Week 6: The Warring Schools of Macroeconomics Flashcards
Name the 5 warring schools of macroeconomic.
Classical economics => Keynesian Economics => Monetarism => Supply Side economics => New Classical Economics.
What are the three major questions about which the major schools of macroeconomics differ?
- Causes of macroeconomic instability.
- Is the economy self-correcting? And if so, what is the speed of adjustment?
- Should the government adhere to rules, or use discretion in setting economic policy?
Explain the difference between rational and adaptive expectations?
Adaptive expectations: if inflation is 3% this year, you expect it to be 3% next year.
Rational expectations take into account all available information (like active monetairy/fiscal policies). “you can fool the public a couple of times, but they will learn”
What is the central policy implication of rational expectations theory?
Renders activist fiscal and monetarist policies innefective, so they should be abandonned.
Provide an economic and political critique of New Classical economics.
Economic: Most people are not as sofisticated as the theory requires, thus the offsetting effect doesn’t happen as fast as predicted.
Political: not popular.
Explain the Keynesian view of what causes macroeconomic instability.
- Significant changes in investment and/or consumption shift the demand curve in or out, causing inflation or recession.
- Adverse supply side shocks shift the aggregate supply curve in, causing stagflation.
Explain the Classical-Monetarist view of what causes macroeconomic instability.
- Bad government policies.
- monetarism is rooted in classical economics, which relies on market processes for adjustment.
- Price and wage flexibility provided by competitive markets cause fluctuations in aggregate demand to alter prices, rather then output. => wages can’t adjust freely downward because of government policies like minimum wage, monopoly protections,…
- Active Government fiscal policy and monetairy policy. => MV = PQ => velocity of money is stable and P is independent of Q thus increasing M increases P (=inflation).
Explain and illustrate the New Classical and monetarist view of a self-correcting economy,
When the economy diverges from full-employement output, internal mechanisms automatically move it back.
Explain the Keynesian-based mainstream view of a self-correcting economy.
Almost all economists acknowledge new classical economics offers important lessons about the theory of aggregate supply. but most strongly disagree with new classical rational expectations theory on the question of downward price and wage flexibility.
=> stock markets, foreign exchange markets and… experience very rapid price changes. but this is not the case in many product markets and labour markets. There appears to be ample evidence that many prices and wages are inflexible downward for long periods => it may take years for an economy to move from recession back to full employement without help from fiscal and monetairy policy.
Contrast the Monetarist versus New Classical views on the speed of adjustment of the economy.
Mon: People form expectations on present realities and only gradually change their expectations => shifts of AS and AD curves and corrections are very slow.
New classical: Workers anticipate future outcomes before they occur => shifts and corrections happen instantly.
For the Monetarists, why does the enactment of a monetary rule make the most sense? Illustrate the Monetarists’ rationale for a monetary rule.
Because monetarists believe discretionary monetary policy is a major source of macroeconomic instability. Rule example: direct the fed to expand the money supply at the same annual rate as the typical growth of the economy’s production capacity.
Why do New Classical rational expectations economists also support a monetary rule?
because easy or tight money policy increases or decreases inflation but not real output. Because of rational expectations, workers would immediatly demand higher wages and the stimulus effect would be immediatly offset. So a monetary rule is needed.
Provide the Keynesian defense of discretionary monetary policy.
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Provide the Keynesian defense of discretionary fiscal policy.
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Explain and illustrate “crowding out.”
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