Module 35
History and
Alternative
Views of
Macroeconomics
John Maynard Keynes & Milton Friedman
1.
Why was classical macroeconomics inadequate for the problems
posed by the Great Depression?
2.
How did Keynes and the experience of the Great Depression legitimize
macroeconomic policy activism?
3.
What is monetarism and what are its views about the limits of
monetary policy?
4.
How have challenges led to a revision of Keynesian ideas and the
emergence of the new classical macroeconomics?
•%∆ M = % ∆ PL
•Short-Run Effects Unimportant
•Focus on the Long-Run
•Keynes - “ (in the long run) we
are all dead.”
•The Business Cycle? HUH?
•No theory of business cycles
•Lack of consensus on how they
worked
•The economy is self correcting,
right?
•Necessity is the mother of
invention
•The Great Depression: maybe
we should re-think all of this
economic stuff…
•The General Theory (Keynes Book
published in 1936)
•Classical View: shifts in AD affect
aggregate price level but not SRAS
because it is vertical
•Keynesian View: shift in AD DOES
affect SRAS & aggregate price level
because it is sloping
•Short - run shifts in aggregate
demand are important
•“Animal Spirits” (business
confidence) can shift AD, not just
the money supply
Legitimized macroeconomic policy activism—the use of monetary and fiscal policy to smooth out the business cycle.
1930: division on the issue of government intervention into the economy…
2012: division on the issue of government intervention into the economy….
Classical Theory
Keynesian
Theory
Wide economic consensus exists that the government should intervene in the economy &
those policies can be useful & beneficial. The division today is to what degree does the
government intervene?
1.
Revival of Monetary Policy
2.
Monetarism
3.
Inflation & NAIRU
4.
Political Business Cycle
•A Monetary History of the United States,
1867 – 1960 (Friedman & Schwartz)
•Post WWII, monetary policy gains
popularity
•Great Depression caused by Fed
contracting the money supply
•Monetary policy is important - less political
University of Chicago
Economist, Milton Friedman
•The Fed is insulated from political
pressure unlike fiscal policy
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Monetarism: GDP will grow steadily if the money supply grows steadily.
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Discretionary Policies make the economy worse - increase MS at a constant
rate regardless of economic fluctuations
Crowding Out by government should disappear - investments can continue
steadily.
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How does this happen? 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. Draw these Graphs.
•Monetary Policy Rule: Fed actions driven by formula (on autopilot)
•Quantity Theory of Money is justification for monetarism
•Quantity Theory of Money: positive relationship between PL & MS (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.
•Velocity of Money (amount of economic activity associated with a
given money supply ~ how many times a dollar is spent per year)
•In the 1980s, Velocity becomes more erratic (not constant) & the
effectiveness of the Monetarism policies decrease
•Natural Rate Hypothesis developed
(NAIRU: Friedman & Phelps)
•Limit to Discretionary Policy (we need
some unemployment because of inflation)
•Higher inflation becomes embedded into
consumer expectations (just spirals up)
•Unemployment rate kept below the
NAIRU, inflation will start to rise
•Stagflation of 1970s proof of Hypothesis
•Natural Rate widely accepted (which put
a dent in Keynes theory)
•Statistical correlation exists between upcoming political
elections and expansionary fiscal policy (nah really?)
•What does that mean, fiscally?
•What is the cost of this political expansionary policy?
•Consequences of Keynes on Politics & Election Day
Economics - may not be the best thing for consumers of
businesses
•Political Business Cycle? A self serving attitude?
•Is there a need for central bank independence?
•
New Classical
Macroeconommics
•
Rational Expectations
•
New Keynesian Economics
•
Real Business Cycle Theory
In the latter half of the 20th century, economists
continued to develop and modify versions of classical
and Keynesian economic models. 2 parts:
A.
Rational Expectations
Rational expectations (1970s) : concept with
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?
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.
New Keynesians: market imperfections lead to price
stickiness and inflation is not always quick to rise,
even if expectations are for higher prices.
B.
Real Business Cycles
Past economic thinking circa 1980s: slowdowns
in productivity growth (usually attributed to
pauses in technological progress), are the main
cause of recessions.
Real business cycle theory: (AS is vertical)
fluctuations in the rate of growth of total factor
productivity cause the business cycle &
business cycles to shifts of the aggregate supply
curve. (deemphasizing AD)
A recession: slowdown in productivity growth:
shifts the AS leftward.
A recovery: pickup in productivity growth:
shifts the AS rightward.
RBC theory: recognized as making valuable
contributions understanding the economy & it
deemphasized aggregate demand
Today: RBC theorists - AS is upward sloping and
that this gives AD potential role in determining
aggregate output as well as AS
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Module Review Questions p. 353 – 354
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Read Module 36 p. 355 –359
Module 36
The Modern
Macroeconomic
Consensus
Insert your
caption
here!
1.
What are the elements of the modern macroeconomic
consensus?
2.
What are the main remaining disputes?
5 Key Questions About Macroeconomic Policy
Classical
Is Expansionary
Monetary Policy
Helpful in Fighting
Recessions?
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?
Keynesian
Monetarism
Modern
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.
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B.
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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.
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.
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D.
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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.
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.
•It is the main role in stabilization policy during recession & inflation
•Independent central bank
•Discretionary fiscal should be used sparingly (cough cough)
1. Central Bank Inflation Targets
2. Asset Prices: Should the Fed be pro-actively influencing the stock market, real estate
market or any asset market?
3. Unconventional Monetary Policies during The Great Recession of 2008
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:
Point 1: Monetary policy should play the main role in stabilization policy.
Point 2: The central bank should be independent, insulated from political pressures, in order to avoid a
political business cycle.
Point 3: 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:
Announced specified inflation targets. - prepares the public for how the central bank will deal with the issue
of inflation if it gets out of line with the target. The Fed doesn’t announce a target rate of inflation, but it is
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? What is your opinion?
3. Unconventional Monetary Policies
Desperate times call for desperate measures!!!
The financial system collapse of 2008: the Fed lent big $$$ to a variety of financial institutions that were
not member banks, buying asset backed mortgages, buying short term business debts…
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The End of Section 6 Inflation, Unemployment &
Stabilization Policies
Test is Tuesday!!