- 1. HISTORY ANDALTERNATIVEVIEWS OFMACROECONOMICSMODULE 35
2. CLASSICAL MACROECONOMICSThe term macroeconomics was first
used in 1933 by the Norwegian economist Ragnar Frisch.Before that,
however, economists were already analyzing the behavior of the
aggregate price level and the aggregate output. 3. MONEY AND THE
PRICE LEVELBeforethe 1930s the classical model dominated economic
thinking about the effects of monetary policy.According to the
classical model, prices are flexible, making the aggregate supply
curve vertical even in the short run, and any increases in the
money supply lead to inflation. 4. MONEY AND THE PRICE
LEVELClassical economists probably did realize that changes in the
money supply affected aggregate output as well as aggregate prices
in the short-run.However, they regarded these short-run effects as
unimportant, stressing the long run instead.For this reason, John
Maynard Keynes said: in the long run, we are all dead. 5. THE
BUSINESS CYCLEAmerican economist Wesley Mitchell pioneered the
quantitative study of business cycles, founding in 1920 the
National Bureau of Economic Research, which announces the
beginnings of recessions and expansions.However, there was no
widely accepted theory of business cycles. 6. THE GREAT DEPRESSION
AND THEKEYNESIAN REVOLUTIONSince there were no clear theories,
views of policy makers were conflicting.In 1930, John Maynard
Keynes used the metaphor of the economy as a car with a defective
alternator to describe the problems of the US and British
economies.He said that to get the economy running would require
only a modest repair, not a complete overhaul. 7. KEYNESS THEORYIn
1936, Keynes wrote The General Theory ofEmployment, Interest, and
MoneyThis book reflected two innovations:1. Keynes emphasized the
short-run effects of shifts in AD on aggregate output, instead of
the long-run determination of the aggregate price level. He focused
the attention of economists on situations in which the SRAS curve
slopes upward and shifts in the AD curve affectaggregateoutput and
employment as well as aggregate prices. 8. CLASSICAL VERSUS
KEYNESIAN MACROECONOMICS 9. KEYNESS THEORY2. Classical economists
emphasized the role of changes in the money supply in shifting the
AD curve. Keynes argued that other factors, especially changes in
animal spirits are mainly responsible for business cycles. 10.
POLICY TO FIGHT RECESSIONSThe main practical consequence of Keynes
work was that it legitimized macroeconomic policy activism (the use
of fiscal and monetary policy to smooth out the business
cycle)Today there is a broad consensus about the useful role that
monetary and fiscal policy can play in fighting recessions.However,
Keyness ideas have not been fully accepted by modern
macroeconomists. 11. CHALLENGES TO KEYNESIAN ECONOMICSKeyness work
suggested that monetary policy wouldnt be very effective in
depression conditions.In fact, in the 1930s interest rates were
very close to 0% (against the zero bound).The term liquidity trap
was first used by the British economist John Hicks in 1937.However,
many economists continued to emphasize fiscal policy and downplay
monetarypolicy. 12. THE REVIVAL OF MONETARYPOLICYIn 1963, Milton
Friedmand and Anna Schwartz published A Monetary History of the
United StatesIn this book, the authors persuaded most economists
that monetary policy should pla a key role in economic
management.This shifted the burden of managing the economy away
from fiscal policy, which meant that economic management could be
made mor technical and less political. 13. MONETARISMMilton
Friedman led a movement, called monetarism, which asserted that GDP
will grow steadily if the money supply grows steadily.This is
carried out through targeting a constant growth in the money
supply, and maintain that rate regardless of any fluctuations in
the economy.Monetarism maintained many Keynesian ideas, such as
that the short run is important, and tha short run changes in AD
affect aggregate output as well as aggregate prices. 14.
MONETARISMMilton Friedmand also agrued that policy should have been
much more expansionary during the Great Depression.However,
Monetarists argued that most of the efforts of policy makers to
smooth out the business cycle actually make things worse, with
concerns about the use of discretionary fiscal policy, due to lags
.Accordingto economists, discretionary monetary policy also faces
lags, but to a lesser extent. 15. MONETARISMMonetarists also point
out fiscal policy is less effective than Keynesians
believe.Friedman pointed out that if the money supply is held fixed
while the government pursues an expansionary fiscal policy,
crowding out will limit the effect of the fiscal expansion on
aggregate demand.As a result, the rightward shift of the AD curve
will be smaller than the multiplier analysis indicates. 16.
MONETARISMHowever,Friedman didnt favor activist monetary policy
either, arguing that the problem of time lags that limit the
ability of discretionary fiscal policy to stabilize the economy
also apply to discretionary monetary policy.The solution, he
argued, was to follow a monetary policy rule, which is a formula
that determines its actions and leave relatively little discretion.
17. THE QUANTITY THEORY OFMONEYUnderlying the the monetary policy
rule wasthe Quantity Theory of Money, which relieson the velocity
of money (which is the ratio ofnominal GDP to the money supply) and
is thenumber of times an average dollar bill in theeconomy turns
over per year.This concept gives rise to the
velocityequation:MxV=PxYWhere M is the money supply, V is velocity,
P isthe aggregate price level, and Y is real GDP. 18. THE QUANTITY
THEORY OFMONEYMonetarists believed that the velocity of money was
stable in the short run and changed only slowly in the long run.As
a result, steady growth in the money supply by the central bank
would ensure steady growth in spending, and therefore in GDP. 19.
THE QUANTITY THEORY OFMONEYAlthoughmonetarism strongly influenced
actual monetary policy in the late 1970s and early 1980s, steady
growth in the money supply didnt ensure steady growth in the
economy, as the velocity of money wasnt stable enough for such a
simple policy rule to work.Traditional monetarists are rare in
todays macroeconomics, although the concern that too much
discretional monetary policy can destabilize the economy has become
widely accepted. 20. INFLATION ANDTHE NATURAL RATE OFUNEMPLOYMENTIn
the 1940s and 1950s many Keynesian economists believed that
expansionary fiscal policy could be used to achieve full employment
on a permanent basis.In the 1960s, Edmund Phelps (Columbia
University) and Milton Friedman, working independently, proposed
the concept of the NRU. 21. INFLATION AND THE NATURAL RATE OF
UNEMPLOYMENTAccording to the natural rate hypothesis, to avoid
accelerating inflation over time, the unemployment rate must be
high enough that the actual inflation rate equels the expected rate
of inflation.Attempts to keep the unemployment rate below the
natural rae will lead to ever-rising inflation rate.Therefore, the
task of government is not to keep unemployment low, but to keep it
stable, preventing large fluctuations in either direction. 22.
INFLATION AND THE NATURAL RATE OF UNEMPLOYMENTThe Friedman-Phelps
hypothesis predicted that once inflation was embedded in the
publics expectation, inflation would continue even in the face of
high unemployment.This was an accurate prediction that was proved
true in the1970s. 23. INFLATION AND THE NATURAL RATE OF
UNEMPLOYMENTThis convinced most of the economists that the natural
rate hypothesis was correct, and became almos universally accepted
among macroeconomists (although some believe that at very low or
negative rates of inflation the hypothesis doesnt work).Traditional
monetarism declined in influence as more evidence accumulated. 24.
THE POLITICAL BUSINESS CYCLEOne more challenge to Keynesian
economics focused not on the validity of the economic analysis but
in its political consequences.Economistsbelieve thatactivist
macroeconomic policy lends itself to political manipulation.The
result of this can be unnecessary instability in the economy, a
political business cycle, caused by the use of macroeconomic policy
to serve political ends. 25. THE POLITICAL BUSINESS CYCLEOne way to
avoid a political business cycle is to place monetary policy in the
hands of an independent central bank.A political business cycle is
also a reason to limit the use of discretionary fiscal policy to
extreme circumstances. 26. RATIONAL EXPECTATIONS, REALBUSINESS
CYCLES, AND NEW CLASSICAL MACROECONOMICSClassical economists
believed tha the SRAS curve was verical, but Keynes emphasized that
it sloped upwards in the long run.As a result, demand shocks,
shifts in the AD curve, can cause fluctuations in aggregate output.
27. RATIONAL EXPECTATIONS, REALBUSINESS CYCLES, AND NEW CLASSICAL
MACROECONOMICSIn the 1970s and 1980s some economists developed an
approach to the business cycle known as new classical
macroeconomics, which returned to the classical view that shifts in
the AD curve affect only affect the aggregate price level and not
the aggregate output. 28. RATIONAL EXPECTATIONS, REALBUSINESS
CYCLES, AND NEW CLASSICAL MACROECONOMICSThis evolved in two
steps:1. Some economists challenged the traditional arguments about
the slope of the SRAS based on rational expectations2. Some
economists suggested that changes in productivity caused economic
fluctuations, a view know as the real business cycle theory. 29.
RATIONAL EXPECTATIONS, REAL BUSINESS CYCLES, AND NEWCLASSICAL
MACROECONOMICSIn 1970, a theory known as rational expectations had
a strong impact on macroeconomics.This theory was introduced by
John Muth in 1961.This is a view that individuals and firms make
decisions optimally, using all available information.For example in
negotiating wage contracts, workers will incorporate not only
expected rates of inflation and the effects on inflation 30.
RATIONAL EXPECTATIONS, REALBUSINESS CYCLES, AND NEW CLASSICAL
MACROECONOMICSRationalexpectations can make a major difference to
the effects of government policy.In the 1970s, Robert Lucas
(University of Chicago) used this logic to argue that monetary
policy can change the level of unemployment only if it comes as a
surprise to the public.So if his analysis is right, monetary policy
is not useful in stabilizing the economy after all, although many
macroeconomists believe that his conclusions were overstated. 31.
RATIONAL EXPECTATIONS, REAL BUSINESS CYCLES, AND NEW CLASSICAL
MACROECONOMICSNew Keynesian economists (a set of ideas that became
influential in the 1990s) provides an explanation at to why the
rational expectations hypothesis doesnt accurately describe how the
economy behaves.It argues that market imperfections interact to
make many prices in the economy temporaril sticky.Over time, new
Keynesian ideas combined with actual experience have reduced the
practical influence of the rational expectations concept. 32. REAL
BUSINESS CYCLESTotal factor productivity is the amount of output
that can be generated wih a given level of factor outputs.Total
factor productivity grows over time, but not smoothly.The real
business cycle theory claims that fluctuations in the rate of
growth of total factor productivity cause the business cycle.They
believe that the AS curve is vertical, so they attribute the source
of business cycles to shifts of the AS curve. 33. REAL BUSINESS
CYCLESA recession occurs when a slowdown in productivity growth
shifts the AS curve leftward, and a recovery occurs when an
increase in productivity growth shifts the AS curve rightward.This
theory has made valuable contributions to understanding the economy
and serves as a useful caution against too much emphasis on
aggregate demand. 34. REAL BUSINESS CYCLESHowever, many real
business cycle theorists now acknowledge that their models need an
upward-sloping AS curve to fit the economic data, and that gives AD
a potential role in determining aggregate output.As seen policy
makers stongly believe that aggregate demand policy has an
important role to play in fighting recessions.
