2 of 41 WHAT YOU WILL LEARN IN THIS CHAPTER 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 discretionary monetary policy How challenges led to a revision of Keynesian ideas and the emergence of new classical macroeconomics The elements of the modern consensus, and the main remaining disputes
3 of 41 The Feds Response to the 2001 Recession
4 of 41 Classical Macroeconomics The first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill. Classical macroeconomics asserted that monetary policy affected only the aggregate price level, not aggregate output. Classical macroeconomics asserted that the short run was unimportant. According to the classical model, prices are flexible, making the aggregate supply curve vertical even in the short run.
5 of 41 Classical Macroeconomics As a result, an increase in the money supply leads, other things equal, to an equal proportional rise in the aggregate price level, with no effect on aggregate output. Increases in the money supply lead to inflation, and that’s all.
6 of 41 Classical Macroeconomics By the 1930s, measurement of business cycles was a well-established subject, but there was no widely accepted theory of business cycles. In 1920 Wesley Mitchell founded National Bureau of Economic Research, an independent, nonprofit organization that to this day has the official role of declraing the beginnings of recessions and expansions. The measurement of business cycle was advanced by The term macroeconomics appears in 1933 by Norwegian economist Ragnar Frisch.
7 of 41 ► ECONOMICS IN ACTION When Did the Business Cycle Begin?
8 of 41 The Great Depression and the Keynesian Revolution In 1936, Keynes presented his analysis of the Great Depression—his explanation of what was wrong with the economy’s alternator—in a book titled The General Theory of Employment, Interest, and Money. The school of thought that emerged out of the works of John Maynard Keynes is known as Keynesian economics.
9 of 41 Classical versus Keynesian Macroeconomics
10 of 41 FOR INQUIRING MINDS The Politics of Keynes The term Keynesian economics is sometimes used as a synonym for leftwing economics. Keynes himself was no socialist—and not much of a leftist. At the time The General Theory was published, many intellectuals in Britain believed that the Great Depression was the final crisis of the capitalist economic system and that only a government takeover of industry could save the economy. Keynes, in contrast, argued that all the system needed was a narrow technical fix. In that sense, his ideas were pro- capitalist and politically conservative.
11 of 41 FOR INQUIRING MINDS The Politics of Keynes What is true is that the rise of Keynesian economics in the 1940s, 1950s, and 1960s went along with a general enlargement of the role of government in the economy, and those who favored a larger role for government tended to be enthusiastic Keynesians. Conversely, a swing of the pendulum back toward free - market policies in the 1970s and 1980s was accompanied by a series of challenges to Keynesian ideas, which we describe later in this chapter.
12 of 41 Policy to Fight Recessions The main practical consequence of Keynes’s work was that it legitimized macroeconomic policy activism—the use of monetary and fiscal policy to smooth out the business cycle.
13 of 41 ► ECONOMICS IN ACTION The End of the Great Depression The basic message many of the young economists who adopted Keynes’s ideas in the 1930s took from his work was that economic recovery requires aggressive fiscal expansion—deficit spending on a large scale to create jobs. And that is what they eventually got, but it wasn’t because politicians were persuaded. Instead, what happened was a very large and expensive war, World War II.
14 of 41 ► ECONOMICS IN ACTION Fiscal Policy and the End of the Great Depression
15 of 41 ► ECONOMICS IN ACTION The End of the Great Depression Figure 33-3 shows the U.S. unemployment rate and the federal budget deficit as a share of GDP from 1930 to As you can see, deficit spending during the 1930s was on a modest scale. In 1940, as the risk of war grew larger, the United States began a large military buildup, and the budget moved deep into deficit. After the attack on Pearl Harbor on December 7, 1941, the country began deficit spending on an enormous scale.
16 of 41 Challenges to Keynesian Economics Monetarism asserted that GDP will grow steadily if the money supply grows steadily. It called for a shift from monetary policy rule to that of a discretionary monetary policy. It argued that GDP would grow steadily if the money supply grew steadily. Monetarism was influential for a time, but was eventually rejected by many macroeconomists.
17 of 41 Fiscal Policy with a Fixed Money Supply
18 of 41 Monetarism Milton Friedman (July 31, 1912 – November 16, 2006), 1976 Nobel laureates in Economics. When the central bank changes interest rates or the money supply based on its assessment of the state of the economy, it is engaged in discretionary monetary policy. A monetary policy rule is a formula that determines the central bank’s actions. The velocity of money is the ratio of nominal GDP to the money supply. The velocity equation: M × V = P × Y
19 of 41 Monetarism Monetarists believed that V was stable, so they believed that if the Federal Reserve kept M on a steady growth path, nominal GDP would also grow steadily. Rule rather than discretionary.
20 of 41 Inflation and the Natural Rate of Unemployment The natural rate of unemployment is also the non- accelerating-inflation rate of unemployment, or NAIRU. According to the natural rate hypothesis, because inflation is eventually embedded into expectations, to avoid accelerating inflation over time the unemployment rate must be high enough that the actual inflation rate equals the expected inflation rate.
21 of 41 Inflation and the Natural Rate of Unemployment The natural rate hypothesis limits the role of macroeconomic policy in stabilizing the economy. The goal is not to seek a permanently lower unemployment rate, but to keep it stable. The natural rate hypothesis became almost universally accepted.
22 of 41 The Political Business Cycle A political business cycle results when politicians use macroeconomic policy to serve political ends. Fear of a political business cycle led to a consensus that monetary policy should be insulated from politics.
23 of 41 ► ECONOMICS IN ACTION The Fed’s Flirtation with Monetarism In the late 1970s, the Fed adopted a monetary policy rule, began announcing target ranges for several measures of the money supply, and stopped setting targets for interest rates. Most people interpreted these changes as a strong move toward monetarism. In 1982, however, the Fed turned its back on monetarism. Since 1982 the Fed has pursued a discretionary monetary policy, which has led to large swings in the money supply. Why did the Fed flirt with monetarism, then abandon it?
24 of 41 ► ECONOMICS IN ACTION The Fed’s Flirtation with Monetarism The turn to monetarism largely reflected the events of the 1970s, when a sharp rise in inflation broke the perceived trade-off between inflation and unemployment and discredited traditional Keynesianism. The turn away from monetarism also reflected events: as shown Figure 33-5, the velocity of money, which had followed a smooth trend before 1980, became erratic after This made monetarism seem like less of a good idea.
25 of 41 ► ECONOMICS IN ACTION The Velocity of Money
26 of 41 Rational Expectations, Real Business Cycles, and New Classical Macroeconomics New classical macroeconomics is an approach to the business cycle. New classical macroeconomics emerged as a school in macroeconomics during the 1970s. The most famous New Classical model is that of Real Business Cycles, developed by Robert Lucas, Jr.,Finn E. Kydland, and Edward C. Prescott, building upon the ideas of, among others, John Muth. It returns to the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not the aggregate output.
27 of 41 Rational Expectations Rational expectations is the view that individuals and firms make decisions optimally, using all available information. This way of modeling expectations was originally proposed by John F. Muth (1961). The idea of rational expectations did serve as a useful caution for macroeconomists who had become excessively optimistic about their ability to manage the economy.
28 of 41 Real Business Cycles According to new Keynesian economics, market imperfections can lead to price stickiness for the economy as a whole. New Keynesian macroeconomic analysis usually assumes that households and firms have rational New Keynesian analysis usually assumes a variety of market failures. New Keynesians assume prices and wages are sticky which means they do not adjust instantaneously to changes in economic conditions. Real business cycle theory says that fluctuations in the rate of growth of total factor productivity cause the business cycle.
29 of 41 FOR INQUIRING MINDS Supply-Side Economics During the 1970s a group of economic writers began propounding a view of economic policy that came to be known as “supply-side economics.” The core of this view was the belief that reducing tax rates, and so increasing the incentives to work and invest, would have a powerful positive effect on the growth rate of potential output. The main reason for this dismissal is lack of evidence. Almost all economists agree that tax cuts increase incentives to work and invest, but attempts to estimate these incentive effects indicate that at current U.S. tax levels they aren’t nearly strong enough to support the strong claims made by supply-siders.
30 of 41 ► ECONOMICS IN ACTION The term "supply side" economics was first used by Herbert Stein, a former economic adviser to President Nixon, in Typical policy recommendations of supply-side economics are lower marginal tax rates and less regulation.
31 of 41 ► ECONOMICS IN ACTION Total Factor Productivity and the Business Cycle Real business cycle theory argues that fluctuations in the rate of growth of total factor productivity are the principal cause of business cycles. In the early days of real business cycle theory, proponents argued that productivity fluctuations are entirely the result of uneven technological progress. Critics pointed out, however, that in really severe recessions, total factor productivity actually declines. Some economists argue that declining total factor productivity during recessions is a result, not a cause, of economic downturns. It’s now widely accepted that some of the correlation between total factor productivity and the business cycle is the result of the effect of the business cycle on productivity, rather than the reverse.
32 of 41 ► ECONOMICS IN ACTION Total Factor Productivity and the Business Cycle
33 of 41 Five Key Questions About Macroeconomic Policy Classical macroeconomics Keynesian macroeconomics Monetarism Modern consensus Is expansionary monetary policy helpful in fighting recessions? NoNot veryYes Yes, except in special circumstances Is expansionary fiscal policy effective in fighting recessions? NoYesNoYes Can monetary and/or fiscal policy reduce unemployment in the long run? NoYesNo Should fiscal policy be used in a discretionary way? NoYesNo No, except in special circumstances Should monetary policy be used in a discretionary way? NoYesNoStill in dispute
34 of 41 Current Debate There are continuing debates about the appropriate role of monetary policy. Some economists advocate explicit inflation targets, but others oppose them. Inflation targeting requires that the central bank try to keep the inflation rate near a predetermined target rate. Economists debate about whether monetary policy should take steps to manage asset prices. Economists debate about what kind of unconventional monetary policy, if any, should be adopted to address a liquidity trap.
35 of 41 The Clean Little Secret of Macroeconomics The clean little secret of modern macroeconomics is how much consensus economists have reached over the past 70 years.
36 of 41 ► ECONOMICS IN ACTION After the Bubble During the 1990s, many economists worried that stock prices were irrationally high, and these worries proved justified. In 2001 the plunge in stock prices helped push the United States into recession. The Fed responded with large, rapid interest rate cuts. But should it have tried to burst the stock bubble when it was happening? Although the economy began recovering in late 2001, the recovery was initially weak. Also the Fed had to cut the federal funds rate to only 1%—uncomfortably close to 0%.
37 of 41 ► ECONOMICS IN ACTION After the Bubble In other words, the events of 2001–2003 probably intensified the debate over monetary policy and asset prices, rather than resolving it. The bursting of the housing bubble after 2006 offered another test. The case of the housing bubble also highlighted the problem of identifying bubbles as they inflate. In late 2004, Alan Greenspan, then Fed Chairman, pronounced a “severe distortion” in housing prices “most unlikely.” It seems safe to predict that, in the future, the Fed will be more inclined to take asset prices into account when setting monetary policy.
38 of 41 SUMMARY 1. Classical macroeconomics asserted that monetary policy affected only the aggregate price level, not aggregate output, and that the short run was unimportant. By the 1930s, measurement of business cycles was a well-established subject, but there was no widely accepted theory of business cycles. 2. Keynesian economics attributed the business cycle to shifts of the aggregate demand curve, often the result of changes in business confidence. Keynesian economics also offered a rationale for macroeconomic policy activism.
39 of 41 SUMMARY 3. In the decades that followed Keynes’s work, economists came to agree that monetary policy as well as fiscal policy is effective under certain conditions. Monetarism, a doctrine that called for a monetary policy rule as opposed to discretionary monetary policy, and which argued—based on a belief that the velocity of money was stable—that GDP would grow steadily if the money supply grew steadily, was influential for a time but was eventually rejected by many macroeconomists. 4. The natural rate hypothesis became almost universally accepted, limiting the role of macroeconomic policy to stabilizing the economy rather than seeking a permanently lower unemployment rate. Fears of a political business cycle led to a consensus that monetary policy should be insulated from politics.
40 of 41 SUMMARY 5. Rational expectations suggests that even in the short run there might not be a trade-off between inflation and unemployment because expected inflation would change immediately in the face of expected changes in policy. Real business cycle theory claims that changes in the rate of growth of total factor productivity are the main cause of business cycles. Both of these versions of new classical macroeconomics received wide attention and respect, but policy makers and many economists haven’t accepted the conclusion that monetary and fiscal policy are ineffective in changing aggregate output. 6. New Keynesian economics argues that market imperfections can lead to price stickiness, so that changes in aggregate demand have effects on aggregate output after all.
41 of 41 SUMMARY 7. The modern consensus is that monetary and fiscal policy are both effective in the short run but that neither can reduce the unemployment rate in the long run. Discretionary fiscal policy is considered generally unadvisable, except in special circumstances. 8. There are continuing debates about the appropriate role of monetary policy. Some economists advocate the explicit use of an inflation target, but others oppose it. There’s also a debate about whether monetary policy should take steps to manage asset prices and what kind of unconventional monetary policy, if any, should be adopted to address a liquidity trap.
42 of 41 The End of Chapter 33 coming attraction: Chapter 34: Open-Economy Macroeconomics