1. Module History and Alternative Views of Macroeconomics35
Module History and Alternative Views of Macroeconomics
John Maynard Keynes & Milton Friedman
KRUGMAN'S
MACROECONOMICS for AP*
Margaret Ray and David Anderson

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
%∆ M = % ∆ PL
Short-Run Effects Unimportant
Focus is on the Long-Run (before 1930s)
Keynes - “ (in the long run) we are all dead.”
According to the classical model:
Prices are flexible.
The aggregate supply curve is vertical even in the short run.
An increase in the money supply leads, other things equal, 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, and that’s all.
Really?
Before 1930, most economists were aware that changes in the money supply affect aggregate output as well as aggregate prices in the short run.
They were aware that the short­ -­ run aggregate supply curve slopes upward.
But they regarded such short­ -­ run effects as unimportant, stressing the long run instead.

4. 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)
There was no consensus theory of how business cycles worked.
However, many economists believed the economy would self-adjust to long-run equilibrium, they assumed that any downturn in the economy was only temporary.
Active policy was not needed to alleviate a recession.
The Great Depression demonstrated that economists could not ignore the SR.

5. 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)
The failure of economic theory to predict, or fix, the Great Depression led many to rethink the way in which the business cycle moved, and the role of government policy in the economy.
In 1936 John Maynard Keynes: presents his explanation of what was wrong with the economy during the Great Depression in a book titled The General Theory of Employment, Interest, and Money.
Keynesian economics mainly reflected two innovations.
1. Short­ -­ run shifts in aggregate demand do affect aggregate output and the price level because there is an upward sloping aggregate supply curve. Rather than minor and temporary shifts, these short-run shifts are important.
2. The AD curve can shift because of several factors including “animal spirits” or business confidence, and that these were the main cause of business cycles.. Classical economists emphasized the role of changes in the money supply in shifting the aggregate demand curve, paying little attention to other factors.

6. Keynesian AS curve normally drawn as straight line….
Keynes’s Theory
Classical Theory
Keynesian Theory
Keynesian AS curve normally drawn as straight line….
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.
In the 1930s, economists were divided on the issue of government policy to affect the business cycle.
Today there is broad consensus that active monetary and/or fiscal policy can play useful roles. The debate today is the degree to which policies should be taken.
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.

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
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)
Over the years, economists became much more aware of the limits to macroeconomic policy activism.
Different theories, or “schools of thought”, were presented and have continued to evolve to shape economic policy.
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.
The revival of interest in monetary policy was significant because it suggested that the burden of managing the economy could be shifted away from fiscal policy—meaning that economic management could largely be taken out of the hands of politicians.
What taxes, and for whom, should be cut?
What programs should receive more government spending?
A central bank, insulated from political pressures, should be able to conduct monetary policy more effectively than fiscal policy.
University of Chicago Economist, Milton Friedman

9. 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.
Milton Friedman led a movement that sought to eliminate macroeconomic policy activism while maintaining the importance of monetary policy.
Monetarism asserted that GDP will grow steadily if the money supply grows steadily.
The monetarist policy prescription was to have the central bank target a constant rate of growth of the money supply, such as 3% per year, and maintain that target regardless of any fluctuations in the economy.
By creating a kind of “monetary rule” the central bank would avoid the political perils of fiscal policy and the effect of large government spending crowding out investment spending.
How would this crowding-out happen?
Note: it might prove to be useful review for the students to draw these graphs as the instructor describes the chain of events.
Suppose government spending increases.
In the AD/AS model, AD shifts to the right.
The price level rises, as well as the real GDP.
In the money market, higher prices cause an increase in money demand.
The interest rate begins to rise.
Higher interest rates reduce private investment, which decreases AD.
Thus the final effect of expansionary fiscal policy is weakened because private investment is crowded out.
The Quantity Theory of Money emerges to justify the slow steady growth of the money supply.
MV = PY
If we assume that V, the velocity of money, is constant then a slow increase in M will increase PY or nominal GDP.
In the 1980s, V becomes more erratic and the effectiveness of the Monetarism policies slides.

10. 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
Milton Friedman led a movement that sought to eliminate macroeconomic policy activism while maintaining the importance of monetary policy.
Monetarism asserted that GDP will grow steadily if the money supply grows steadily.
The monetarist policy prescription was to have the central bank target a constant rate of growth of the money supply, such as 3% per year, and maintain that target regardless of any fluctuations in the economy.
By creating a kind of “monetary rule” the central bank would avoid the political perils of fiscal policy and the effect of large government spending crowding out investment spending.
How would this crowding-out happen?
Note: it might prove to be useful review for the students to draw these graphs as the instructor describes the chain of events.
Suppose government spending increases.
In the AD/AS model, AD shifts to the right.
The price level rises, as well as the real GDP.
In the money market, higher prices cause an increase in money demand.
The interest rate begins to rise.
Higher interest rates reduce private investment, which decreases AD.
Thus the final effect of expansionary fiscal policy is weakened because private investment is crowded out.
The Quantity Theory of Money emerges to justify the slow steady growth of the money supply.
MV = PY
If we assume that V, the velocity of money, is constant then a slow increase in M will increase PY or nominal GDP.
In the 1980s, V becomes more erratic and the effectiveness of the Monetarism policies slides.

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.
Not all economists were convinced that monetarism was the way to go.
In 1968, Milton Friedman and Edmund Phelps of Columbia University, working independently, proposed the concept of the natural rate of unemployment.
In Module 34 we saw that the natural rate of unemployment is also the non-accelerating inflation rate of unemployment, or NAIRU.
Note: this could be a good opportunity to use the Phillips curve to review how higher inflation becomes embedded into expectations. In order to avoid accelerating inflation over time, the unemployment rate must be high enough so that actual inflation equals the expected inflation rate.
The important result is that if the unemployment rate is kept below the NAIRU, inflation will start to rise.
The natural rate hypothesis was validated with empirical testing and the influence of monetarism declined.

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
Not all economists were convinced that monetarism was the way to go.
In 1968, Milton Friedman and Edmund Phelps of Columbia University, working independently, proposed the concept of the natural rate of unemployment.
In Module 34 we saw that the natural rate of unemployment is also the non-accelerating inflation rate of unemployment, or NAIRU.
Note: this could be a good opportunity to use the Phillips curve to review how higher inflation becomes embedded into expectations. In order to avoid accelerating inflation over time, the unemployment rate must be high enough so that actual inflation equals the expected inflation rate.
The important result is that if the unemployment rate is kept below the NAIRU, inflation will start to rise.
The natural rate hypothesis was validated with empirical testing and the influence of monetarism declined.

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
Researchers have found statistical correlation between upcoming political elections and expansionary fiscal policy.
This means that, in months leading up to an election, government either cuts taxes or announces new spending programs. These policies put more money in the pockets of voters and also tend to lower the unemployment rate. The eventual cost is inflation, but by then the election is over and inflation can be addressed at a later date.
This is even more justification for putting economic policy in the hands of a central bank that is free of political influence.
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.
In the latter half of the 20th century, economists continued to develop and modify versions of classical and Keynesian economic models.
A. Rational Expectations
In the 1970s a concept known as rational expectations had a powerful impact on macroeconomics. Rational expectations (John Muth in 1961) is the view that individuals and firms make decisions optimally, using all available information.
What is the implication of this assumption for economic policy?
According to the original version of the natural rate hypothesis, a government attempt to trade off higher inflation for lower unemployment would work in the short run but would eventually fail because higher inflation would get built into expectations.
According to rational expectations, we should remove the word eventually: if it’s clear that the government intends to trade off higher inflation for lower unemployment, the public will understand this, and expected inflation will immediately rise.
Most macroeconomists accept a notion of the New Keynesians that price stickiness does exist in the economy and that inflation is not always quick to rise, even if expectations are for higher prices.
B. Real Business Cycles
In the 1980s a number of economists argued that slowdowns in productivity growth, which they attributed to pauses in technological progress, are the main cause of recessions.
Real business cycle theory claims that fluctuations in the rate of growth of total factor productivity cause the business cycle.
Believing that the aggregate supply curve is vertical, real business cycle theorists attribute the source of business cycles to shifts of the aggregate supply curve.
A recession occurs when a slowdown in productivity growth shifts the aggregate supply curve leftward.
A recovery occurs when a pickup in productivity growth shifts the aggregate supply curve rightward.
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.
But many RBC theorists themselves now acknowledge that their models need an upward­ -­ sloping aggregate supply curve to fit the economic data—and that this gives aggregate demand a potential role in determining aggregate output. And as we have seen, policy makers strongly believe that aggregate demand policy has an important role to play in fighting recessions.

15. Module The Modern Macroeconomic Consensus36
KRUGMAN’S MACROECONOMICS for AP*
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
The previous module separated economic debates into several macroeconomic schools of thought. On paper, there are striking differences between some of them.
However in practice, as more years of data have been observed, there exists more of a growing consensus amongst macroeconomists then the previous module might suggest.
A. 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 shift the aggregate demand curve and to reduce economic instability.
The classical view that changes in the money supply affect only aggregate prices, not aggregate output, has few supporters today.
The view once held by some Keynesian economists—that changes in the money supply have little effect—has equally few supporters.
Now, it is generally agreed that monetary policy is ineffective only in the case of a liquidity trap.
B. 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. But that strong view has become relatively rare.
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: they agree that the role of the budget as an automatic stabilizer helps keep the economy on an even keel.
C. Can Monetary and/or Fiscal Policy Reduce Unemployment in the Long Run?
Classical macroeconomists didn’t believe the government could do anything about unemployment. Some Keynesian economists moved to the opposite extreme, arguing that expansionary policies could be used to achieve a permanently low unemployment rate, perhaps at the cost of some inflation. Monetarists believed that unemployment could not be kept below the natural rate.
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.
D. Should Fiscal Policy Be Used in a Discretionary Way?
Today most macroeconomists believe that tax cuts and spending increases are at least somewhat effective in increasing aggregate demand.
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.

18. 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
Classical macroeconomists didn’t think that monetary policy should be used to fight recessions; Keynesian economists didn’t oppose discretionary monetary policy, but they were skeptical about its effectiveness. Monetarists argued that discretionary monetary policy was doing more harm than good.
Today there is a broad consensus among macroeconomists on these points:
Monetary policy should play the main role in stabilization policy.
The central bank should be independent, insulated from political pressures, in order to avoid a political business cycle.
Discretionary fiscal policy should be used sparingly, both because of policy lags and because of the risks of a political business cycle.
1. Central Bank Targets
Some central banks have announced specified inflation targets. This provides more information to the public about how the central bank would take action if actual inflation got out of line with the target.
The Federal Reserve does not announce a target rate of inflation, although some observers believe that Fed actions are consistent with a target of about 2%.
2. Asset Prices
Should the Fed be pro-actively influencing the stock market, real estate market or any asset market?
For example, if the Fed thought the stock market was at an unsustainably high level, should the Fed intervene and try to slow down investors? Some people don’t want the Fed to intervene in any market. However, if the stock market bubble bursts, the damage can be very painful, so maybe the Fed should prevent that from happening.
3. Unconventional Monetary Policies
Desperate times require desperate measures.
In 2008 when the financial system seemed on the verge of collapse, the Fed took some steps that don’t normally appear in the Fed’s playbook.