Alternative theory + additional stuff

How do classical people view the AS-AD curve?

-LRAS is vertical

• LRAS is always at QF

• In the LR, only prices change. Not Qf

How do keynesian people view the AS-AD curve

-Horizontal AS curve

• This is because of wage/price inflexibility

What do monetarists think causes instability in economy

They think inappropriate monetary policy causes instability

MV=PQ

• They think M is unstable, and velocity is stable

What is the equation of exchange

MV=PQ

M= money supply

V= velocity

PQ=GDP (price x quantity)

Monetarists are also known as

classicals

Mainstreams are also known as

keynesians

What do mainstreams think causes instability in economy

They think the volatility of Ig and Supply shocks

In MV=PQ, velocity is the problem

Do new classical economists think the economy can self correct

Yes!

-They believe in the adaptive expectation theory and the rational expectation theory

What does Adaptive expectation theory say?

People form future inflation expectations based on past inflation and adjust them gradually over time.

-People adapt to changes as experiences unfold

-SR changes first (AD shift), then Long Run (AS shift)

-Could take a year or so

What does the rational expectation theory say?

-people use all available information, including current policies, to predict future inflation

-Fully anticipated, people demand higher wages right away

Do mainstream people think the economy can self correct?

-NO!

-They think prices and wages are inflexible downward

-They think that it could take years for economy to fix itself

-Believe in help from monetary and fiscal policies

What is the ratchet effect

Prices or wages easily rise but are slow to fall, causing inflation to stick even when demand drops.

-This is what mainstream ppl believe

-Applies to wage contracts, minimum wage, etc.

Do monetarists/classical economists believe in rules or discretionary policy?

Rules!

For monetary policy:

• Monetary Rule

For fiscal policy:

• Monetarists oppose fiscal policy

Why do monetarists/classical economists oppose fiscal policy?

They question its effectiveness because of the crowding in/out effect.

They believe the crowding in/out makes fiscal policy ineffective.

What is monetary rule?

-What monetarists/ Classicals believe in

-Expand the Supply of money 3-5% each year, at the same rate as economic growth

Monetarists and other classical economists are proactive/active?

proactive. Monetary rule proactively prevents a recession.

Do mainstream/keynesian believe in rules or discretionary policy?

Discretionary policy:

For monetary policy:

• Easy/tight money policy

For fiscal policy:

• They believe it works

What do keynesians/mainstreams believe about crowding in/out

They believe that when they use fiscal policy, crowding in/out is minimal (if at all)

What is disinflation

-Actual rate of inflation is lower than the expected rate, so unemployment rate will increase to balance expect and actual rates

In the SR, nominal wages _____ as price level changes

do not fully adjust

What is a wage price inflationary spiral

• rising wages cause PUPS to increase

• , causing businesses to raise prices

• workers to demand even higher wages,

  • creating a self-reinforcing cycle of inflation.

What happens in deflation

• assets/equity loss,

• unemployment,

• the ability to lower rates any more

What happens in inflation (demand driven)

• people working

• happy

• wages/assets increasing

  • could lead to hyperinflation

What is worse, inflation or deflation

Deflation. it can cause a "deflationary spiral" of falling prices, reduced consumption, and high unemployment.

What happens in demand driven recession

• people working

• spending

• assets growing

• fixable

• hyperinflation

What happens in cost push inflation

• inflation and a recession

• not fixable

• could lead to wage price inflationary spiral

• however it’s self-limiting

Which is worse, demand pull inflation or cost push inflation

Cost push inflation

What would be the largest criticism today with a self-correcting economy

Lots of damage in economy (timing problem), unanchored inflation expectations

What are problems with any policy

-Timing lag

-Recognition lag

-Administrative lag

What causes LRAS to change

A shift in Ig or productive capacity

Stagflation

high inflation combined with high unemployment

What do classical/monetarists believe is stable in the AS-AD curve

-AS is stable as long as Sm is constant

What do mainstream/keynesian believe is unstable

AD is unstable

• Ig is volatile…changes a lot