Question

Place "MON," "RET," or "MAIN" beside the statements that most closely reflect monetarist, rational expectations, or mainstream views, respectively: a. Anticipated changes in aggregate demand affect only the price level; they have no effect on real output. b. Downward wage inflexibility means that declines in aggregate demand can cause long-lasting recession. c. Changes in the money supply \(M\) increase \(P Q\); at first only \(Q\) rises, because nominal wages are fixed, but once workers adapt their expectations to new realities, \(P\) rises and \(Q\) returns to its former level. d. Fiscal and monetary policies smooth out the business cycle. e. The Fed should increase the money supply at a fixed annual rate.

Short answer

a: RET, b: MAIN, c: MON, d: MAIN, e: MON

Step-by-step solution

Identify Monetarist Views

Monetarists believe that changes in the money supply have direct effects on the economy. Therefore, the statement el denotes a monetarist view, as it suggests a focus on money supply management. Thus, statement (e) "The Fed should increase the money supply at a fixed annual rate" is labeled "MON." Statement (c) shows the impact of money on output and price with adjustments of expectations, which aligns with monetarist views, so "MON" applies.

Recognize Rational Expectations Views

Rational expectations theory posits that individuals use all available information to make decisions and predict future policies. Statement (a) suggests anticipated changes affect only the price level with no real output impact, indicating rational expectations as individuals adjust to changes with no surprise effects, hence labeled "RET."

Identify Mainstream Economic Views

Mainstream economic views often acknowledge wage inflexibility and the role of governmental policies. Statement (b) indicates how downward wage inflexibility leads to prolonged recession, a common mainstream view, so it's labeled "MAIN." Statement (d) implies using fiscal and monetary policies to stabilize the economy, aligning with mainstream perspectives, thus labeled "MAIN."

Key concepts

Monetarist Economics

Monetarist Economics is a school of thought that emphasizes the role of governments in controlling the amount of money in circulation. Monetarists believe that changes in the money supply have direct and predictable effects on both the economy and inflation rates. The most famous proponent of this theory is Milton Friedman.

In monetarist theory, the money supply is seen as the primary driver of economic activity, with too much money leading to inflation and too little causing deflation. **Key Beliefs of Monetarism:**

• The economy experiences natural cycles of expansion and contraction.
• Long-term economic stability can be achieved by regulating the money supply.
• Monetary policy is more effective than fiscal policy.
• Advocacy for a fixed money supply growth rate to avoid unexpected shocks.

Monetarists argue that an anticipated change in the money supply can initially affect employment and production, but eventually, only changes in price levels (inflation) will occur once expectations adjust.

Rational Expectations

The Rational Expectations theory suggests that individuals and firms make decisions based on their rational outlook, available information, and past experiences. This concept was developed to explain how expectations about the future affect current economic decisions. Economists Robert Lucas and Thomas Sargent are notable figures in this field.

**Core Aspects of Rational Expectations:**

• Individuals and businesses use all accessible information to forecast future economic variables.
• They adjust their behavior to align with anticipated policy changes and economic conditions.
• Unexpected events disrupt the economy, whereas anticipated ones do not.

This theory implies that only unanticipated changes in economic policy will have real effects on the economy because people already incorporate all foreseeable changes into their economic planning. Therefore, consistent and predictable policies are seen as essential to economic stability.

Mainstream Economics

Mainstream Economics is a broad term that refers to widely accepted economic theories and policies that govern most developed economies. This approach often incorporates a blend of ideas from Keynesian and classical economics. It emphasizes the importance of fiscal and monetary policies to manage economic cycles and ensure stability.

**Characteristics of Mainstream Economics:**

• Recognition of market imperfections and rigidities such as wage and price stickiness.
• Endorsement of government intervention in cases of market failure.
• Use of fiscal policy (government spending and taxes) and monetary policy (control of money supply) to manage demand.
• Focus on both short-term and long-term impacts of economic policies.

Mainstream economists often support policies that aim to smooth out the business cycle and address unemployment and inflation, which are viewed as manageable through thoughtful policy-making.

Aggregate Demand

Aggregate Demand (AD) is the total demand for goods and services within a particular market at any given time. It reflects the purchasing intentions of households, businesses, and the government combined.

**Components of Aggregate Demand:**

• Consumption: Spending by households on goods and services.
• Investment: Expenditure on capital goods by businesses.
• Government Spending: Governmental expenditure on goods and services.
• Net Exports: Difference between a nation's exports and imports.

Economic theories like Keynesian economics stress the importance of AD in driving economic performance. A decrease in AD can lead to a recession, so policies are often designed to bolster demand, especially during economic downturns. In contrast, monetarists believe a stable money supply can effectively manage AD.

Fiscal Policy

Fiscal Policy involves the use of government spending and tax policies to influence economic conditions, including demand, employment, and inflation. It is a vital tool of economic management by the government.

There are two main types of fiscal policy:

• **Expansionary Fiscal Policy**: Involves increasing government spending and/or decreasing taxes to stimulate economic growth.
• **Contractionary Fiscal Policy**: Involves decreasing spending or increasing taxes to slow down the economy, usually to combat inflation.

Fiscal policy plays a crucial role in managing the economy, especially during economic uncertainties. It is often used in tandem with monetary policy,
to ensure comprehensive management of economic activities. Mainstream economists advocate for fiscal policy as a means to cushion the impact of economic cycles and maintain stability.