly adjust to changes in policy.
In RET, unanticipated price-level changes, called price-level surprises, cause short-run
changes in real output because it causes misperceptions about the economy among
workers and firms. In RET, fully anticipated price-level changes do not change real
output even in the short-run because workers and firms anticipate and counteract the
effects of the changes. [text: E pp. 361-364; MA pp. 361-364]

17. Compare and contrast the new classical and the mainstream view of self-correction in
the economy.

The new classical view of economics, held by monetarists and rational expectation
economists, is that the economy may deviate from the full-employment level of output,
but it eventually returns to this output level because there are self-corrective
mechanisms in the economy. Graphically, if aggregate demand increases, it temporarily
raises real output and the price level. Then, nominal wages rise and productivity falls,
so short-run aggregate supply decreases, thus bringing the economy back to its long-run
output level. There is disagreement about the speed of adjustment. The monetarists
adopt the adaptive expectations view that there will be a slower, temporary change in
output, but in the long-run it will return to its natural level.

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Disputes over Macro Theory and Policy

Other new classical economists adopt the rational expectations theory (RET) that there
will be a rapid adjustment with little or no change in output. RET is based on two
assumptions: people understand how the economy works so that they quickly anticipate
the effect on the economy of an economic event; all markets in the economy are so
competitive that equilibrium prices and quantities quickly adjust to changes in policy.
In RET, unanticipated price-level changes, called price-level surprises, cause short-run
changes in real output because it causes misperceptions about the economy among
workers and firms. In RET, fully anticipated price-level changes do not change real
output even in the short-run because workers and firms anticipate and counteract the
effects of the changes.

The mainstream view of self-correction suggests that price and wages may be inflexible
downward in the economy. Graphically, a decrease in aggregate demand will decrease
real output, but not the price level because nominal wages will not decline and cause the
short-run aggregate supply curve to shift right. The economy can get stuck in a
recession for a long time period.

Downward wage inflexibility primarily arises because of wage contracts and the legal
minimum wage, but they may also occur from efficiency wages and insider-outsider
relationships according to mainstream economics. An efficiency wage minimizes the
firm’s labor cost per unit of output, but may be higher than the market wage. This
higher wage may result in greater efficiency because it stimulates greater work effort,
requires less supervision costs, and reduces job turnover. Insider-outsider relationships
may also produce downward wage inflexibility. During a recession, outsiders (who are
less essential to the firm) may try to bid down wages to try to keep their jobs, but the
firm may not lower wages because it does not want to alienate insiders (who are more
essential to the firm) and disrupt the cooperative environment in the firm that is needed
for production. [text: E pp. 361-365; MA pp. 361-365]

18. Describe the mainstream view of self-correction in the economy.

The mainstream view of self-correction suggests that price and wages may be inflexible
downward in the economy. Graphically, a decrease in aggregate demand will decrease
real output, but not the price level because nominal wages will not decline and cause the
short-run aggregate supply curve to shift right. The economy can get stuck in a
recession for a long time period.

Downward wage inflexibility primarily arises because of wage contracts and the legal
minimum wage, but they may also occur from efficiency wages and insider-outsider
relationships according to new Keynesian economics. An efficiency wage minimizes
the firm’s labor cost per unit of output, but may be higher than the market wage. This
higher wage may result in greater efficiency because it stimulates greater work effort,
requires less supervision costs, and reduces job turnover. Insider-outsider relationships
may also produce downward wage inflexibility. During a recession, outsiders (who are
less essential to the firm) may try to bid down wages to try to keep their jobs, but the
firm may not lower wages because it does not want to alienate insiders (who are more
essential to the firm) and disrupt the cooperative environment in the firm that is needed
for production. [text: E pp. 364-365; MA pp. 364-365]

New 19. How can paying workers an above-market wage result in greater efficiency? What are
the implications for the flexibility of wages?

An above-market wage raises the opportunity cost of losing a job. Workers thus have
more incentive to work hard and put more effort into their jobs. Higher wages also
reduce shirking on the job, so the firm does not have to hire as many supervisory
personnel to make sure workers are doing their jobs. The higher wage also reduces

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turnover which can be costly to firms. The implication for the flexibility of wages is
that they would tend to be more inflexible if efficiency wages are paid. Employers
would be reluctant to cut wages because it can lower morale, increase shirking, and
increase turnover. [text: E pp 364-365; MA pp. 364-365]

New 20. What is insider–outsider theory? How does it explain the downward inflexibility of
wages?

This theory suggests that people who are looking for work at firms (outsiders) may not
be able to underbid the wages of people already working at firms (insiders) during
periods of recession or widespread unemployment. The reason for this situation is that
employers might fear that insiders would resent the underbidding of outsiders and refuse
to cooperate with them. Cooperation and teamwork are important in modern businesses.
Thus, outsiders who want to work for the firm may not be hired at lower wages than
insiders already working for the firm even during periods of higher unemployment.
[text: E p. 365; MA p. 365]

21. Answer the following questions for a hypothetical economy whose situation in year 1
was as follows: M = \$800 billion; long-term annual growth of real GDP = 3%; V = 4.
The banking system has no excess reserves and the reserve requirement is 10%.
Assume that V is constant and the economy is at full employment.

(a) What is the nominal GDP in year 1?

(b) If the Federal Reserve adheres to the monetarist rule of increasing the money supply
by a constant 5% using open-market operations, explain whether it will have to buy or
sell bonds and by how much between years 1 and 2 in order to meet the rule.

(c) Based on the information given above and calculated in (b) above, what will be the
nominal GDP in year 2?

(d) Is this change greater or less than the change in real GDP? Explain.

(a) Nominal GDP = \$800 billion times 4 = \$3200 billion.
(b) M must grow by 5% which would require the Fed to buy bonds in the amount of
0.05 times 800 or \$40 billion (assuming no monetary multiplier has time to take effect).
Alternatively, if we assume a money multiplier of 10 or 1/.10, a \$4 billion purchase
could result in the \$40 billion rise.
(c) The nominal GDP in year 2 should be \$3360 billion.
(d) This change is greater than the change in real GDP which is said to grow by only
3% in this economy. The nominal GDP grew by 5%, so some of the change must have
been due to higher prices. [text: E pp. 365-366; MA pp. 365-366]

22. How do new classical economists view the importance of policy rules and discretion in
macroeconomic policy?

Monetarists and other new classical economists argue for policy rules to reduce
government intervention in the economy that they believe cause macroeconomic
instability. In regard to monetary policy, monetarists have proposed a monetary rule
that the money supply be increased at the same annual rate as the potential annual rate of
increase in the real GDP. A monetary rule would shift aggregate demand rightward to
match a shift in the long-run aggregate supply curve that occurs because of economic
growth, thus keeping the price level stable over time.

Monetarists and other new classical economists question the value of fiscal policy and
some extreme proposals have called for a required balanced federal budget over time.

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Disputes over Macro Theory and Policy

The reason that monetarists and new classical economists dislike fiscal policy is that it
will tend to crowd-out investment and only cause a temporary increase in output. RET
economists also think that fiscal policy is ineffective and that people will anticipate it
and their acts will counteract its intended effects. [text: E pp. 365-367; MA pp. 365-
367]

23. What reasons do monetarists give for downgrading the importance of fiscal policy
relative to monetary policy?

Monetarists downgrade fiscal policy’s importance because of the so-called crowding-out
effect or because of the way in which fiscal policy is financed. If government finances
increased spending by running a deficit and selling bonds, then this government
borrowing will increase the demand for money, raise the interest rate, and crowd out
much private investment. Hence, the net effect of a budget deficit based on borrowing
from the public is weak. If the government finances the budget deficit through the
creation of new money, then there would not be crowding out, but the increase in the
money supply is really monetary policy, not fiscal policy in this case. [text: E pp. 365-
367; MA pp. 365-367]

24. Distinguish between discretionary monetary policy and monetary “rules.” How do the
mainstream economists and monetarists differ on their recommendations for the use of
rules or discretionary policy?

Discretionary monetary policy is the use of an expansionary monetary policy to combat
a recession and a contractionary policy to combat an inflationary period. In other words,
it is an activist monetary policy for stabilizing the economy. Mainstream economists
would argue for discretionary monetary policy to complement fiscal stabilization policy.
Monetarists argue for monetary “rules” designed to be implemented without regard to
the state of the economy. Supposedly they will have a neutral effect on the cyclical ups
and downs of the economy. A suggested monetary rule is to keep the money supply
expanding at about 3-5% per year which is about the same as the potential growth rate
of real GDP. The point for a monetary rule is to avoid mistakes and to provide enough
liquidity to allow the economy to expand at its potential rate. [text: E pp. 365-368; MA
pp. 365-368]

25. Compare and contrast the views of new classical economists and mainstream
economists on the issue of policy rules versus the use of discretionary monetary and
fiscal policy.

Monetarists and new classical economists argue for policy rules to reduce government
intervention in the economy that they believe cause macroeconomic instability. In
regard to monetary policy, monetarists have proposed a monetary rule that the money
supply be increased at the same annual rate as the potential annual rate of increase in the
real GDP. A monetary rule would shift aggregate demand rightward to match a shift in
the long-run aggregate supply curve that occurs because of economic growth, thus
keeping the price level stable over time.

Monetarists and new classical economists question the value of fiscal policy and some
extreme proposals have called for a required balanced federal budget over time. The
reason that monetarists and new classical economists dislike fiscal policy is that it will
tend to crowd-out investment and only cause a temporary increase in output. RET
economists also think that fiscal policy is ineffective and that people will anticipate it
and their acts will counteract its intended effects.

Mainstream economists think that discretionary fiscal and monetary policy can be
effective and are opposed to a monetary rule and a balanced budget requirement. They

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see velocity as relatively unstable and a loose link between changes in the money supply
and aggregate demand. This means that a monetary rule might produce too great a shift
in aggregate demand (and demand-pull inflation) or too small a shift (and deflation) to
match the shift in aggregate supply. Such a rule would contribute to price instability,
not price stability. They support the use of fiscal policy during a recession or to counter
growing inflation. Fiscal policy, however, should be reserved for those situations where
monetary policy is relatively ineffective. They also oppose a balanced budget
amendment because its effects would be procyclical and reinforce recessionary or
inflationary tendencies, rather than being countercyclical. Mainstream economists also
note that there has been greater stability in the macro economy since 1946 when
discretionary monetary and fiscal policy was being more actively used to moderate the
effects of the business cycle. [text: E pp. 365-368; MA pp.365-368]

26. Below are price level (PL) and output (Q) combinations to describe aggregate demand
and aggregate supply curves: (1) PL and Q1 is AD1. (2) PL and Q2 is AD2. (3) PL and
Q3 is ASLR1. (4) PL and Q4 is ASLR2.

PL            Q1                 Q2                Q3                 Q4
50             0               100                200                300
40           100               200                200                300
30           200               300                200                300
20           300               400                200                300
10           400               500                200                300

(a) Use the graph below to graph AD1, AD2, ASLR1, and ASLR2. Label the vertical axis
as the price level and the horizontal axis as real output (Q).

(b) If the economy is initially in equilibrium where AD1 and ASLR1 intersect, what will
the price level and real output be?

(c) If over time, the economy grows from AS LR1 to ASLR2, what will be the equilibrium
price level and real output?

(d) Assume a monetary rule is adopted that increases the money supply proportionate to
the increase in aggregate supply. Aggregate demand will increase from AD 1 to AD2, so
what will the equilibrium price level and real output be?

(e) Mainstream economists would argue that velocity is unstable, so a constant increase
in the money supply might not shift AD1 all the way to AD2. It might also be the case
that the constant increase in the money supply might shift AD 2 beyond its expected level
of output. For both cases, explain what mainstream economists think will happen to the
price level.

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Disputes over Macro Theory and Policy

(a) See graph above.
(b) The price level will be 30 and real output will be 200.
(c) The price level will be 20 and real output will be 300.
(d) The price level will be 30 and real output will be 300.
(e) In the first case, the price level would fall below the target of 30 and lead to
deflation. In the second case, the price level would rise above the target of 30 and cause
demand-pull inflation. In either case a monetary rule may not produce price level
stability. [text: E pp. 365-368; MA pp. 365-368]

27. What rationale does rational expectations theory provide for the ineffectiveness of
discretionary policies?

Adherents contend that the aggregate responses of the public to its expectations will
render ineffective anticipated discretionary policies. For example, if monetary
authorities announce an easy money policy to increase output and employment, the
public will expect inflation in the future. Therefore, they will demand higher nominal
wages, businesses will increase product prices, and lenders will raise interest rates.
These actions will frustrate the attempt of policy makers to expand real output. The
only time that policy may be effective is when it is unanticipated, but this is virtually
impossible in a society with democratic institutions and free flow of information. [text:
E pp. 365-367; MA pp. 365-367]

28. Explain the mainstream economists’ justification for the use of discretionary fiscal and
monetary policy and their criticisms of policy rules.

Mainstream economists think that discretionary fiscal and monetary policy can be
effective and are opposed to a monetary rule and a balanced budget requirement. They
see velocity as relatively unstable and a loose link between changes in the money supply
and aggregate demand. This means that a monetary rule might produce too great a shift
in aggregate demand (and demand-pull inflation) or too small a shift (and deflation) to
match the shift in aggregate supply. Such a rule would contribute to price instability,
not price stability. They support the use of fiscal policy during a recession or to counter
growing inflation. Fiscal policy, however, should be reserved for those situations where
monetary policy is relatively ineffective. They also oppose a balanced budget
amendment because its effects would be procyclical and reinforce recessionary or
inflationary tendencies, rather than being countercyclical. Mainstream economists also
note that there has been greater stability in the macro economy since 1946 when
discretionary monetary and fiscal policy was being more actively used to moderate the
effects of the business cycle. [text: E pp. 367-368; MA pp. 367-368]

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Chapter 19

29. Identify how ideas from monetarism and rational expectations have been incorporated

First, monetarists have gotten mainstream economists to recognize that changes in the
money supply are an important element in explaining long-lasting and rapid inflation.
Second, mainstream economists now recognize that expectations matter because of
rational expectation theory and because of theories coordination failures in the economy.
[text: E p. 368; MA p. 368]

30. Which aspects, if any, of monetarist or rational expectations theory have been integrated
into mainstream macroeconomics?

Mainstream economists today largely accept the monetarist position that the money
supply is an important variable affecting economic activity and that excessive growth
over a long period of time can be inflationary. The notion of “crowding out” of private
investment has been recognized as a weakness of expansionary fiscal policy without
coordinated monetary policy. Finally, policy makers have become much more sensitive
to expectations and the interaction of policy with particular markets in the
macroeconomy. [text: E p. 368; MA p. 368]

31. Mainstream and new classical view are compatible perspectives on macroeconomic
issues and policies. Do you agree? Explain.

It would be difficult to argue that these theories are compatible. One could list several
major ways in which they are incompatible: (1) mainstream economists believe the
economy is inherently unstable while new classical economists view it as being
inherently stable over the long run; (2) monetarists believe any instability is caused by
inappropriate monetary policy; (3) mainstream economists support the use of monetary
and fiscal policy as tools for achieving and maintaining full-employment, price stability,
and economic growth; new classical economists believe that fiscal policy is weak and
ineffective and discretionary monetary policy too difficult to manage; (4) mainstream
economists view the velocity of money as unstable while monetarists believe it is stable;
(5) mainstream economists believe that cost-push inflation is possible while new
classical economists believe that inflation is not possible in the long run unless there is
excessive money supply growth; and (6) mainstream economists contend that wages and
prices are inflexible downward while monetarists believe that prices and wages are
flexible.

Having given the sources of incompatibility, it is also possible to say that these theories
are not totally incompatible. Most economists agree that both are inherently plausible.
In both theories, monetary policy affects the economy in the same direction-the
disagreement is over the way it happens and the extent to which the economy is
affected. Both sides agree that crowding out can occur, and that the way in which
deficits are financed will affect their impact. Both camps evaluate the status of
aggregate demand and aggregate supply in their analyses. [text: E pp. 357-368; MA pp.
357-368]

New 32. (Last Word) Describe three major features of the Taylor rule.

The rule suggests that monetary policy should respond to changes in both real GDP and
inflation. The adjustments would be made through the interest rate. First, if real GDP
rises 1 percent above potential GDP, the Fed should raise the Federal funds rate relative
to current inflation by half a percent. Second, if inflation rises by 1 percent above its
target of 2 percent then the Fed should raise the Federal funds rate by half a percent
relative to the inflation rate. Third, given optimal conditions in the economy (real GDP
equals potential GDP and inflation is equal to its target of 2 percent), then the Federal

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Disputes over Macro Theory and Policy

funds rate should be 4 percent to give a real interest rate of 2 percent. [text: E p. 369;
MA p. 369]

New 33. (Last Word) What is the basic purpose of the Taylor rule?

It is a rule that takes into account changes in real GDP and inflation. The key purpose is
to have the Fed justify its action relative to the rule. Following such a rule would make
the Fed more accountable for its actions. It would also permit market participants to do
a better job of predicting Fed behavior and thus reduce uncertainty about monetary
policy. The rule, however, is not a permanent one. Should economic conditions require
it, the Fed has the discretion to suspend following the rule, but would still have to justify
its action in that case. [text: E p. 369; MA p. 369]

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