1. Modules 35 & 36: Historical & Modern Macroeconomics

2. Key Economic Concepts Macroeconomic theories, like all economic theories, are constantly evolving. Most of the debate centers upon whether the business cycle is self-correcting or whether economic policies can be used to smooth out the cycle. If economists agree that policies could be used to influence the business cycle, the debate moves to which policy option, fiscal or monetary, is the best option.

3. Classical Macroeconomics According to the classical model: Prices are flexible. An increase in the money supply leads to a proportional rise in the aggregate price level. An increase in the money supply does not increase aggregate output. Key result is that increases in the money supply lead to inflation. Any downturn in the economy was only temporary. Active policy was not needed to alleviate a recession.

4. The Great Depression and the Keynesian Revolution 1. Short-run shifts in aggregate demand do affect aggregate output and the price level because there is an upward sloping aggregate supply curve. 2. The AD curve can shift because of several factors including “animal spirits” or business confidence. 3. Monetary and fiscal policy to smooth out the business cycle.

5. Challenges to Keynesian Economics Monetary policy began to gain traction after WWII. Milton Friedman and Anna Schwartz (1963) published: A Monetary History of the United States, 1867–1960. They showed that business cycles had historically been associated with fluctuations in the money supply. In particular, the money supply fell sharply during the onset of the Great Depression. They persuaded most economists that monetary policy should play a key role in economic management.

6. Challenges to Keynesian Economics 1. Monetarism GDP will grow steadily if the money supply grows steadily 2. Inflation and the Natural Rate of Unemployment In 1968, Milton Friedman and Edmund Phelps of Columbia University, working independently, proposed the concept of the natural rate of unemployment. 3. The Political Business Cycle Researchers have found statistical correlation between upcoming political elections and expansionary fiscal policy.

7. Rational Expectations, Real Business Cycles, and New Classical Macroeconomics A. Rational Expectations Rational expectations (John Muth in 1961) is the view that individuals and firms make decisions optimally, using all available information. B. Real Business Cycles RBC 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.

8. Key Economic Concepts The wide gaps in economic debate of the 20th century are narrowing. There are a few notions that share broad acceptance across macroeconomists. For example, most economists agree that monetary policy is usually preferred to discretionary fiscal policy to reverse the effects of a recession.

9. Is Expansionary Monetary Policy Helpful in Fighting Recessions? Classical economics really didn’t believe that monetary policy would reverse a recession. Keynesians thought it could have limited effectiveness. Milton Friedman and his followers convinced economists that monetary policy is effective. Nearly all macroeconomists now agree that monetary policy can be used to reduce economic instability.

10. Is Expansionary Fiscal Policy Effective in Fighting Recessions? Classical macroeconomists were even more opposed to fiscal expansion than monetary expansion. Keynesian economists, on the other hand, gave fiscal policy a central role in fighting recessions. Monetarists argued that fiscal policy was ineffective as long as the money supply was held constant. Most macroeconomists now agree that fiscal policy, like monetary policy, can shift the aggregate demand curve. Most macroeconomists also agree that the government should not seek to balance the budget regardless of the state of the economy.

11. Can Monetary and/or Fiscal Policy Reduce Unemployment in the Long Run? Almost all macroeconomists now accept the natural rate hypothesis and agree on the limitations of monetary and fiscal policy. They believe that effective monetary and fiscal policy can limit the size of fluctuations of the actual unemployment rate around the natural rate, but can’t keep unemployment below the natural rate.

12. Should Fiscal Policy Be Used in a Discretionary Way? Many, but not all, macroeconomists believe that discretionary fiscal policy is usually counterproductive: the lags in adjusting fiscal policy mean that, all too often, policies intended to fight a slump end up intensifying a boom. As a result, the macroeconomic consensus gives monetary policy the lead role in economic stabilization. Discretionary fiscal policy plays the leading role only in special circumstances when monetary policy is ineffective, such as those facing Japan during the 1990s when interest rates were at or near the zero bound and the economy was in a liquidity trap.