Module 35 History and Alternative Views of Macroeconomics

John Maynard Keynes & Milton Friedman

Module 35 Essential Questions

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?

Classical Macroeconomics: Money and the Price Level

•%∆ M = % ∆ PL

•Short-Run Effects Unimportant

•Focus on the Long-Run

•Keynes - “ (in the long run) we are all dead.”

Classical Macroeconomics: The Business Cycle

•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…

Keynes’ Theory

•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

Keynes’ Theory

Classical TheoryKeynesianTheory

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….

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?

Challenges to Keynesian Economics

1. Revival of Monetary Policy

2. Monetarism

3. Inflation & NAIRU

4. Political Business Cycle

Challenges to Keynesian Economics: 1) The Revival of Monetary Policy

•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

•The Fed is insulated from political pressure unlike fiscal policy

University of Chicago Economist, Milton Friedman

Monetarism: GDP will grow steadily if the money supply grows steadily.

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.

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.

Challenges to Keynesian Economics: 2) Monetarism

Challenges to Keynesian Economics: 2) Monetarism

•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

Challenges to Keynesian Economics: 3) Inflation and the Natural Rate of Unemployment

•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)

Challenges to Keynesian Economics: 4) The Political Business Cycle

•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?

Rational Expectations, Real Business Cycles, and New Classical Macroeconomics

• 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.

Rational Expectations, Real Business Cycles, and New Classical Macroeconomics

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

Rational Expectations, Real Business Cycles, and New Classical Macroeconomics

Module Review Questions p. 353 – 354

Read Module 36 p. 355 –359

Module 36 The Modern Macroeconomic Consensus

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caption here!

Module 36 Essential Questions:

1. What are the elements of the modern macroeconomic consensus?

2. What are the main remaining disputes?

Consensus…hummmm…ok

Classical Keynesian Monetarism

Modern

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?

5 Key Questions About Macroeconomic Policy

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.

The Modern Consensus Explained

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.

The Modern Consensus Explained

The Modern Consensus

Should Monetary Policy Be Used in a Discretionary Way?

•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…

Should Monetary Policy Be Used in a Discretionary Way?

That’s All Folks!

The End of Section 6 Inflation, Unemployment & Stabilization Policies

Test is Tuesday!!