Econ 103 Ch 18 KE Keynesian Economics Keynes believed in an activist federal government that would fight inflation and unemployment Keynesian economics is primarily associated with the concept of an activist federal government According to KE when the economy is experiencing inflation the best course of action is to reduce government spending or increase taxes According to KE bc wages and prices are sticky and it can take a long time for the economy to return to full employment the government should intervene in the macroeconomy The quantity theory of money equation is M money supply x V velocity of money P x Y Assumption that the velocity of money is constant or virtually onstant Nominal GDP is P x Y If economy is operating at potential GDP nominal GDP real GDP The strict monetarist view argues that monetary changes only influence the money supply so real GDP is unaffected Inflation is always and solely a monetary phenomenon The velocity of money can be defined as the average number of times a dollar changes hands during the year or the ratio of nominal GDP to the stock of money V GDP M Friedman advocated using a policy of slow and steady monetary growth to accommodate real growth but deter inflation Money supply should grow at a rate equal to the average growth of real output Without increases in the money supply inflation cannot sustain itself indefinitely Monetarists believe that since there are significant lags the best intervention is no intervention at all According to new classical economists best course of action is to do nothing since the economy will return to equilibrium quickly on its own Since rational expectations are correct on average markets will quickly clear returning the economy to full employment Rational expectations means that people know the true model of the economy and use it to form their expectations of the future If ppl have rational expectations they know the true model of the economy and form expectations accordingly If expectations are rational people correctly predict the results of any anticipated policy and thus only surprises have any effect on real output Statement associated with new classical economics According to the Lucas supply function prices surprises cause firms to supply more in the short run because firms know more about their own price than the price level so they believe that they are receiving more for their product and thus will supply more Lucas supply function embodies the idea that output Y depends on the difference between the actual price level and the expected price level Y f P P e The general conclusion is that any announced policy change has no effect on real output because the policy change affects both actual and expected price levels in the same way Price surprise actual price level minus expected price level Real business cycle theory Shocks to production technology can cause fluctuations in aggregate supply and thus business cycles are created According to supply side economics when the economy is experiencing unemployment the best course of action is to cut taxes and increase incentives to save and invest Cutting taxes and increasing incentives to save and invest will increase aggregate supply and thus increase employment Economic Recovery Act of 1981 sharply cut both personal and corporate income tax rates President Reagan argued that these were supply side tax cuts and believed that the primary effect of these tax cuts would be to increase work and investment incentives By cutting taxes to firms and consumers work and investment incentives rise thus increasing aggregate supply According to the strict interpretation of the quantity theory of money assuming velocity is constant the money supply should grow at a rate equal to the average growth of real GDP When the growth rate of the money supply exceeds the growth rate of real GDP inflation would be expected to rise Keynesians advocate the application of coordinated monetary and fiscal policy tools to reduce instability in the economy to fight inflation and unemployment Keynes was the first stress aggregate demand and links between the money market and the goods market Increases in the money supply increase the demand for goods and stimulate the growth of real GDP According to supply side economics the most lasting impacts on output occur from changes in supply Research done during 1980s suggests that tax cuts seem to only increase the supply of labor moderately According to Keynesian economics expectations do not adjust quickly so there can be an impact on output The Laffer Curve demonstrates that reducing tax rates can increase tax revenues Reverse C shape with tax rates on y axis and tax revenues on x axis If velocity is constant and real GDP is growing a rate of 2 per year a 5 increase in the money stock must lead to a 3 increase in the price level New Keynesian economics is a field in which models are developed under the assumptions of rational expectations and sticky prices and wages When expectations are not rational there are likely to be unexploited profit opportunities and most economists believe such opportunities are rare and short lived