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
The Fed’s Response to the 2001 Recession
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.
ECONOMICS IN ACTION
When did the business cycle begin?
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
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 procapitalist 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 freemarket 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.
ECONOMICS IN ACTION
Fiscal Policy and the End of the Great Depression
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
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
Velocity of Money (1960–2011)
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.
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.
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.
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.
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.
ECONOMICS IN ACTION
Total Factor Productivity and the Business Cycle
Five Key Questions About Macroeconomic Policy
Great
Classical
Keynesian
Monetarism Moderation
macroeconomics macroeconomics
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?
No
Yes
No
Yes
Can monetary and/or
fiscal policy reduce
unemployment in the
long run?
No
Yes
No
No
Should fiscal policy be
used in a discretionary
way?
No
Yes
No
No, except in
special
circumstances
Should monetary policy
be used in a
discretionary way?
No
Yes
No
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.
Cyclically adjusted budget deficit (percent of GDP)
Real GDP growth rate (percent)
Cyclically
adjusted
budget
deficit
(percent
of GDP)
14
12
10
8
6
4
2
0
1986
8
6
4 Real GDP
growth rate
2 (percent)
1987
1988
Year
1989
0
1990
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
Short-term interest rate
Export growth rate (percent)
14
14
12
12
10
Short-term
interest
rate
10
8
6
8
4
6
2
4
1986
1987
1988
Year
1989
0
1990
Export
growth
rate
(percent)
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%.
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
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 wellestablished 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.
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.
Summary
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.
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.
Summary
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.
7. 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
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.
Key Terms
• Keynesian economics
• Macroeconomic policy
activism
• Monetarism
• Discretionary monetary
policy
• Monetary policy rule
• Velocity of money
• Natural rate hypothesis
• Political business cycle
• New classical
macroeconomics
• Rational expectations
• New Keynesian economics
• Real business cycle theory
• The Great Moderation
consensus