Macro Roots

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 right: flexible prices and wages
✜ the left: price and wage rigidities
■ Issue 2: Flexibility of aggregate supply

✜ the right: aggregate supply determined
independently of aggregate demand
Different aggregate supply curves: (a)
AS
Price level
O Y
National output
AS
Price level
P1
AD1
O Y
National output
AS
Price level
P2
P1
AD2
AD1
O Y
National output
THREE KEY ISSUES


✜ the left: aggregate supply responsive to
changes in aggregate demand
Price level Different aggregate supply curves: (b)
P AS
National output
P AS
AD1
O Y1
National output
P AS
AD2
AD1
O Y1 Y2
National output
THREE KEY ISSUES

✜ the left: aggregate supply responsive to
changes in aggregate demand
✜ some consensus on nature of short-run AS
curve
Different aggregate supply curves: (c)
AS
Price level
National output
AS
Price level
P1
AD1
O Y1
National output
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 right: expectations adjust rapidly to
changes in prices
✜ the left: expectations of prices depend on

expectations of output and employment
Classical
Macroeconomics
CLASSICAL MACROECONOMICS
■ Classical analysis of output and

employment
✜ markets clear
✦ labourmarket
✦ market for loanable funds
The market for loanable funds
Saving (supply)
Rate of interest
Investment (demand)
O
Quantity of loanable funds
Saving (supply)
Rate of interest
r1
Investment (demand)
O
Saving (supply)
Rate of interest
r1
Investment (demand)
O
Saving (supply)
Rate of interest
r2
Investment (demand)
O
Saving (supply)
Rate of interest
r2
Investment (demand)
O
Saving (supply)
Rate of interest
re
Investment (demand)
O

employment
✜ markets clear
✦ labour market
✦ market for imports and exports:
the gold standard

employment
✜ markets clear
✦ labour market
the gold standard
✜ Say’s law

employment
✜ markets clear
✦ labour market
the gold standard
✜ Say’s law
■ Classical analysis of prices and
inflation

employment
✜ markets clear
✦ labour market
the gold standard
✜ Say’s law
inflation
✜ the quantity theory of money

employment
✜ markets clear
✦ labour market
the gold standard
✜ Say’s law
inflation
✜ the equation of exchange: MV = PY

employment
✜ markets clear
✦ labour market
the gold standard
✜ Say’s law
■ Classical analysis of prices and inflation
✜ the equation of exchange: MV = PY
✜ implications for monetary policy
■ The Great Depression and the return to

the gold standard
✜ the depression of the 1920s
UK unemployment and inflation: 1919 − 38
24
Unemployment
22
20
Unemployment (% of workforce)
18
16
14
12
10
8
6
4
UK unemployment and inflation: 1919 − 38
24
Unemployment
22
20
Unemployment (% of workforce)
Inflation
18
16
14
12
10
8
6
4

the gold standard
✜ return to the gold standard

the gold standard
✜ effects on the economy

the gold standard
✜ the policy response

the gold standard
✜ classical rejection of public works

the gold standard
✦ the fear of inflation

the gold standard
✦ the fear of inflation
✦ the problem of crowding out
The effect of printing extra money: the classical analysis
AS
Price level
P2
P1
AD2
AD1
O Q1
National output
The Keynesian
Revolution
THE KEYNESIAN REVOLUTION
■ Keynes’ rejection of classical theory

✜ rigidities in the labour market
✜ the problem of deficiency of demand
The problem of demand deficiency in the labour market
ASL
Real wage rate (W / P)
W1
ADL1
ADL2
O
Quantity of labour

✜ rejection of increased saving as a means
of increasing investment
Disequilibrium in the market for loanable funds
Savings 1
Savings 2
Rate of interest
r1
r2
Investment
O

✜ rejection of simple quantity theory

✜ rejection of a balanced budget

■ Keynes’ analysis of employment and

inflation


inflation
✜ the importance of aggregate 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

✜ rejection of increased saving as a means of
increasing investment

inflation
✜ the importance of aggregate demand
✜ the multiplier process
The circular flow of income
Cd
Incomes Cd
Incomes Cd
W=S+T+M
J=I+G+X
Incomes Cd
W=S+T+M
J=I+G+X
Incomes Cd
W=S+T+M
J=I+G+X
Incomes Cd
W=S+T+M
J=I+G+X
Incomes Cd
W=S+T+M
■ Keynes’ policy recommendations

✜ demand management by fiscal and
monetary policies
■ Keynesian policies in 1950s and 60s

✜ stop–go policies
✜ criticisms of short-term demand
management
✜ the breakdown of the Phillips curve
The Monetarist–
Keynesian Debate
THE MONETARIST–KEYNESIAN DEBATE
■ The monetarist counter-revolution

✜ the restatement of the quantity theory
✜ rejection of Keynesian demand
management policies
✜ the problem of inflationary expectations
✜ reappraisal of the Phillips curve
✦ unemployment
✦ inflation
The monetarist version of the long-run Phillips curve
Inflation (%)
O Un
Unemployment
(a) Keynesian aggregate supply curve
AS
Price level
O Ymax YP
National output
Inflation (%) (b) Keynesian Phillips curve
O
Umin
Unemployment

management policies
✦ unemployment
✦ inflation
✜ monetarist policies

management policies
✦ unemployment
✦ inflation
✜ monetarist policies
✜ attempts at such policies in the 1980s
■ Modern-day Keynesians
✜ inflation
✜ unemployment
✜ structural problems
✜ hysteresis
✦ low capital stock
✦ deskilling
✦ insiders and outsiders

✜ criticisms of monetarism
✜ Keynesian policy proposals
The Current Position

THE CURRENT POSITION
■ The current range of views

✜ new classical / rational expectations school
✜ moderate monetarists
✜ moderate Keynesians (new Keynesians)
✜ extreme Keynesians
✜ the radical left
✜ eclectic economists
THE CURRENT POSITION
■ A mainstream consensus?
✜ short-run effects of changes in AD
✜ long-run effects of changes in AD
✜ no simple trade-off between inflation and

unemployment
✜ role of expectations
✜ effects of excessive growth in the money

supply
✜ importance of supply-side policies
✜ erosion of governments' power by the

process of globalisation

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Macro Roots

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The Roots of Modern

Setting the Scene: Three

■ Issue 1: Flexibility of prices and wages

■ Issue 2: Flexibility of aggregate supply

■ Issue 1: Flexibility of prices and wages

■ Issue 2: Flexibility of aggregate supply

■ Issue 1: Flexibility of prices and wages

■ Issue 3: The role of expectations in the

✜ the left: expectations of prices depend on

■ Classical analysis of output and

■ Classical analysis of output and

■ Classical analysis of output and

■ Classical analysis of output and

■ Classical analysis of output and

■ Classical analysis of output and

■ Classical analysis of output and

■ The Great Depression and the return to

■ The Great Depression and the return to

■ The Great Depression and the return to

■ The Great Depression and the return to

■ The Great Depression and the return to

■ The Great Depression and the return to

■ The Great Depression and the return to

■ Keynes’ rejection of classical theory

■ Keynes’ rejection of classical theory

■ Keynes’ rejection of classical theory

■ Keynes’ rejection of classical theory

■ Keynes’ rejection of classical theory

■ Keynes’ analysis of employment and

■ Keynes’ rejection of classical theory

■ Keynes’ analysis of employment and

■ Keynes’ rejection of classical theory

■ Keynes’ analysis of employment and

■ Keynes’ policy recommendations

■ Keynesian policies in 1950s and 60s

■ The monetarist counter-revolution

■ The monetarist counter-revolution

■ The monetarist counter-revolution

✦ insiders and outsiders

The Current Position

■ The current range of views

✜ no simple trade-off between inflation and

✜ effects of excessive growth in the money

✜ erosion of governments' power by the

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