Chapter 18 Alternative Views in Macroeconomics Keynesian Economics Keynesian economics foundation of all macroeconomics Keynes was the first to emphasize aggregate demand and links between the money market and goods market also emphasized sticky wages Keynes believed in activist federal gov believed that the gov had a role to play in fighting inflation and unemployment monetary and fiscal policy should be used to manage the Macroeconomy Monetarism Monetarist message money matters Velocity of money the number of times a dollar bill changes hands on average during a year the ratio of nominal GDP to the stock of money o Income velocity of money nominal GDP money o Expand this definition by noting that nominal income GDP is equal to real output income Y times the overall price level P so therefore through substitution V triple equal sign P Y M or M V triple equal sign P Y Quantity theory of money the theory based on the identity M V triple equal sign P Y and the assumption that the velocity of money V is constant or virtually constant o Equation M V bar P Y double equal sign not triple equal sign bc the equation is no longer an identity o Is V really constant though Demand for money does not ONLY depend on nominal income but also the interest rate Many definitions of the money supply velocity might be constant if we compare to M2 money supply but changing velocity if we look at M1 Time lag between a change in the money supply and its effects on nominal GDP Strict monetarist view changes in money supply affect only P and not Y inflation is a purely monetary phenomenon Sustained inflation is a monetary phenomenon inflation cannot continue indefinitely without increases in the money supply Monetarist spokesman Milton Friedman blamed instability in economy on the Fed arguing that high inflation in the US encountered from time to time could have been avoided if the Fed had not expanded the money supply so rapidly advocated a policy of steady and slow money growth money supply should grow at a rate equal to the average growth of real output income Y Supply Side Economics Problem with economy in late 1970s early 1980s was not demand but was high rates of taxation and heavy regulation that reduced the incentive to work to save to invest need better incentives to stimulate supply Cut taxes ppl take home more income work harder save more Businesses get to keep more of their profits and get away from gov regulation they will invest more this added labor supply and investment or capital supply will lead to an expansion of the supply of goods services will reduce inflation and unemployment Major cut in taxes might actually increase tax revenue tax rates would be lower but more ppl would be working and earning income and firms would earn more profits so that increases in the tax bases profits sales income would outweigh the decrease in rates Laffer Curve o Tax rate vertical axis o Tax revenue horizontal axis o Assumption there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate
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