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Module History and Alternative Views of Macroeconomics KRUGMAN'S MACROECONOMICS for AP* 35 Margaret Ray and David Anderson John Maynard Keynes & Milton.

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Presentation on theme: "Module History and Alternative Views of Macroeconomics KRUGMAN'S MACROECONOMICS for AP* 35 Margaret Ray and David Anderson John Maynard Keynes & Milton."— Presentation transcript:

1 Module History and Alternative Views of Macroeconomics KRUGMAN'S MACROECONOMICS for AP* 35 Margaret Ray and David Anderson John Maynard Keynes & Milton Friedman

2 What you will learn in this Module : Why classical macroeconomics wasn’t adequate for the problems posed by the Great Depression How Keynes and the experience of the Great Depression legitimized macroeconomic policy activism What monetarism is and its views about the limits of monetary policy How challenges led to a revision of Keynesian ideas and the emergence of the new classical macroeconomics

3 Classical Macroeconomics: Money and the Price Level Classical Macroeconomics: Money and the Price Level %∆ M = % ∆ PL Short-Run Effects Unimportant Focus is on the Long-Run (before 1930s) Keynes - “ (in the long run) we are all dead.”

4 Classical Macroeconomics: The Business Cycle Classical Macroeconomics: The Business Cycle The Business Cycle (measurement yes but no theory of business cycles) Series of short- run cycles….. Lack of consensus Necessity is the mother of invention (Great Depression spurred LOTS of theories) The Great Depression demonstrated that economists could not ignore the SR.

5 Keynes’s Theory Keynes’s Theory The General Theory (Keynes, 1936) one of the most influential economic books ever written Classical View (next page graph) Keynesian View (next page graph) “Animal Spirits” (Keynes argued “AnSp” were mainly responsible for business cycles---today it’s called business confidence )

6 Keynes’s Theory Keynes’s Theory Classical Theory Keynesian Theory Important difference: SRAS is vertical (CT) so a shift in AD changes PL but not output. In Keynesian view, a shift affects both PL and output. Keynesian AS curve normally drawn as straight line….

7 The main practical consequence of Keynes’s work was that it legitimized macroeconomic political activism---the use of fiscal and monetary policy to smooth out the business cycle.

8 Challenges to Keynesian Economics: The Revival of Monetary Policy Challenges to Keynesian Economics: The Revival of Monetary Policy A Monetary History of the United States, Great Depression caused by Fed contracting the money supply Business cycles caused by fluctuations in the money supply. Monetary policy is important - less political (economics policy can be taken out of the hands of politicians) University of Chicago Economist, Milton Friedman

9 Challenges to Keynesian Economics: Monetarism Challenges to Keynesian Economics: Monetarism Monetarism: idea that GDP will grow steadily if the MS grows steadily. Discretionary Fiscal Policies – bad because of “lags”—policies may actually feed a boom Crowding Out: if MS is held fixed while the government pursues an expansionary fiscal policy, crowding out will limit the effect of the fiscal expansion on AD. Monetary Policy Rule: formula that determines actions of FED and leaves little discretion.

10 Challenges to Keynesian Economics: Monetarism Challenges to Keynesian Economics: Monetarism Quantity Theory of Money, MV = PY: relies on velocity of money (stable in SR, slow growth in LR) -- -this means that steady growth in MS = steady growth in spending = steady growth in GDP Velocity of Money: measure of the number of times the average dollar is spent per year. Erratic Velocity undermines Monetarism: steady through the 1870s, erratic starting in 1980s

11 Challenges to Keynesian Economics: Inflation and the Natural Rate of Unemployment Natural Rate Hypothesis (NAIRU): because inflation is embedded into expectations, the unemployment rate must be high enough that actual inflation must be high enough that it meets expected inflation.

12 Challenges to Keynesian Economics: Inflation and the Natural Rate of Unemployment Limit to Discretionary Policy: Friedman-Phelps Hypothesis (NAIRU) predicted that the apparent tradeoff between inflation and unemployment would not survive a period of extended period of rising prices. Stagflation of 1970s proof of Hypothesis Natural Rate widely accepted

13 Challenges to Keynesian Economics: The Political Business Cycle Consequences of Keynes on Politics: lends itself to political manipulation Election Day Economics: misery index predicts which party will get into office based on economy in months preceding the election Political Business Cycle: caused by use of macroeconomic policy to serve political ends….pay the price with infl or unemp to get reelected. The need for central bank independence The need for central bank independence President Obama and Senator McCain

14 Rational Expectations, Real Business Cycles, and New Classical Macroeconomics New Classical Macroeconomics: (1970s/1980s) returned to view that shifts in AD curve only affects AggPL, not AggOP. Rational Expectations Theory: view that individuals and firms make decisions optimally, using all available information New Keynesian Economics: even small costs to changing prices can lead to substantial price stickiness and make the economy behave in Keynesian fashion Real Business Cycle Theory : fluctuations in rate of growth of total factor productivity cause the business cycle.

15 Module The Modern Macroeconomic Consensus KRUGMAN’S MACROECONOMICS for AP* 36 Margaret Ray and David Anderson

16 What you will learn in this Module : The elements of the modern macroeconomic consensus The main remaining disputes

17 The Modern Consensus

18 Should Monetary Policy Be Used in a Discretionary Way? Should Monetary Policy Be Used in a Discretionary Way? Main role in stabilization policy Independent central bank Discretionary fiscal - sparingly Central Bank Targets Asset Prices Unconventional Monetary Policies


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