Macroeconomics: Events and Ideas THIRD EDITION ECONOMICS and MACROECONOMICS Paul Krugman | Robin Wells Chapter 18(33) Macroeconomics: Events and Ideas

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 Great Moderation consensus that emerged after the 2008 financial crisis, and the debates following the crisis WHAT YOU WILL LEARN IN THIS CHAPTER

The Fed’s Response to the 2001 Recession Figure Caption: From Earlier Edition: The Fed responded to the 2001 recession, indicated by the shaded area in both panels, with a rapid expansion of the money supply (panel a) and sharp cuts in the Federal funds rate (panel b).

Classical Macroeconomics 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.

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. By the 1930s, the measurement of business cycles was a well-established subject, but there was no widely accepted theory of business cycles. 5

When did the business cycle begin? ECONOMICS IN ACTION When did the business cycle begin? Figure Caption: Figure 18(33)-1: The Changing Character of the Nineteenth Century Economy In the first half of the nineteenth century, the United States was an overwhelmingly agricultural economy and probably didn’t have modern business cycles. By the late nineteenth century, it was mainly industrial, and the modern business cycle had come into existence. Source: Robert E. Gallman, “Economic Growth and Structural Change in the Long Nineteenth Century,” in Stanley L. Engerman and Robert E. Gallman, editors. The Cambridge Economic History of the United States, vol. II: The Long Nineteenth Century (Cambridge, UK: Cambridge University Press, 2000), pp. 1–55.

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.

Classical versus Keynesian Macroeconomics Figure Caption: Figure 18(33)-2: Classical versus Keynesian Macroeconomics One important difference between classical and Keynesian economics involves the short-run aggregate supply curve. Panel (a) shows the classical view: the SRAS curve is vertical, so shifts in aggregate demand affect the aggregate price level but not aggregate output. Panel (b) shows the Keynesian view: in the short run the SRAS curve slopes upward, so shifts in aggregate demand affect aggregate output as well as aggregate prices.

FOR INQUIRING MINDS The Politics of Keynes The term Keynesian economics is sometimes used as a synonym for left-wing 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.

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.

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.

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.

ECONOMICS IN ACTION The End of the Great Depression The following figure shows the U.S. unemployment rate and the federal budget deficit as a share of GDP from 1930 to 1947. 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.

Fiscal Policy and the End of the Great Depression ECONOMICS IN ACTION Fiscal Policy and the End of the Great Depression Figure Caption: Figure 18(33)-3: Fiscal Policy and the End of the Great Depression During the 1930s, in an effort to prop up the economy, the U.S. government began deficit spending. The deficits were, however, fairly small as a percentage of GDP. In 1937 the government even tried to balance the budget, only to face a renewed rise in unemployment. The U.S. entry into World War II in 1941 brought on deficit spending on a massive scale and ended the Great Depression. 14

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.

Monetarism 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 Notes to the Instructor: If the government makes an effort to keep unemployment below the natural rate of unemployment, the short-run Phillips curve implies that this will lead to a higher inflation rate than people expect. Over time, however, people will come to expect this higher level of inflation, and the short-run Phillips curve will shift upward. If the government insists on keeping unemployment below its natural rate, this will lead to further increases in expected inflation, and so on. So keeping unemployment below its natural rate requires an ever-higher rate of inflation. This analysis suggests that policy makers should not try to achieve an unemployment rate below the natural rate. However there can be political opportunism and/or wishful thinking.

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.

Fiscal Policy with a Fixed Money Supply Figure Caption: Figure 18(33)-4: Fiscal Policy with a Fixed Money Supply In panel (a) an expansionary fiscal policy shifts the AD curve rightward, driving up both the aggregate price level and aggregate output. However, this leads to an increase in the demand for money. If the money supply is held fixed, as in panel (b), the increase in money demand drives up the interest rate, reducing investment spending and offsetting part of the fiscal expansion. So the shift of the AD curve is less than it would otherwise be: fiscal policy becomes less effective when the money supply is held fixed. 18

Velocity of Money (1960–2011) Caption on Fig 33-5: From 1960 to 1980, the velocity of money was stable, leading monetarists to believe that steady growth in the money supply would lead to a stable economy. After 1980, however, velocity began moving erratically, undermining the case for traditional monetarism. As a result, traditional monetarism fell out of favor.

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. Notes to the Instructor: In 1968, Milton Friedman and Edmund Phelps of Columbia University, working independently, proposed the concept of the natural rate of unemployment.

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. Notes to the Instructor: In 1968, Milton Friedman and Edmund Phelps of Columbia University, working independently, proposed the concept of the natural rate of unemployment.

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.

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?

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: the velocity of money, which had followed a smooth trend before 1980, became erratic after 1980. This made monetarism seem like less of a good idea.

New classical macroeconomics is an approach to the business cycle. Rational Expectations, Real Business Cycles, and New Classical Macroeconomics New classical macroeconomics is an approach to the business cycle. It returns to the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not the aggregate output.

Rational Expectations Rational expectations is the view that individuals and firms make decisions optimally, using all available information. The idea of rational expectations served as a useful caution for macroeconomists who had become excessively optimistic about their ability to manage the economy.

Real Business Cycles According to new Keynesian economics, market imperfections can lead to price stickiness for the economy as a whole. Real business cycle theory says that fluctuations in the rate of growth of total factor productivity cause the business cycle. Notes to the Instructor: Current status of RBC: The theory is widely recognized as having made valuable contributions to our understanding of the economy, and it serves as a useful caution against too much emphasis on aggregate demand. But many of the real business cycle theorists themselves now acknowledge that their models need an upward-sloping aggregate supply curve to fit the data—and that this gives aggregate demand a potential role in determining aggregate output. And as we have seen, policy makers believe strongly that aggregate demand policy has an important role to play in fighting recessions.

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. But unlike rational expectations and real business cycle theory, supply-side economics is generally dismissed by economic researchers.

FOR INQUIRING MINDS Supply-Side Economics 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.

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.

ECONOMICS IN ACTION Total Factor Productivity and the Business Cycle 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.

Total Factor Productivity and the Business Cycle ECONOMICS IN ACTION Total Factor Productivity and the Business Cycle Figure Caption: Figure 18(33)-6: Total Factor Productivity and the Business Cycle There is a clear correlation between declines in the rate of total factor productivity growth and recessions (indicated by the shaded areas). Real business cycle theory says that fluctuations in productivity growth are the main cause of business cycles. Other economists argue, however, that business cycles cause productivity fluctuations, not the other way around. 32

Five Key Questions About Macroeconomic Policy Classical macroeconomics Keynesian macroeconomics Monetarism Great Moderation consensus Is expansionary monetary policy helpful in fighting recessions? No Not very Yes Yes, except in special circumstances Is expansionary fiscal policy effective in fighting recessions? Can monetary and/or fiscal policy reduce unemployment in the long run? Should fiscal policy be used in a discretionary way? No, except in special circumstances Should monetary policy be used in a discretionary way? Still in dispute

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 whether monetary policy should take steps to manage asset prices. Economists debate what kind of unconventional monetary policy, if any, should be adopted to address a liquidity trap.

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.

ECONOMICS IN ACTION AN IRISH ROLE MODEL? Over the course of 2010 and 2011 a fierce debate raged, both among economists and among policy makers, over whether countries suffering large budget deficits should move quickly to reduce those deficits if they were also suffering from high unemployment. Many economists argued that cuts in spending and/or tax increases should be delayed until economies had recovered.

ECONOMICS IN ACTION AN IRISH ROLE MODEL? Others argued that fast action on deficits would actually help the economy even in the short run, by improving confidence—a claim that came to be known as “expansionary austerity.” The figure on the next slide compares Ireland’s cyclically adjusted budget deficit as a percentage of GDP with its growth rate.

ECONOMICS IN ACTION Between 1986 and 1989 Ireland drastically reduced its underlying deficits with a combination of spending cuts and tax hikes, while the Irish economy’s growth sharply accelerated. A number of observers suggested that nations facing large deficits in the aftermath of the 2008 financial crisis should seek to emulate that experience.

ECONOMICS IN ACTION A closer look suggested, however, that Ireland’s situation in the 1980s was very different from that facing Western economies in 2010 and 2011. The figure on the next slide shows two other economic indicators for Ireland from 1986 to 1990: short-term interest rates and export growth. Ireland entered into fiscal austerity with high interest rates, which fell sharply between 1986 and 1988 as investors gained more confidence in its solvency (although they rose thereafter).

ECONOMICS IN ACTION At the same time, Ireland had a major export boom, partly due to rapid economic growth in neighboring Britain. Both factors helped offset any contractionary effects from lower spending and higher taxes.

ECONOMICS IN ACTION

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 1%—uncomfortably close to 0%. From Previous Edition

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 the problem. The case of the housing bubble 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.

Summary 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. 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.

Summary 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.

Summary 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.

Summary 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.

Summary 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. The Great Moderation 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.

Summary 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.

Key Terms Keynesian economics New Keynesian economics Macroeconomic policy activism Real business cycle theory The Great Moderation consensus Monetarism Discretionary monetary policy Monetary policy rule Velocity of money Natural rate hypothesis Political business cycle New classical macroeconomics Rational expectations