INTERMEDIATE MACROECONOMICS

(ECN 2215)

NEW MACROECONOMICS

Banda, CM,
University of Zambia, 2018
Introduction
• Now that you fully understand earlier thinking in
economics including the classical theories of
economics founded on the invisible hand
concept; the Keynesian theories of Maynard
Keynes and the role of government.
• This last topic introduces you to recent thinking
in the field of macroeconomics.
• Not long ago, the world experienced damaging
failure of financial market operation.
Introduction Cont’d
• As Madrick (2014) points out, the economics
profession has not covered itself with glory either in its
failure to anticipate many an economic crisis, or in its
response to the new situation.
• As you probably would expect, when a particular theory
fails to explain an observed phenomena, scholars know
it’s time to look for better and more relevant theories.
• Economics therefore has kept evolving with new ideas
improving upon the old ones.
Introduction Cont’d
• This topic seeks to introduce you to new
developments in the thinking around
macroeconomics issues.
• Particularly, the topic aims to introduce you
to;
i. Monetarism as a school of economic
thinking;
ii. The Rational Expectations Theory and;
iii. The Real Business Cycle Theory.
What does new macroeconomics focus on?
• Broadly put, two major schools of economic
thinking constitute new macroeconomics.
These include;
i. Monetarism and;
ii. New classical economics.
• Recall that Keynesian economics is the
foundation of modern macroeconomics,
whose economists advocate active
government intervention in the economy.
 Monetarism
• The main message of monetarists is that money
matters in influencing the real side of the
economy.
• Monetarism, however, is usually considered to
go beyond the notion that money matters.
• The monetarist analysis of the economy places
emphasis on the velocity of money, or the
number of times a Kwacha note changes hands,
on average, during a year; the ratio of nominal
GDP to the stock of money (M).
 The quantity theory of money
• The quantity theory of money is a theory based on the identity M x V = P x Y
and the assumption that the velocity of money (V) is constant (or virtually
constant).
• Then, the theory can be written as the equality were V is made the subject of
the formula.
• If there is equilibrium in the money market, then the quantity of money
supplied is equal to the quantity of money demanded.
• When M is taken to be the quantity of money demanded, this equality would
make the quantity of money demanded dependent on nominal GDP, but not the
interest rate.
• The demand for money may depend not only on nominal income, but also on
the interest rate.
• Whether velocity is constant or not may depend partly on how we measure the
money supply.
 Inflation as a Purely Monetary Phenomenon
• Monetarists believe that inflation is always a monetary
phenomenon.
• If the money supply does not change, the price level will
not change.
• The view that changes in the money supply affect only the
price level, without a change in the level of output, is called
the “strict monetarist” view. The “strict monetarist” view is
not compatible with a non-vertical AS curve.
• Almost all economists agree that sustained inflation is
purely a monetary phenomenon. Inflation cannot continue
indefinitely without increases in the money supply.
Inflation as a Purely Monetary Phenomenon Cont’d
• Because of monetarists assumption that expectations
are formed adaptively and that money is not neutral in the
short-run (Short-run money non-neutrality), they believe
monetary policy plays a role in fine-tuning the short-run
economy though they regard fiscal policy as ineffective.
• Friedman states that the accelerated inflation in the
1970s proves the effect of excessive monetary growth on
raising prices. To counter high inflation, Monetarism
insists that controlling the growth of the money
aggregates rather than interest rates would be more
effective.
The Keynesian Vs Monetarist Debate
• Milton Friedman has been the leading spokesman for
monetarism over the last few decades. Most monetarists
argue that inflation in an economy could be avoided if only
the central bank does not expand the money supply so
rapidly.
• Most monetarists do not advocate an activist monetary
policy stabilization, which is, expanding the money supply
during bad times and slowing its growth during good times.
• Time lags are the most common argument against such
management.
• Monetarists advocate a policy of steady and slow money
growth, at a rate equal to the average growth of real output.
The Keynesian Vs Monetarist Debate Cont’d
• Keynesians on the other hand advocate the
application of coordinated monetary and
fiscal policy tools to reduce instability in the
economy—to fight inflation and
unemployment.
• Others reject the strict monetarist position in
favour of the view that both monetary and
fiscal policies make a difference and at the
same time believe the best possible policy is
basically noninterventionist.
New Classical Macroeconomics
• The New Classical economics is closely related to
Monetarism in its interpretations of the nature of economic
variables, the interactions between these variables, and the
characteristics of economic agents.
• Due to the similarities that both schools share, Frank Hahn
(in Hoover, 1984, p.58) considered the New Classical
economists as essentially monetarists.
• However, basing on the monetarist framework, New
Classicalists further develop their distinctive ideas
regarding the nature of people’s economic expectations,
continuous market-clearing models and the questioned
independence of central banks.
New Classical Macroeconomics Cont’d
• On the theoretical level, new classical macroeconomists
argue that traditional models have assumed that
expectations are formed in naive ways.
• Naive expectations are inconsistent with the assumptions
of microeconomics.
• If people are out to maximize utility and profits, they should
form their expectations in a smarter way.
• On the empirical level, new classical theories were an
attempt to explain the apparent breakdown in the 1970s of
the simple inflation-unemployment trade-off predicted by
the Phillips Curve.
Expectations

1) Expectations are static; they do not change over time

2) Expectations are adaptive; the expectation change gradually
when current expectations have proven wrong
3) Expectations are rational; everyone in the economy has and
uses the same economic information as the policy makers
and bases their expectations on that information
Rational Expectations
• Expectations have been a central issue in macroeconomics from
the very foundation of the subject.
• Recall that the price of capital goods varies not only by reason of
past changes but also by reason of expected changes either in
gross income or in rates of depreciation and insurance' Walras
(1954).
• Much early empirical work on expectations centred around
attempts to provide direct measures of agents expectations, and
the thrust of much of this research was towards a psychological
understanding of individual expectations formation.
• The adaptive expectations hypothesis was an important
departure because it allowed the treatment of expectations to be
made explicit.
Rational Expectations Cont’d
• The rational expectations theory is an economic idea
that the people make choices based on their rational
outlook, available information and past experiences.
• The theory suggests that the current expectations in the
economy are equivalent to what people think the future
state of the economy will become.
• The rational-expectations hypothesis assumes people
know the “true model” of the economy and that they use
this model to form their expectations of the future.
• For clarity, by “true” model we mean a model that is on
average correct in forecasting inflation.
 Rational Expectations Cont’d
• People are said to have rational expectations if they use
“all available information” in forming their expectations.
• Because there are costs associated with making a
wrong forecast, it is not rational to overlook information,
as long as the costs of acquiring that information do not
outweigh the benefits of improving its accuracy.
• The main disadvantage of the RE approach is the
extreme assumption which is required about the
information available to the economic agent.
Implications of Rational Expectations on Market Clearing
• If firms have rational expectations, on average, prices and wages will be set
at levels that ensure equilibrium in the goods and labour markets. In other
words, on average, there will be no unemployment.
• When expectations are rational, disequilibrium exists only temporarily as a
result of random, unpredictable shocks. On average, all markets clear and
there is full employment. There is no need for government intervention.
• The most important implication of the rational expectations model on
economics during the last decade or so has been that aggregate demand
management designed to lower unemployment will always be ineffective.
• In other words, it means that the monetary and fiscal policies are unable to
alter the level of employment; this is called ‘policy impotency result of
rational expectations’.
• In this way the theory of rational expectations poses a great challenge to the
proposition that any systematic aggregate demand policy can never be
effective, if expectations are formed rationally.
 Lucas supply function
•
Evaluating Rational-Expectations Theory
• If expectations are not rational, there are
likely to be unexploited profit
opportunities—most economists believe
such opportunities are rare and short-lived.
• The argument against rational expectations
is that it required households and firms to
know too much. People must know the true
model, or at least a good approximation of it,
and this is a lot to expect.
Real Business Cycle Theory
• The Real Business cycle theory accepts the Rational Expectations
Hypothesis, but views cycles arising in frictionless, perfectly competitive
economies with complete markets.
• It argues that cycles arise through the reactions of optimizing agents to
real disturbances, such as random changes in technology or
productivity.
• Real Business Cycle (RBC) models follow the classical monetarist
tradition. Generally they come to the same conclusions but by
employing different methods.
• Key conclusions of Real Business cycle theory are as stated below.
• Economy not susceptible to aggregate demand shocks (Keynesian view), but
is susceptible to shocks that affect output.
• Government aggregate demand management policies are not useful in curing
recessions. Recessions are caused on the supply side not on the demand side.
Supply-Side Economics
• Orthodox macro theory consists of demand -oriented theories
that failed to explain the stagflation of the 1970s.
• Supply-side economists believe that the real problem was that
high rates of taxation and heavy regulation had reduced the
incentive to work, to save, and to invest.
• What was needed was not a demand stimulus but better
incentives to stimulate supply.
The Laffer Curve
• With the tax rate measured on the vertical axis and tax
revenue measured on the horizontal axis;
• The Laffer curve shows 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.
• The Laffer curve shows the amount of revenue the
government collects is a function of the tax rate.
• When tax rates are very high, an increase in the tax rate could cause
tax revenues to fall.
• Similarly, a cut in the tax rate could generate enough additional
economic activity to cause revenues to rise
Figure:The laffer curve
Evaluating Supply-Side Economics
• Among the criticisms of supply-side
economics is that it is unlikely a tax cut
would substantially increase the supply of
labor.
• When households receive a higher after-tax
wage, they might have an incentive to work
more, but they may also choose to work less.
 End of Course

All the Best in your Final Exams