Module 6 MODERN ECONOMIC THEORIES FISCAL AND MONETARY POLICIES Mrs. Dannie G. McKee Sevenstar Academy July 2013 Resource: Paul Krugman and Robin Wells, Microeconomics, 2 nd Edition - Teacher, 2008 Worth Publishers.

Classical Macroeconomics Money and the Price Level Money and the Price Level Classical macroeconomics asserted that monetary policy affected only the aggregate price level, not aggregate output, and that the short run was unimportant. Classical macroeconomics asserted that monetary policy affected only the aggregate price level, not aggregate output, and that the short run was unimportant. By the 1930s, measurement of business cycles was a well established subject, but there was no widely accepted theory of business cycles. By the 1930s, measurement of business cycles was a well established subject, but there was no widely accepted theory of business cycles.

When Did the Business Cycle Begin? In the first half of the nineteenth century, the United States was an overwhelmingly agricultural economy and probably didn’t have modern business cycles. By the late nineteenth century, it was mainly industrial, and the modern business cycle had come into existence.

Classical Versus Keynesian Macroeconomics One important difference between classical and Keynesian economics involves the short-run aggregate supply curve. Panel (a) shows the classical view: the SRAS curve is vertical, so shifts in aggregate demand affect the aggregate price level but not aggregate output. Panel (b) shows the Keynesian view: in the short run the SRAS curve slopes upward, so shifts in aggregate demand affect aggregate output as well as aggregate prices.

Fiscal Policy and the End of the Great Depression During the 1930s, in an effort to prop up the economy, the U.S. government began deficit spending. The deficits were, however, fairly small as a percentage of GDP. In 1937 the government even tried to balance the budget, only to face a renewed rise in unemployment. The onset of World War II brought on deficit spending on a massive scale and ended the Great Depression.

 The Revival of Monetary Policy – Milton Friedman  Monetarism Challenges to Keynesian Economics

Fiscal Policy with a Fixed Money Supply In panel (a) an expansionary fiscal policy shifts the AD curve rightward, driving up both the aggregate price level and aggregate output. However, this leads to an increase in the demand for money. If the money supply is held fixed, as in panel (b), the increase in money demand drives up the interest rate, reducing investment spending and offsetting part of the fiscal expansion. So the shift of the AD curve is less than it would otherwise be: fiscal policy becomes less effective when the money supply is held fixed.

The Velocity of Money From 1960 to 1980, the velocity of money followed a smooth trend, leading monetarists to believe that steady growth in the money supply would lead to a stable economy. After 1980, however, velocity began moving erratically, undermining the case for strict monetarism. Source: Federal Reserve Bank of St. Louis.

Inflation and the Natural Rate of Unemployment The natural rate of unemployment is also the non- accelerating-inflation rate of unemployment, or NAIRU. The natural rate of unemployment is also the non- accelerating-inflation rate of unemployment, or NAIRU.  inflation eventually gets built into expectations, so any attempt to keep the unemployment rate below the natural rat will lead to an ever-rising inflation rate.  inflation eventually gets built into expectations, so any attempt to keep the unemployment rate below the natural rat will lead to an ever-rising inflation rate.

Rational Expectations, Real Business Cycles, and New Classical Macroeconomics New classical macroeconomics is an approach to the business cycle that returns to the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not aggregate output. New classical macroeconomics is an approach to the business cycle that returns to the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not aggregate output. Rational expectations is the view that individuals and firms make decisions optimally, using all available information. Rational expectations is the view that individuals and firms make decisions optimally, using all available information.

The Modern Consensus

The Government Budget and Total Spending Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve. The two types of government spending are purchases of goods and services and government transfers. The big items in government purchases are national defense and education. The big items in government transfers are Social Security and health care programs.

Expansionary and Contractionary Fiscal Policy Expansionary Fiscal Policy Can Close a Recessionary Gap At E 1 the economy is in short-run equilibrium where the aggregate demand curve AD 1 intersects the SRAS curve. At E 1, there is a recessionary gap of Y E − Y 1. An expansionary fiscal policy—an increase in government purchases, a reduction in taxes, or an increase in government transfers—shifts the aggregate demand curve rightward. It can close the recessionary gap by shifting AD 1 to AD 2, moving the economy to a new short-run equilibrium, E 2, which is also a long-run equilibrium.

Expansionary and Contractionary Fiscal Policy Contractionary Fiscal Policy Can Eliminate an Inflationary Gap Contractionary Fiscal Policy Can Eliminate an Inflationary Gap At E 1 the economy is in short-run equilibrium where the aggregate demand curve AD 1 intersects the SRAS curve. At E 1, there is an inflationary gap of Y 1 − Y E. A contractionary fiscal policy—reduced government purchases, an increase in taxes, or a reduction in government transfers—shifts the aggregate demand curve leftward. It can close the inflationary gap by shifting AD 1 to AD 2, moving the economy to a new short-run equilibrium, E 2, which is also a long-run equilibrium.

The Multiplier Effect of an Increase in Government Purchases of Goods and Services A $50 billion increase in government purchases of goods and services has the direct effect of shifting the aggregate demand curve to the right by $50 billion. However, this is not the end of the story. The rise in GDP causes a rise in disposable income, which leads to an increase in consumer spending, which leads to a further rise in GDP, which leads to a further rise in consumer spending, and so on. The eventual shift, from AD 1 to AD 2, is a multiple of the rise in GDP. What happens if government purchases of goods and services are instead reduced? The math is exactly the same, except that there’s a minus sign in front: if government purchases fall by $50 billion and the marginal propensity to consume is 0.6, the AD curve shifts leftward by $125 billion.

 Automatic Stabilizers  Discretionary Fiscal Policy How Taxes Affect the Multiplier