John Maynard Keynes: father of Macroeconomics



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John Maynard Keynes: father of Macroeconomics

  • John Maynard Keynes: father of Macroeconomics

  • Developed consensus that the government should be proactive and manage the economy

  • Created fiscal policy ideas to combat unemployment and inflation.



I: John M. Keynes is best known for advocating

  • I: John M. Keynes is best known for advocating

    • a. a policy of annually balancing the budget.
    • b. deficit spending during some recessions.
    • c. the fixed-growth-rate monetary rule.
  • Answer: deficit spending during recessions.

  • He believed demand drives the economy

  • “Animal spirits”

  • Fiscal policy is more effective than monetary policy



Classical economists –during the 1700’s and early 1800’s – Adam Smith, David Riccardo, Jean Baptiste Say, and Frederic Bastiat believed in no government involvement, laissez-faire, private property is absolute-let the free market rein.

  • Classical economists –during the 1700’s and early 1800’s – Adam Smith, David Riccardo, Jean Baptiste Say, and Frederic Bastiat believed in no government involvement, laissez-faire, private property is absolute-let the free market rein.

  • Microeconomics was the study.





Classical economist who stated that supply creates its own demand

  • Classical economist who stated that supply creates its own demand



Austrian school of Economics was founded in 1871 by Carl Menger- created the law of diminishing marginal utility.

  • Austrian school of Economics was founded in 1871 by Carl Menger- created the law of diminishing marginal utility.

  • Ludwig von Mises continued school of thought.

  • Frederick von Hayek-pupil of Mises and rival of Keynes during the 20th century

  • Austrians believe in unfettered markets

  • Price is driven by consumer preference not the supply and demand( Classical) or the cost of production (Keynes)

  • Private property is absolute-competition works

  • No government intervention period-

  • Do not agree with Federal Reserve and monetary policy





Two major schools decidedly against government intervention have developed: monetarism and new classical economics.

  • Two major schools decidedly against government intervention have developed: monetarism and new classical economics.

  • Hayek’s free market ideas begin to resurface in the 1970’s when the US, Europe and Great Britain suffered from stagflation.



The main message of monetarists is that money matters.

  • The main message of monetarists is that money matters.

  • 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 dollar bill changes hands, on average, during a year; the ratio of nominal GDP to the stock of money (M):

  • The monetarist analysis of the economy places emphasis on the velocity of money, or the number of times a dollar bill changes hands, on average, during a year; the ratio of nominal GDP to the stock of money (M):



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 following equality:

  • 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 following equality:



  • 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 is always a monetary phenomenon. If the money supply does not change, the price level will not change.

  • 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.

  • They want a stable money supply

  • But not active monetary policy-some but not a lot.



Father of monetarism

  • Father of monetarism

  • Chicago school of Economics

  • Came out of the rise of socialism in the wake of WWII and differed slightly from New Classical/Hayek/Austrian School

  • Majority of monetarists argue that inflation in the United States during the 1970’s could have been avoided if only the Fed had not expanded the money supply so rapidly.

  • Advocate for minimal govt. intervention- deregulation.



The “strict monetarist” view is not compatible with a nonvertical AS curve.

  • The “strict monetarist” view is not compatible with a nonvertical AS curve.

  • Most all economists agree that sustained inflation is purely a monetary phenomenon.

  • Inflation cannot continue indefinitely without increases in the money supply.



Monetarist believe in the Fed doing minimal policy making.

  • Monetarist believe in the Fed doing minimal policy making.

  • Monetary policy is more effective than fiscal policy

  • Competition is best to keep prices stable

  • Too much money in circulation will lead to inflation.



Monetarists believe in a policy of steady and slow money growth, at a rate equal to the average growth of real output (Y).

  • Monetarists believe in a policy of steady and slow money growth, at a rate equal to the average growth of real output (Y).



New classical macroeconomists argue that traditional models have assumed that expectations are formed in simple ways.

  • New classical macroeconomists argue that traditional models have assumed that expectations are formed in simple ways.

  • People base their expectations on what they see and feel.

  • 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.



  • 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.

  • By “true” model we mean a model that is on average correct in forecasting inflation.

  • Developed by John F. Muth in the sixties.

  • The theory holds that people have rational expectations if they have use all of the available information and knowledge to make decisions and form their expectations.



If firms have rational expectations, on average, prices and wages will be set at levels that ensure equilibrium in the goods and labor markets. In other words, on average, there will be no unemployment.

  • If firms have rational expectations, on average, prices and wages will be set at levels that ensure equilibrium in the goods and labor markets. In other words, on average, there will be no unemployment.

  • The market clears and finds equilibrium

  • There is no need for government stabilization or intervention.



The real business cycle theory is an attempt to explain business cycle fluctuations under assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks.

  • The real business cycle theory is an attempt to explain business cycle fluctuations under assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks.



Macro theory consists of demand-oriented theories that failed to explain the stagflation of the 1970s.

  • Macro theory consists of demand-oriented theories that failed to explain the stagflation of the 1970s.

  • Reagonomics- Coined term b/c Reagan and Thatcher adopted many of the ideas.

  • Thatcher and Reagan used Hayek’s and Friedman’s ideas.

  • 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.



Supply-side policies: Government policies that promote economic growth by limiting government involvement .

  • Supply-side policies: Government policies that promote economic growth by limiting government involvement .

  • Based on Say’s Law: Supply creates demand.

  • Measures undertaken by the government aimed at increasing the level of aggregate supply in a nation, and thereby meant to promote long-run economic growth

  • Examples include:

  • Lower tax rates on income and businesses

  • No need for minimum wage- eliminate price controls

  • Limit power of labor unions.

  • Reduce unemployment benefits and give incentives to work

  • Deregulate

  • Free Trade

  • Investments in human and physical capital

  • Supply side polices increase productivity, reduce cost to production so that companies re invest and hire more workers, pay more to keep workers, and that drives the market.



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.

  • 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.





Among the criticisms of supply-side economics is that it is unlikely a tax cut would substantially increase the supply of labor.

  • 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.



What do you think are the dominant economic policies used by governments today?

  • What do you think are the dominant economic policies used by governments today?

  • Could it be those philosophies are why we don’t see robust economic growth?




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