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AP Economics

Lesson Plan

Alternative Views on Macroeconomics

Learning Targets: 1. Explain the assumptions of Keynesian economics

2. Describe how Keynesian economics is used to address recessions

3. Explain what Monetarism is and how it challenges Keynes

4. Describe the Quantity Theory of Money

Textbook Chapter: Chapter 33: Macroeconomics: Events and Ideas (pages 886-899)

1. WARM-UP: Phillips Curve FRQ

2. VIDEO: Is Obama a Kenyesian? (Do we even know what a Kenyesian is?!?)

3. ASK: What does the classical model say about the impact of monetary policy on output?

a. Prices are flexible and not sticky

b. Aggregate supply is always vertical (even in the short run)

c. A change in MS then leads to an equivalent change in price levels

d. Changes in MS only lead to inflation and not economic growth

4. During the 1930s there was strong disagreement the impact monetary and fiscal policy had on the economy

a. No consensus existed on how business cycles worked

b. Also no consensus on how to respond to downturns in the economy

c. Existence of the Great Depression led to a variety of new economic schools of thought

5. The primary school in the 1930s was led by JOHN MAYNARD KEYNES

a. VIDEO: Part 1 – Keynesianism () (~7:47)

b. Theory reflected a few innovations in economic thought

i. Short-run shifts in aggregate demand impact output

1. SHOW: Figure 35.1

2. Classical theory shows that a shift in AD leads to inflation

3. Keynes has SRAS being upward-sloping so a shift in AD affects total output (in the short-run)

ii. AD can shift due to several factors, like business confidence

1. Called “animal spirits”

2. Captured today in idea of bulls (those with strong expectations for growth) and bears (those with weak expectations for growth)

iii. Fiscal policy can have a stronger impact than monetary policy (especially in depressions)

1. Noted the presence of LIQUIDITY TRAPS (Make sure to cover this)

a. Realization that interest rates cannot fall below 0%

b. Monetary policy that drops rates to 0% has limited effect

2. Fiscal policy has no such limitation (in Keynes’ theory)

c. His work justified MACROECONOMIC POLICY ACTIVISM

i. Policy makers began using monetary and fiscal policy to smooth out business cycles

ii. Belief is widely held today by most economists (even some conservatives)

6. Many challenges to Keynes have risen since he first released his book (The General Theory of Employment, Interest, and Money)

a. Austrian school of economics (led by Hayek and von Mises)

b. VIDEO: Part 2 – The Bust ()

7. VIDEO: Fear the boom and bust ()

8. MONETARISM

a. Argues that business cycles are caused by fluctuations in the money supply

b. Also argued that fiscal policy does not have the same impact that Keynes believed

i. ASK: What is the impact of increased government spending on AD? It shifts it to the right

ii. ASK: What happens to price levels as a result of this shift? They increase

iii. ASK: If price levels rise then what will happen to the demand for money and interest rates? It will increase money and drive interest rates up

iv. ASK: What will happen to private investment if interest rates rise? It will decreased because some projects will not be pursued

v. Monetarists argue that the drop in investment spending will offset the impact of government spending (I decreases while G increases)

vi. The result is a diminishing of the multiplier effect in the real world

c. Believe that a steady growth in money supply is the way to ensure steady growth in GDP

i. Constant rate of money supply is all you need

ii. Use policies that will ensure a set amount of growth in MS regardless of fluctuations in economy

iii. Developed the QUANTITY THEORY OF MONEY

1. M * V = P * Y

a. M = money supply

b. V = velocity of money (times a dollar turns over between buyers and sellers in a year)

c. P = aggregate price level

d. Y = real GDP

2. Assumes velocity is constant over time

3. Therefore increasing M leads to a growth in nominal GDP

iv. SHOW: Figure 35.3

1. Velocity was relatively stable

2. Changes when banks begin offering interest on checkable deposits

3. The more interest you earn on checkable deposits the less velocity there is since there is an incentive to keep money in your account

4. ASK: What do you notice about the velocity of money up until shortly after 1980? Its growth was reasonably stable

5. ASK: What impact does the change in velocity after 1980 have on the quantity theory of money? It calls it into question since it assumes a constant growth in the velocity of money

9. The RATIONAL EXPECTATIONS MODEL challenges Keynes by using the Classical Model

a. Argued that people will make decisions based on what they expect the market to do

b. Assumes that adjustments are made automatically based on available information

c. Aggregate supply then is vertical (just like in the classical model)

d. ASK: If you expect long-term inflation then what will you do when you negotiate your labor contract for this year? Build in an increase for expected inflation

e. ASK: How can monetary or fiscal policy work if people automatically adjust their behavior? Changes need to come as a surprise instead of a constant

10. VIDEO: Keynes vs. Hayek Round Two ()

Points of Emphasis in Class

▪ Equation of Exchange handout in class

▪ Rational expectations

▪ Music video – Round #1

o Keynes

▪ “Animal spirits” weaken the economy – government does not face the same challenge

▪ Paradox of thrift ( Savings is non-consumption

▪ Liquidity traps make monetary policy less powerful

▪ Government spending should focus on those that SPEND (mostly lower income people) [why not the rich?]

o Hayek

▪ Intervention creates distortions in asset markets

▪ Interest rates that are artificially low encourage unsustainable investment

▪ The “boom” can create the “bust” when there aren’t enough resources to go around and when investments are made in bad industries

Alternative Views on Macroeconomics

Review Quiz

1. Because classical economists stressed mostly the long run, they:

A. perceived the economy as being mostly self-adjusting.

B. favored the use of fiscal policy over monetary policy.

C. expected the government to purge the rottenness out of the system.

D. favored the use of monetary policy over fiscal policy.

E. favored the coordinated use of both monetary and fiscal policy.

2. According to a Keynesian economist, a recessionary gap should be fixed with:

A. a monetary rule.

B. supply-side tax cuts to stimulate investment and work.

C. decreases in government spending.

D. expansionary fiscal policy.

E. Patience and a balanced budget.

3. Keynesians argued that monetary policy would NOT be effective if:

A. there was a liquidity trap.

B. the Fed was independent of political pressure.

C. other countries did not follow monetary policy similar to that of the United States.

D. no one bought bonds when the Fed conducted open-market operations.

E. the investment demand curve was downward sloping.

4. Suppose the money supply is equal to $10 billion and the velocity of money is 6. If the aggregate price level is 4, then the real GDP is:

A. $60 billion.

B. $30 billion.

C. $20 billion.

D. $15 billion.

E. $10 billion.

5. According to monetarism:

A. Congress and the President should be responsible for controlling the money supply.

B. output will grow steadily if the money supply grows at a steady rate.

C. the Fed should vary the growth rate of the money supply on a monthly basis.

D. changes in the money supply only affect the real output in the long run.

E. if the money supply grows at a steady rate, potential GDP will grow at the same rate.

6. Under rational expectations, government policy can be effective:

A. if it is rationally thought out before implementation.

B. if it is anticipated, so people can make realistic preparations.

C. if it surprises people when it occurs.

D. whenever the economy reacts rationally to the decision.

E. if it is announced well in advance.

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