The Roots of Modern

Macroeconomics
The Roots of Modern Macroeconomics

Setting the Scene:

Three Key Issues
 THREE KEY ISSUES

• Issue 1: Flexibility of prices and wages

–– the
the right:
right: flexible
flexible prices
prices and
and wages
wages
–– the
the left:
left: price
price and
and wage
wage rigidities
rigidities

• Issue 2: Flexibility of aggregate supply

–– the
the right:
right: aggregate
aggregate supply
supply determined
determined
independently
independently ofof aggregate
aggregate demand
demand
 Different aggregate supply curves: (a)
AS

Aggregate supply
independent of
Price level

aggregate demand

O Y
National output
 Different aggregate supply curves: (a)
AS
Price level

P1

AD1
O Y
National output
 Different aggregate supply curves: (a)
AS
Price level

P2

P1
AD2

AD1
O Y
National output
 THREE KEY ISSUES

• Issue 1: Flexibility of prices and wages

–– the
the right:
right: flexible
flexible prices
prices and
and wages
wages
–– the
the left:
left: price
price and
and wage
wage rigidities
rigidities

• Issue 2: Flexibility of aggregate supply

–– the
the right:
right: aggregate
aggregate supply
supply determined
determined
independently
independently ofof aggregate
aggregate demand
demand
–– the
the left:
left: aggregate
aggregate supply
supply responsive
responsive to
to
changes
changes in in aggregate
aggregate demand
demand
 Different aggregate supply curves: (b)

Aggregate supply
totally dependent on
Price level

aggregate demand

P AS

National output
Price level Different aggregate supply curves: (b)

P AS

AD1
O Y1
National output
Price level Different aggregate supply curves: (b)

P AS

AD2

AD1
O Y1 Y2
National output
 THREE KEY ISSUES

• Issue 1: Flexibility of prices and wages

–– the
the right:
right: flexible
flexible prices
prices and
and wages
wages
–– the
the left:
left: price
price and
and wage
wage rigidities
rigidities
• Issue 2: Flexibility of aggregate supply
–– the
the right:
right: aggregate
aggregate supply
supply determined
determined
independently
independently ofof aggregate
aggregate demand
demand
–– the
the left:
left: aggregate
aggregate supply
supply responsive
responsive to
to
changes
changes in in aggregate
aggregate demand
demand
–– some
some consensus
consensus on
on nature
nature of
of short-run
short-run AS
AS
curve
curve
 Different aggregate supply curves: (c)
Aggregate supply becoming
less and less responsive to
aggregate demand as full
employment is reached
AS
Price level

National output
 Different aggregate supply curves: (c)
Aggregate supply becoming
less and less responsive to
aggregate demand as full
employment is reached
AS
Price level

P1

AD1
O Y1
National output
 Different aggregate supply curves: (c)
Aggregate supply becoming
less and less responsive to
aggregate demand as full
employment is reached
AS
Price level

P2
P1
AD2

AD1
O Y1 Y2
National output
 THREE KEY ISSUES

• Issue 3: The role of expectations in the

working of the market
–– the
the right:
right: expectations
expectations adjust
adjust rapidly
rapidly to
to
changes
changes in in prices
prices

–– the
the left:
left: expectations
expectations of
of prices
prices depend
depend on
on
expectations
expectations ofof output
output and
and employment
employment
The Roots of Modern Macroeconomics

Classical
Macroeconomics
 CLASSICAL MACROECONOMICS

• Classical analysis of output and

employment
–– markets
markets clear
clear
•• labour
labour market
market
•• market
market for
for loanable
loanable funds
funds
 The market for loanable funds
Saving (supply)
Rate of interest

Investment (demand)
O
Quantity of loanable funds
 The market for loanable funds
Saving (supply)
Rate of interest

r1

Excess supply drives

interest rates down.

Investment (demand)
O
Quantity of loanable funds
 The market for loanable funds
Saving (supply)
Rate of interest

Excess demand drives

interest rates up.

r2

Investment (demand)
O
Quantity of loanable funds
 The market for loanable funds
Saving (supply)
Rate of interest

re

Investment (demand)
O
Quantity of loanable funds
 CLASSICAL MACROECONOMICS

• Classical analysis of output and

employment
–– markets
markets clear
clear
•• labour
labour market
market
•• market
market for
for loanable
loanable funds
funds
•• market
market for
for imports
imports and
and exports:
exports:
the
the gold
gold standard
standard
 CLASSICAL MACROECONOMICS

• Classical analysis of output and

employment
–– markets
markets clear
clear
•• labour
labour market
market
•• market
market for
for loanable
loanable funds
funds
•• market
market for
for imports
imports and
and exports:
exports:
the
the gold
gold standard
standard
–– Say’s
Say’s law
law
 CLASSICAL MACROECONOMICS

• Classical analysis of output and

employment
–– markets
markets clear
clear
•• labour
labour market
market
•• market
market for
for loanable
loanable funds
funds
•• market
market for
for imports
imports and
and exports:
exports:
the
the gold
gold standard
standard
–– Say’s
Say’s law
law
• Classical analysis of prices and inflation
 CLASSICAL MACROECONOMICS

• Classical analysis of output and

employment
–– markets
markets clear
clear
•• labour
labour market
market
•• market
market for
for loanable
loanable funds
funds
•• market
market for
for imports
imports and
and exports:
exports:
the
the gold
gold standard
standard
–– Say’s
Say’s law
law
• Classical analysis of prices and inflation
–– the
the quantity
quantity theory
theory of
of money
money
 CLASSICAL MACROECONOMICS

• Classical analysis of output and

employment
–– markets
markets clear
clear
•• labour
labour market
market
•• market
market for
for loanable
loanable funds
funds
•• market
market for
for imports
imports and
and exports:
exports:
the
the gold
gold standard
standard
–– Say’s
Say’s law
law
• Classical analysis of prices and inflation
–– the
the quantity
quantity theory
theory of
of money
money
–– the
the equation
equation of
of exchange:
exchange: MV
MV == PY
PY
 CLASSICAL MACROECONOMICS

• Classical analysis of output and

employment
–– markets
markets clear
clear
•• labour
labour market
market
•• market
market for
for loanable
loanable funds
funds
•• market
market for
for imports
imports and
and exports:
exports:
the
the gold
gold standard
standard
–– Say’s
Say’s law
law
• Classical analysis of prices and inflation
–– the
the quantity
quantity theory
theory of
of money
money
–– the
the equation
equation of
of exchange:
exchange: MV
MV == PY
PY
–– implications
implications for
for monetary
monetary policy
policy
 CLASSICAL MACROECONOMICS

• The Great Depression and the return to

the gold standard
–– the
the depression
depression of
of the
the 1920s
1920s
 UK unemployment and inflation: 1919 38
24 15
Unemployment
22
10
20
Unemployment (% of workforce)

18 5
16
0

Inflation (%)
14
12 -5
10
-10
8
6 -15
4
-20
2
0 -25
1919 1921 1923 1925 1927 1929 1931 1933 1935 1937
 UK unemployment and inflation: 1919 38
24 15
Unemployment
22
10
20
Unemployment (% of workforce)

18 Inflation 5
16
0

Inflation (%)
14
12 -5
10
-10
8
6 -15
4
-20
2
0 -25
1919 1921 1923 1925 1927 1929 1931 1933 1935 1937
 CLASSICAL MACROECONOMICS

• The Great Depression and the return to

the gold standard
–– the
the depression
depression of
of the
the 1920s
1920s
–– return
return to
to the
the gold
gold standard
standard
 CLASSICAL MACROECONOMICS

• The Great Depression and the return to

the gold standard
–– the
the depression
depression of
of the
the 1920s
1920s
–– return
return to
to the
the gold
gold standard
standard
–– effects
effects on
on the
the economy
economy
 CLASSICAL MACROECONOMICS

• The Great Depression and the return to

the gold standard
–– the
the depression
depression of
of the
the 1920s
1920s
–– return
return to
to the
the gold
gold standard
standard
–– effects
effects on
on the
the economy
economy
–– the
the policy
policy response
response
 CLASSICAL MACROECONOMICS

• The Great Depression and the return to

the gold standard
–– the
the depression
depression of
of the
the 1920s
1920s
–– return
return to
to the
the gold
gold standard
standard
–– effects
effects on
on the
the economy
economy
–– the
the policy
policy response
response
–– classical
classical rejection
rejection of
of public
public works
works
 CLASSICAL MACROECONOMICS

• The Great Depression and the return to

the gold standard
–– the
the depression
depression of
of the
the 1920s
1920s
–– return
return to
to the
the gold
gold standard
standard
–– effects
effects on
on the
the economy
economy
–– the
the policy
policy response
response
–– classical
classical rejection
rejection of
of public
public works
works
•• the
the fear
fear of
of inflation
inflation
 CLASSICAL MACROECONOMICS

• The Great Depression and the return to

the gold standard
–– the
the depression
depression of
of the
the 1920s
1920s
–– return
return to
to the
the gold
gold standard
standard
–– effects
effects on
on the
the economy
economy
–– the
the policy
policy response
response
–– classical
classical rejection
rejection of
of public
public works
works
•• the
the fear
fear of
of inflation
inflation
•• the
the problem
problem of
of crowding
crowding out
out
 The effect of printing extra money: the classical analysis

AS

Effect is purely higher

Price level

prices not higher output

P2

P1
AD2

AD1
O Q1
National output
The Roots of Modern Macroeconomics

The Keynesian
Revolution
 THE KEYNESIAN REVOLUTION

• Keynes’ rejection of classical theory

–– rigidities
rigidities in
in the
the labour
labour market
market
–– the
the problem
problem ofof deficiency
deficiency of
of demand
demand
 The
The problem
problem of
of demand
demand deficiency
deficiency in
in the
the labour
labour market
market
ASL
Real wage rate (W / P)

W1

ADL1
Disequilibrium
unemployment
ADL2
O
Quantity of labour
 THE KEYNESIAN REVOLUTION

• Keynes’ rejection of classical theory

–– rigidities
rigidities in
in the
the labour
labour market
market
–– the
the problem
problem of of deficiency
deficiency of
of demand
demand
–– rejection
rejection of
of increased
increased saving
saving as
as aa means
means of
of
increasing
increasing investment
investment
 Disequilibrium
Disequilibrium in
in the
the market
market for
for loanable
loanable funds
funds
Savings 1
Savings 2
Rate of interest

r1
Fall in consumption may
r2 discourage investment.

Investment
O
Quantity of loanable funds
 THE KEYNESIAN REVOLUTION

• Keynes’ rejection of classical theory

–– rigidities
rigidities in
in the
the labour
labour market
market
–– the
the problem
problem of of deficiency
deficiency of
of demand
demand
–– rejection
rejection of
of increased
increased saving
saving as
as aa means
means of
of
increasing
increasing investment
investment
–– rejection
rejection of
of simple
simple quantity
quantity theory
theory
 THE KEYNESIAN REVOLUTION

• Keynes’ rejection of classical theory

–– rigidities
rigidities in
in the
the labour
labour market
market
–– the
the problem
problem of of deficiency
deficiency of
of demand
demand
–– rejection
rejection of
of increased
increased saving
saving as
as aa means
means of
of
increasing
increasing investment
investment
–– rejection
rejection of
of simple
simple quantity
quantity theory
theory
–– rejection
rejection of
of aa balanced
balanced budget
budget
 THE KEYNESIAN REVOLUTION

• Keynes’ rejection of classical theory

–– rigidities
rigidities in
in the
the labour
labour market
market
–– the
the problem
problem of of deficiency
deficiency of
of demand
demand
–– rejection
rejection of
of increased
increased saving
saving as
as aa means
means of
of
increasing
increasing investment
investment
–– rejection
rejection of
of simple
simple quantity
quantity theory
theory
–– rejection
rejection of
of aa balanced
balanced budget
budget
• Keynes’ analysis of employment and
inflation
 THE KEYNESIAN REVOLUTION

• Keynes’ rejection of classical theory

–– rigidities
rigidities in
in the
the labour
labour market
market
–– the
the problem
problem of of deficiency
deficiency of
of demand
demand
–– rejection
rejection of
of increased
increased saving
saving as
as aa means
means of
of
increasing
increasing investment
investment
–– rejection
rejection of
of simple
simple quantity
quantity theory
theory
–– rejection
rejection of
of aa balanced
balanced budget
budget
• Keynes’ analysis of employment and
inflation
–– the
the importance
importance of
of aggregate
aggregate demand
demand
 The effects of increases in aggregate demand
on national output
AS
Price level

O YP
National output
 The effects of increases in aggregate demand
on national output
AS
Price level

AD4

AD3
AD1 AD2
O Y1 Y2 Y3 Y4 YP
National output
 THE KEYNESIAN REVOLUTION

• Keynes’ rejection of classical theory

–– rigidities
rigidities in
in the
the labour
labour market
market
–– the
the problem
problem of of deficiency
deficiency of
of demand
demand
–– rejection
rejection of
of increased
increased saving
saving as
as aa means
means of
of
increasing
increasing investment
investment
–– rejection
rejection of
of simple
simple quantity
quantity theory
theory
–– rejection
rejection of
of aa balanced
balanced budget
budget
• Keynes’ analysis of employment and
inflation
–– the
the importance
importance ofof aggregate
aggregate demand
demand
–– the
the multiplier
multiplier process
process
The circular flow of income
The circular flow of income

Cd
 The circular flow of income

Incomes Cd
 The circular flow of income

Incomes Cd

W=S+T+M
 The circular flow of income

J=I+G+X

Incomes Cd

W=S+T+M
 THE KEYNESIAN REVOLUTION

• Keynes’ policy recommendations

–– demand
demand management
management by
by fiscal
fiscal and
and
monetary
monetary policies
policies

• Keynesian policies in 1950s and 60s

–– stop–go
stop–go policies
policies
–– criticisms
criticisms of
of short-term
short-term demand
demand
management
management
–– the
the breakdown
breakdown of
of the
the Phillips
Phillips curve
curve
The Roots of Modern Macroeconomics

The Monetarist–
Keynesian Debate
THE MONETARIST–KEYNESIAN DEBATE

• The monetarist counter-revolution

–– the
the restatement
restatement of of the
the quantity
quantity theory
theory
–– rejection
rejection of
of Keynesian
Keynesian demand
demand
management
management policies
policies
–– the
the problem
problem of of inflationary
inflationary expectations
expectations
–– aa vertical
vertical long-run
long-run Phillips
Phillips curve
curve
 The monetarist version of the long-run Phillips curve
Inflation (%)

O Un
Unemployment
THE MONETARIST–KEYNESIAN DEBATE

• The monetarist counter-revolution

–– the
the restatement
restatement of
of the
the quantity
quantity theory
theory
–– rejection
rejection of
of Keynesian
Keynesian demand
demand
management
management policies
policies
–– the
the problem
problem of
of inflationary
inflationary expectations
expectations
–– aa vertical
vertical long-run
long-run Phillips
Phillips curve
curve
–– monetarist
monetarist policies
policies
THE MONETARIST–KEYNESIAN DEBATE

• The monetarist counter-revolution

–– the
the restatement
restatement of
of the
the quantity
quantity theory
theory
–– rejection
rejection of
of Keynesian
Keynesian demand
demand
management
management policies
policies
–– the
the problem
problem of
of inflationary
inflationary expectations
expectations
–– aa vertical
vertical long-run
long-run Phillips
Phillips curve
curve
–– monetarist
monetarist policies
policies
–– attempts
attempts at
at such
such policies
policies in
in the
the 1980s
1980s
THE MONETARIST–KEYNESIAN DEBATE

• Modern-day Keynesians
–– inflation
inflation
–– unemployment
unemployment
•• structural
structural problems
problems
•• hysteresis
hysteresis
–– low
low capital
capital stock
stock
–– deskilling
deskilling
–– insiders
insiders and
and outsiders
outsiders

–– criticisms
criticisms of
of monetarism
monetarism
–– Keynesian
Keynesian policy
policy proposals
proposals
The Roots of Modern Macroeconomics

The Current
Position
 THE CURRENT POSITION

• The current range of views

–– new
new classical
classical // rational
rational expectations
expectations school
school
–– moderate
moderate monetarists
monetarists
–– moderate
moderate Keynesians
Keynesians (new
(new Keynesians)
Keynesians)
–– extreme
extreme Keynesians
Keynesians
–– the
the radical
radical left
left
–– eclectic
eclectic economists
economists
 THE CURRENT POSITION

• A mainstream consensus?
–– short-run
short-run effects
effects of
of changes
changes in in AD
AD
–– long-run
long-run effects
effects of
of changes
changes inin AD
AD
–– no
no simple
simple trade-off
trade-off between
between inflation
inflation and
and
unemployment
unemployment
–– role
role of
of expectations
expectations
–– effects
effects of
of excessive
excessive growth
growth in
in the
the money
money
supply
supply
–– importance
importance of of supply-side
supply-side policies
policies
–– erosion
erosion ofof governments'
governments' power
power by by the
the
process
process ofof globalisation
globalisation