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- Keynesians suffered a major blow as their postulates failed to explain the happenings during the post-1968 period when the rate of growth of output declined, the rate of inflation increased coupled with rising unemployment. This paradox of stagflation is inconsistent with the tenets of Keynesian economics that cyclical movements in prices and outputs relative to trend are positively correlated. Ellis led to reconsideration of theories underlying policymaking and rival schools of thought such as Monetarist School, Rational Expectations and Supply-side Economics (popularly known as Reaganomics). Supply-side economics represent a return to orthodox classical economics and its recent more formal statement the New Classical Macroeconomics.
- The school of Monetarism argues that disturbances within the monetary sector are the principal causes of instability in the economy. According to them, the money supply is the principal determinant of the levels of output and employment in the short run and the price level in the long run.
- Rational Expectations School argues that expectations on the future values of economic variables play an important role in macroeconomic analysis and economic analysis in general. The hypothesis of rational expectations has three important implications for macroeconomic analysis and policy.
a .The advocates of rational expectations school contend that their usefulness is limited, because the parameters of the model will change when new policies are given prominence over the others. Since estimates of the effects of the new policies arc based on the original set of parameters, the actual implications may be quite different. As a result, economic models are considered not so helpful in selecting an appropriate policy option.
b. A W Phillips showed an inverse relationship between the ratio of change of money wage rates and unemployment rate, it was argued that lower unemployment could be obtained at the expense of higher inflation rates through more rapid increases in affective demand. However, some economists argued that a trade-off existed in the short run, but not in the long run. According to rational expectations, no trade-offs exist even in the short run. It is because, if workers and business firms realize that any disturbance leads to higher inflation, wages and prices (which are assumed to be flexible in rational expectations model) will adjust automatically. Assuming full employment in the economy, money wages and prices increase proportionately, leaving the real wage and unemployment unaffected. Thus, according to rational expectations, even though inflation has increased, the unemployment rate remains the same, implies no trade-off between money wage rate and unemployment rate.
c. Discretionary monetary and fiscal policy cannot be used to stabilize the economy.
Supply side economics is a view emphasizing policy measures to affect aggregate supply or potential output. This approach holds that high marginal tax rates on labor and capital incomes reduce work effort and saving.
- Keynesians suffered a major blow as their postulates failed to explain the happenings during the post-1968 period when the rate of growth of output declined, the rate of inflation increased coupled with rising unemployment. This paradox of stagflation is inconsistent with the tenets of Keynesian economics that cyclical movements in prices and outputs relative to trend are positively correlated. Ellis led to reconsideration of theories underlying policymaking and rival schools of thought such as Monetarist School, Rational Expectations and Supply-side Economics (popularly known as Reaganomics). Supply-side economics represent a return to orthodox classical economics and its recent more formal statement the New Classical Macroeconomics.