Chapter 33 Summary

A. Classical Stirrings and Keynesian Revolution

1. Classical economists relied upon Say's Law of Markets, which holds that "supply creates its own demand." In modern language, the classical approach means that flexible wages and prices quickly erase any excess supply or demand and quickly reestablish full employment and full utilization of capacity. In a classical system, macroeconomic policy has no role to play in stabilizing the real economy, although it will still determine the path of prices.

2. The Keynesian revolution postulated inflexibility of prices and wages, so output and unemployment are determined by the interaction of supply and demand forces. The Keynesian AS curve is upward-sloping rather than classically vertical, and monetary or fiscal policies therefore affect both prices and real output. There is no automatic self-correcting price mechanism, and the economy can therefore experience prolonged periods of depression or inflation.

3. In the modern Keynesian view, monetary and fiscal policies can substitute for flexible wages and prices, stimulating the economy during recessions and slowing aggregate demand during booms to forestall inflationary tendencies.

B. The Monetarist Approach

4. Monetarism holds that the money supply is the primary determinant of short-run movements in both real and nominal GDP as well as of long-run movements in nominal GDP.

5. Monetarism relies upon the analysis of trends in the velocity of money to understand the impact of money on the economy. The income velocity of circulation of money (V) is defined as the ratio of the dollar GDP flow to the stock of M:

V = PQ/M = GDP/M

While V is definitely not a constant - if only because it rises with interest rates - monetarists count on its movements being regular and predictable.

6. From velocity's definition comes the quantity theory of prices:

P = kM where k = V/Q

The quantity theory of prices regards P as almost strictly proportional to M. This view is useful for understanding hyperinflations and certain long-term trends, but it should not be taken literally.

7. The monetarist school holds to three major propositions: (a) The growth of the money supply is the major systematic determinant of nominal GDP growth; (b) prices and wages are relatively flexible; and (c) the private economy is stable. These propositions suggest that macroeconomic fluctuations arise primarily from erratic money-supply growth.

8. Monetarism is generally associated with a laissez-faire and anti-big-government political philosophy. Because of a desire to avoid active government and a belief in the inherent stability of the private sector, monetarists often propose that the money supply grow at a fixed rate of 3 or 5 percent annually. Some monetarists believe that this will produce steady growth with stable prices in the long run.

9. The Federal Reserve conducted a full-scale monetarist experiment from 1979 to 1982. The experience from this period convinced remaining skeptics that money is a powerful determinant of aggregate demand and that most of the short-run effects of money changes are on output rather than on prices. However, as suggested by the Lucas critique, velocity may become quite unstable when a monetarist approach is followed.

C. New Classical Macroeconomics

10. New classical macroeconomics rests on two fundamental hypotheses: People's expectations are formed efficiently and rationally, and prices and wages are flexible. It follows from these assumptions in a new classical economy that unemployment is voluntary. Further, the Phillips curve is vertical in the short run, even though it may appear otherwise. The theory of the real business cycle points to supply-side technological disturbances and labor market shifts as the clue to business-cycle fluctuations.

11. The policy ineffectiveness theorem holds that predictable government policies cannot affect real output and unemployment. The new classical theory states that, while we may observe a downward-sloping short-run Phillips curve, we cannot exploit the slope for the purposes of lowering unemployment. If economic policymakers systematically attempt to increase output and decrease unemployment, people will soon come to understand and to anticipate the policy. Fixed policy rules will produce better economic outcomes.

12. Critics of new classical macroeconomics argue that prices and wages are inflexible in the short run. And the predictions - particularly that business cycles are caused by misperceptions and that cyclical unemployment comes when confused people quit their jobs - seem farfetched as an explanation of serious downturns, like those of the 1930s or early 1980s in the United States and of the 1990s in Europe.

13. Study the interim appraisal for the current mainstream synthesis of the warring schools of macroeconomics.


Keynes vs. the Classical Economists
flexible vs. sticky wages and prices
Say's Law of Markets
alternative views of aggregate supply

Velocity and Monetarism
equation of exchange: MV = PQ
velocity of circulation of money: V = PQ/M
quantity theory of money and prices: P = kM
1979-1982 monetarist experiment

New Classical Macroeconomics
rational (forward-looking) expectations, adaptive (backward-looking) expectations
policy ineffectiveness theorem
real business cycle, efficiency wages
tenets of supply-side economics
key assumptions: rational expectations and flexible prices and wages
Lucas critique
Ricardian view of fiscal policy

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