Theories of BC

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Section 1

Question Answer
Neoclassical and Austrian SchoolsALL MARKETS- EQUILIBRIUM because of the “invisible hand, or free market,” and the price will be found for every good at which Supply = Demand. RESOURCES BASED ON PRINCIPLE- marginal cost = marginal revenue, and NO INVOLUNTARY unemployment of labor or capital.
Say’s law:All that is produced will be sold because supply creates its own demand. French economist J.B. Say pointed out that if something is produced, the capital and labor used for that production will have to be compensated. This compensation of the factors (interest for capital and wages for labor) creates purchasing power in the sense that the workers receive a paycheck and thus can buy goods and services they need. Widespread declines in demand would be strictly temporary
Schumpeter’s creative destruction theorycycles within industries as a result of technological progress but no economy-wide fluctuations.2 Schumpeter formulated a theory of innovations, which explained cycles limited to individual industries: When an inventor comes up with a new product (e.g., the digital music player in recent decades) or a new, better way to produce an existing good or service (e.g., radio frequency identification tracking of inventories), then the entrepreneur that introduces the new discovery will likely have bigger profits and may drive the existing producers out of business
Austrian school(short)the roles of money and government.
Austrian schoolIt is misguided government intervention. Von Hayek - governments that try to increase GDP and employment-SO fluctuations (thus perhaps increasing voters’ consensus) by adopting expansionary monetary policies. Governments- LOWER MKT INTRST RATE below its natural value (aggregate demand SHIFTS RIGHT) and thus lead companies to overinvest (an inflationary gap). Once companies realize that they have accumulated too much equipment and too many structures, -STOP INVESTING, which depresses aggregate demand (aggregate demand SHIFTS LEFT) and causes a crisis throughout the economy. NEW EQUILIBRIUM- all prices including wages must DECREASE.
Keynesian Schoolthe human suffering is excessive while waiting for all shocks to be absorbed and for the economy to return to EQUILIBRIUM.
KeynesianWorkers-LOW SALARIES,- exacerbate the crisis-REDUCE AGGREGATE DEMAND rather than solving it because lower wage expectations would SHIFT aggregate demand LEFT. For example, if wages fell, workers would need to cut back on their spending. This response would cause a further contraction in the demand for all sorts of goods and services, starting from the more expensive items, such as durable goods, and move in a “domino effect” through the economy (the downward spiral of the aggregate demand curve continuously shifting left, as mentioned earlier).
CRITICISMS OF KEYNESIANFISCAL DEFICITS mean HIGHER GOVT DEBT that needs to be serviced and repaid eventually. There is a danger that government finances could move out of control. Keynesian cyclical policies are focused on the SHORT. In the long run, the economy may come back and the presence of the expansionary policy may cause it to “OVERHEAT”—that is, to have unsustainably fast economic growth, which causes INFLATION and other problems. This result is because of the typical LAGS involved in expansionary policy taking effect on the economy. Fiscal POLICY takes TIME TO IMPLEMENT. Quite often, by the time stimulatory fiscal policy kicks in, the economy is already recovering. (Monetary policy determines the available quantities of money and loans in an economy.)
Monetarist School-objected to Keynesian intervention for four main reasons1. The Keynesian model does not recognize the supreme importance of the money supply. If the money supply grows too fast, there will be an unsustainable boom, and if it grows too slowly, there will be a recession. Friedman focused mainly on broad measures of money, such as M2. The Keynesian model lacks a complete representation of utility-maximizing agents and is thus not logically sound. Keynes’ short-term view failed to consider the long-term costs of government intervention (e.g., growing government debt and high cost of interest on this debt). The timing of governments’ economic policy responses was uncertain, and the stimulative effects of a fiscal expansion may take effect after the crisis was over, and thus cause more harm than good.
Monetarist schoolbusiness cycles -because of exogenous shocks and government intervention. It is better to let aggregate demand and supply find their own equilibrium than to risk causing further economic fluctuations.KEY: is that the money supply needs to continue to grow at a Moderate rate. If it falls, as occurred in the 1930s, - SEVERE ECONOMIC DOWNTURN, whereas if money grows too fast, inflation will follow.

Section 2

Question Answer
new classical macroeconomicsan approach to macroeconomics that seeks the macroeconomic conclusions of INDIVIDUALS MAXIMIZING UTILITIES on the basis of rational expectations and companies maximizing profits. The assumption is made that all agents are roughly alike, and thus solving the problem of one agent is the same as solving that of millions of similar agents (or the per capita income and consumption of the average agent).
Models without Money: Real Business Cycle TheoryRBC models of the business cycle conclude that EXPANSIONS and CONTRACTIONS represent EFFICIENT operation of the economy in response to EXTERNAL REAL SHOCKS. Because the level of economic activity at any time is consistent with maximizing expected utility, the policy recommendation of RBC theory is for government not to intervene in the economy with discretionary fiscal and monetary policy.
Critics of RBC modelslabor market. They rely on EFFICIENT MARKETS, employment-SHORT TERM: apart from frictional unemployment, if markets are efficient, a person who does not have a job can only be a person who does not want to work. If a person is unemployed, in the context of efficient markets, he just needs to lower his wage rate until he finds an employer who hires him. This assumption is logical because if markets are perfectly flexible, all markets must find equilibrium and full employment.
feature of RBC modelsAS-Prominent,show that supply shocks, such as advances in technology or changes in the relative prices of inputs, cause the aggregate supply (AS) to shift LEFT.
A new technology can change potential GDP,moving LONG-run AS to the RIGHT
increase of energy pricesshifts short-run AS to the left (higher prices and lower GDP).
LONG RUN- companies and households can learn to use less of the expensive energy inputssubstitution effect: and therefore LONG-run AS will shift RIGHT (higher GDP) if the economy learns to produce more goods with less energy.
suppliers cannot keep up with demand.prices will tend to grow faster than normal—that is, inflation. As a consequence, the central bank will often intervene to limit inflation by “tightening” monetary policy, which generally means increasing interest rates, so that the cost of borrowing will be higher and demand for goods and services will slow down (a leftward shift in aggregate demand caused by the higher cost of money). This response will decrease equilibrium GDP and can result in a recession.
Models with MoneyIn one type of model, the economy receives SHOCKS from delta technology and consumer preferences (like in the RBC case), but can also receive shocks from monetary policy, which sometimes can tame the business cycle and at other times may exacerbate it.
Neo-Keynesians or New Keynesians-Models with Moneyplace macroeconomics on sound microeconomic foundations. In contrast to the New Classical school the Neo-Keynesian school assumes slow-to-adjust (“sticky”) prices and wages. The Neo-Keynesian models show that markets do not reach equilibrium immediately and seamlessly, but even small imperfections may cause markets to be in disequilibrium for a long time. As a consequence, government intervention as advocated in the 1930s by Keynes may be useful to eliminate unemployment and bring markets toward equilibrium.