BRINNER1902mit15.pptAttacks on the Traditional Approaches toMacroeconomicsLecture 14BRINNER2902mit15.pptAlternative Theoriesto Define Alternative Policies◆ Monetarism is an argument against discretionary monetary policyto counter the business cycle◆ Other theories have also been proposed in recent decades toevaluate (and minimize) the theoretical potency of monetaryand/or fiscal policy. At least two have added lasting value,although they extend rather than replace traditional theory:– “New Classical or ‘neoclassical’ inflation and unemploymenttheory”– “rational expectations”BRINNER3902mit15.pptNeoclassical Inflation and UnemploymentTheory◆ Classical (i.e. pre-Keynesian) theory thought of markets as always being inequilibrium◆ But how could unemployment, particularly of the magnitude and durationexperienced in the Depression, be considered an equilibrium? Keynesianthinking evolved to understand unemployment in the terms we havelearned with IS-LM analysis and an accelerationist Phillips Curve◆ Other theorists proposed alternative explanations for unemployment thattreat it a voluntary and hence equilibrium or market clearing. This returnto a contention that markets cleared--everyone who wanted a job at theprevailing wage had a job--was termed “neoclassical” because it was a newversion of classical conclusions◆ To be an accurate explanation of cycles, neoclassical labor theoryfundamentally requires people to be fooled and uninformed about thewages being offered so that they mistakenly, voluntarily turn down joboffers and stay unemployedBRINNER4902mit15.pptRational Expectations◆ Another theoretical approach, sometimes even considered to beallied with the neoclassical unemployment and inflation theory,argued that fiscal and monetary policy would be impotent ifpeople understood and anticipated its consequences.. i.e. if theywere “rational” in their decisions.◆ In a “rational expectations” world, consumers and businesses seethe full IS-LM reactions work out in advance and thus cut off thereal output macroeconomic responses.◆ For rational expectations to be an effective denial of the potency ofpolicy and business cycles in the real world, you might say thatpeople must not be fooled.◆ This, of course, is the exact opposite of the neoclassical model butsome theorists think they can simultaneously defend both!BRINNER5902mit15.pptNeoclassical Inflation and UnemploymentTheory◆ Phelps, a leading proponent, treats unemployment as a decision under thecontrol of the employee◆ Four types: speculative, precautionary, search, queue--but the differencesare not crisp (note historical link to “money theory”)– spec.: withhold work because wages are low– precaut./wait: individual “between jobs” waiting for the randomarrival of the next contract– search: active rejection of offers while actively looking for better offer– queue: like wait unemployment, by worker who believes offering alower wage will do no good because the employer will only assume hemust be worth less if offering to work for less◆ “These are...essentially informational in origin”– “the typical unemployed worker..is acting on an erroneous estimate ofthe demand for his services”◆ “...lead to the Monetary Phillips Curve”BRINNER6902mit15.pptThe Role of Expectations in NeoclassicalUnemployment Models◆ “...Unexpected inflation (of wages and prices) brings with it above-equilibrium employment and the process of unexpected deflationbrings with it below-equilibrium unemployment”◆ The hypothesized sequence:– surge of demand from tax or monetary policy brings higherwages (recognized)..– .. and higher prices (not recognized at first) and...– .. lures more workers to accept jobs;– then price increase is recognized..– ..and jobs are quit, and the process reverses.◆ The model thus explains the correlation of unemployment andinflation in reverse flow and timing versus traditional theory. Here:– U=E - E\1 = f ( RW\1 - RPexpected)– Unemployment is an error in expectations due to “staticexpectations about future wages and price levels”BRINNER7902mit15.pptReview the Traditional Alternative--Simple Micro in the Labor Market :Prices, Demand and Supply◆ Demand: More Workers/Hours Will Be Demanded by Employersthe Lower the Real Wage, Other Things Equal◆ Supply: More Hours Will Be Supplied by Individuals the Higherthe Real Wage◆ Equilibrium: Demand=Supply» All Those Wanting to Work at the Current Real Wage Can FindWork after a Reasonable Period of SearchBRINNER8902mit15.pptSimple Micro in the Labor Market :Prices, Demand and SupplyDEMANDSUPPLYREALWAGEWORKERS or HOURS DEMANDED AND SUPPLIEDEQUILIBRIUMBRINNER9902mit15.ppt Simple Dynamics: DisequilibriumMeans Change in the Labor Market◆ Unemployed Workers:– Voluntary, as in searching for a job at a wage higher than they or theirpeers are being offered: not a sign of Disequilibrium– Involuntary: Would accept the prevailing wage but no offerforthcoming.» By definition, Supply greater than Demand...at the prevailing wage◆ Involuntary Unemployment Creates Pressure for (Real) Wages to Fall◆ In the Traditional Model, knowledge of prices, wages, and offers isreasonably complete on the part of both workers and firms but prices andwages simply take time to adjust to gaps that have opened between demandand supply. Note sequence timing and logic of the flow is the reverse of theNeoclassical– RW or RP = f (U or U\1)◆ In the 1970s, the very important improvement in the traditional model wasthe inclusion of a full response of RW to RPexpected so that there would beonly one equilibrium level of unemploymentBRINNER10902mit15.pptSimple Dynamics: DisequilibriumMeans Change in the Labor MarketDEMANDSUPPLYREALWAGEWORKERS / HOURS DEMANDED AND SUPPLIEDDISEQUILIBRIUMINVOLUNTARYUNEMPLOYMENTBRINNER11902mit15.pptFluctuations in Unemployment Reveal Job Loss to be thePrimary Source of Changes in Unemployment--i.e. action by theemployer and not the employee0123456789101967 1971 1975 1979 1983 1987 1991Job Losers ReenterNew Entrants Job LeaversBRINNER12902mit15.pptFluctuations in Unemployment0123456789101949 1955 1961 1967 1973 1979 1985 1991Enemployment Rate Full Employment- Unemployment RateBRINNER13902mit15.pptRational Expectations◆ Argues that fiscal and monetary policy would be impotent ifpeople understood and anticipated its consequences.. i.e. if theywere “rational” in their
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