Monetarists and Production Theory Report Write the weekly report for each topics. I upload the related Powerpoints. tUse one-two paragraphs answering the following questions:What did you learn in class this week?What were this week’s main conclusions?What was the most confusing thing this week? Are there any unanswered questions? Macroeconomics after Keynes
Chapters 9 and 10, Froyen
• Origins of monetarism in the early 1950s with Milton Friedman’s
reformulation of the quantity theory of money
• Policy conclusion and role of money in the macroeconomy
• Theory of the natural rate of unemployment within the context of the
Phillips curve graph
• One of the main attacks of Keynesian Economics was on the Quantity
Theory of Money – the idea that money only serves for transactions, and
that the quantity money does not affect the real economy, only prices.
• In the 1960s, Keynesian started to be seen as a school focused only on
expansionary fiscal policy.
• Monetarists started to reassert the importance of money supply and
monetary policy. The father of monetarism was Milton Friedman, one of
two most important economists of the 20th century. The other one was
1. The QTM is valid: money influences the price level
2. Real variables, such as output (GDP) and employment, are
determined in the long run by real factors, such as the stock of capital
goods, the size and quality of the labor force, and the state of
3. In the short run, the supply of money can influence real variables.
4. Economy is inherently stable. Instabilities come from mistaken
government policies, especially in the growth of money supply, but also
other policies like rent control, minimum wage, etc.
• Stability in money supply is crucial for economic stability, and that is best
achieved through a rule for monetary policy, instead of discretion.
• Monetarists revitalized and reformulated the QTM. Friedman believed
that the causes of the great depression had been wrongly assessed.
• Monetarists accused Keynesians of being too loose on monetary policy.
• Since in the post WWII interest rates were kept low to keep government debt low
and because of fear of a return to the depression conditions. Interest rate stability
would also avoid speculative demand for money
Restatement of the QTM
• QUANTITY of money was the main determinant of Y in the short term
• Keynes viewed money DEMAND as central and determined mainly by
uncertainty and speculation, and thus unstable
• But, for Friedman, demand for money is stable
• There is nothing particular about money for Friedman, it is an asset just like
others (unlike Keynes, who viewed money as liquidity)
• If money demand is stable, money supply must follow it. The main causes of
prices changing is money supply different than money demand
• Friedman: monetary policy should just react with a rule, and not be proactive.
• Keynesians believed that the business cycle fluctuations (caused mainly by fluctuations
on private investment) could be offset by active fiscal and monetary policies – “active
• Monetarists view the private sector as stable and shock-absorbing
• Keynesians see the private sector as shock-producing and unstable
• The peak of monetarist influence in policy came at the end of the 1970s,
when the Fed adopted a monetary growth rule. “monetarist experiment”
• However, the school lost influence in the post 1980 period. But its focus and
obsession on inflation remained as a legacy to schools that came after.
The natural rate of unemployment
• Concept is still used today to answer questions pertaining the relationship
between output, unemployment, and inflation – a central question in any
• Introduced by Friedman
• Natural rate: “there exists an equilibrium level of output and an accompanying
rate of unemployment determined by the supply of factors of production,
technology, and institutions of the economy”.
• The natural rates of output and employment do not depend on aggregate demand
• At the natural rate, there is no INVOLUNTARY unemployment, only voluntary
and frictional unemployment.
• Everyone is ‘happy’ with their status: those who are working are satisfied with the real
wage, and those who are not working choose not do so because they think the wage is
too low and not worth leaving their house for.
Natural rate of unemployment
• Expansionary monetary policy move output above the natural rate.
• Since NRU is “which has the property that it is consistent with equilibrium in
the structure of real wage rates.”
• However, in the long run, the economy returns to the natural rate. If
the policymakers continue to do active monetary policy to maintain
the output above the natural rate, then they must be willing to accept
an ever-accelerating rate of inflation.
• Let’s consider that the economy is at equilibrium. The economy has
been growing at 2%, and money growth, the same – so inflation is
• Then the CB decides to increase money growth it to 5%.
• This will stimulate AD, and GDP. Both will increase in the short run.
• This is shown by the Phillips Curve.
• When there is an increase in money growth, prices will increase (as the QTM states)
by 5%, and firms will think that demand for their product increased.
• Employers may face this as a structural shift in the economy (and not a temporary one
just caused by monetary policy) and hire more workers to produce more. But the only
way to do that is increasing the nominal wage to attract more people to the labor
force (remember: the economy was ‘resting’ in the natural rate of unemployment)
• Since nobody went yet ‘to the market’ to see that all prices increased, firms will
produce more (increasing demand), increasing nominal wages (5%) to hire more
• Since economic actors were expecting inflation to be equal to the last period – 2%(ADAPTATIVE EXPECTATIONS) and the higher inflation (5%) will only come at a later
time (‘lag’), unemployment rate will decrease in the short run (from 6% to 3%) when
economic actors are suffering from ‘money illusion’.
• ‘Money illusion’ is when actors confuse nominal and real changes.
• Demand will increase in the short run, but then decrease in the long run, as
workers eventually realize that prices increased the same as the nominal
• The economy will go back to the natural rate, but with a higher inflation,
since now EXPECTATIONS are higher and workers/ firms will anticipate a
price change and will be expecting 5%. The economy moves to C, and the
Phillips Curve shifts to the right.
• This is a trade-off between unemployment and inflation, but only in the
• The long run Phillips Curve is vertical.
What is Microeconomics?
• Theory of PRICES and DECISIONS – households, firms, etc – and how they interact with each other
• It studies limits and allocation of scarce resources.
• It deals with the ways companies interact to form markets and industries
• Rationality => important assumption, maximization
• In markets, there are two groups interacting: buyers and sellers => interaction determines prices.
• 3 main parts: consumer theory, production theory, and market structures (for goods and services and factors
• More modern theories: game theory, regulation
• Main question to be answered is how consumer allocates its LIMITED budget to
acquire goods and services.
• Focus on DEMAND
• It is divided in 3 steps: 1) preferences; 2) budget constraint; 3) choices (demand)
1) Preferences: based on consumer behavior. Why a consumer chooses one basket
of good and not another one? Preferences are shown with indifference curves – all
combinations of goods that give consumer the same utility, satisfaction. It shows
the trade-off, how much a consumer will want of a good in order to give up a
certain amount of the other good.
Preferences => Utility
• Why do people demand goods?
• Because consumption gives some kind of satisfaction. There is no demand for
• If we can measure satisfaction, it is called “utility”
• How does utility behave?
• As we increase the amount of a good, the satisfaction given by the
last one decreases
• Marginal utility: the utility added by the last unit to the total utility
• Given utility, how much of a good one consumes?
• Let’s assume 2 goods: clothing and food
• Mary consumes a certain basket each month with 4 units of clothing
and 3 clothes. If we ask Mary to tell us what other options are as
desirable as this one, she could answer:
This is called an INDIFFERENCE curve
Map of indifference curves
More is always better
2) Budget constraint: P1*x1 + P2*x2 M
P1*x1 => quantity of money spent with good 1
M => quantity of money available for consumer to spend
This equation can be rewritten as: 2 =
− ( ) 1
M/P2 is the y intercept
(- P1/P2) is the slope: relative price, opportunity cost
• consumers chose in a rational way, they decide the quantity of a certain good in
order to maximize their satisfaction, given their budget constraint.
• Consumer spends all its income, there is no hoarding.
• Consumer will choose the basket that is tangent to the budget line
• From this, we can derive the demand curve – that will give us the choice with
different prices and incomes.
• In each point of the demand curve, the consumer is maximizing its utility.
• If we add each individual demand curve, we will get the market demand curve.
Now let’s turn to production theory
• Consumers: inputs are commodities and output is utility
• Firms: inputs are land, labor, machines (commodities) and outputs
are commodities (to be consumed)
• Firms are a relatively new thing. Before mid-1800s, almost all
production was done by farmers and craftsmen. Firms coordinate
producing efforts, they direct the production of salaried workers.
• Capitalism means the use of labor as a commodity to produce goods.
• Labor is hired, and land and machines may be rented or owned (and even if they are
owned, firms have an opportunity cost – meaning that underutilizing a certain factor has
costs associated with it). So in theory the firm is considered renting all the resources.
• Theory is attempting to tell a story about how firms select amongst different
combinations of factors in order to minimize the cost of producing a certain quantity of
• Firms like consumers have budget constraints. Their inputs are ‘commodities’ and come
at a price per unit. Production is the process of transformation of factors into goods and
• We will analyze the supply of outputs, not the factors market.
• As consumer tries to extract as much utility as possible from a certain budget,
firms try to ensure that for a given expenditure on inputs (e.g. labour, land)
maximum output will be produced.
• 3 steps:
1) Production technology: how inputs can be transformed into outputs. Just as the
consumer can reach a certain degree of satisfaction from a certain amount of
goods, the firm will produce a level of output by using different combinations of
inputs (capital and labor).
2) Cost constraints: firms take into account the prices of inputs.
3) Input choices: given the technology and the prices, the firm will choose the best
combination of inputs to maximize output.
1) PRODUCTION TECHNOLOGY
• firms use inputs (workers – skilled and non-skilled, managers), materials (steel, plastics,
electricity, water), and capital (land, buildings, machinery, inventories)
• Production function: q = F (K,L)
• q = highest output possible for a combination of inputs
• Since inputs can be combined in different ways, output can also be produced in many
ways (wine, for example)
• Short run: quantity of at least one input is fixed (intensity with which firms utilize their
plants – we usually consider capital to be fixed)
• Long run: all inputs are variable (size of the plant changes)
The short run
• When deciding how much a particular input to use (and buy), a firm has to
compare the cost of the input and the benefit. We use two measures of
benefit and cost: average and marginal.
• If capital is fixed, then the only way a firm can increase production is by
• Imagine that you have a clothing factory. If you have a fixed amount of
equipment, you still can hire more people to sew. You decide how much
labor to hire and how much to produce. To make this decision, you must
know how much q increases when L increases.
Amount of L
Marginal product (△q/△L)
Average vs. marginal
• The average product of labor measures the productivity of the firm’s
workforce in terms of how much output each worker produces on
average. Average product increases initially, but then decreases after
• Marginal product of labor is the additional output produced as the
labor input is increased by 1 unit. Marginal labor starts to decrease
after 3 workers.
• Producing with more than 8 workers is not rational, as the total output starts
• the marginal product of labor at a point is given by the slope of the total
product at that point.
• The Law of Diminishing Marginal returns: as the use of an input increases in
equal increments (with other inputs fixed), a point will eventually be reached
at which the resulting additions to output decrease.
• When there are too many workers, some workers become ineffective and the marginal
product of labor falls.
• It is not a question of quality, it is not the case that the workers that are hired last are
less productive. We are assuming that all labor inputs have the same quality.
The long run
• Now the firm can change/combine different quantities of labor and
capital to produce output. How to choose?
• We begin by looking at isoquants. Let’s consider labor and capital are
used to produce food.
• Curves are called isoquants – iso means
equal – combinations of the quantities of
the factors of production (in our example
labor and machinery – capital) which give
rise to the same quantity of output.
• At point A the firm produces 100 units
making use of 6 units of capital and 1 unit
• If it were to reduce its capital by 1 unit
without reducing its output, it would have
to increase its labor utilization by about 1
unit; a rate of 1/1. This rate (i.e. the rate at
which it must increase its utilization of one
factor in order to compensate for the loss
of a small amount of the other factor) is
called the marginal rate of technical
• The geometrical depiction of this rate is
the slope of the isoquant.
Returns to scale
• Increasing Scale: increasing all of the inputs to production in
proportion. If it takes one farmer working with one harvesting
machine on one acre of land to produce 100 bushels of wheat, what
will happen to output if we put two farmers to work with two
machines on two acres of land? Output will almost certainly increase,
but will it double, more than double, or less than double?
• Increasing returns to scale: If output more than doubles when inputs are doubled,
there are increasing returns to scale.
• If there are increasing returns, then it is economically advantageous to have one large firm
producing (at relatively low cost) rather than to have many small firms (at relatively high cost).
Because this large firm can control the price, it may need to be regulated. Ex. Electricity
• Constant returns to scale: output doubles when inputs are doubled. Ex. a large
travel agency might provide the same service per client and use the same ratio of
capital (office space) and labor (travel agents) as a small agency that services fewer
• Decreasing returns to scale: output less than doubles when all inputs double.
Decreasing- returns case is likely to be associated with the problems of coordinating
tasks and maintaining a useful line of communication between management and
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