1 of 41 chapter: 33 >> Krugman/Wells ©2009  Worth Publishers Macroeconomics: Events and Ideas

2 of 41 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

3 of 41 The Feds Response to the 2001 Recession

4 of 41 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.

5 of 41 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.

6 of 41 Classical Macroeconomics  By the 1930s, measurement of business cycles was a well-established subject, but there was no widely accepted theory of business cycles.

7 of 41 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.

8 of 41 Classical versus Keynesian Macroeconomics

9 of 41 FOR INQUIRING MINDS The Politics of Keynes  The term Keynesian economics is sometimes used as a synonym for leftwing 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 pro- capitalist and politically conservative.

10 of 41 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 free - market policies in the 1970s and 1980s was accompanied by a series of challenges to Keynesian ideas, which we describe later in this chapter.

11 of 41 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.

12 of 41 ►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.

13 of 41 ►ECONOMICS IN ACTION Fiscal Policy and the End of the Great Depression

14 of 41 ►ECONOMICS IN ACTION The End of the Great Depression  Figure 33-3 shows the U.S. unemployment rate and the federal budget deficit as a share of GDP from 1930 to  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.

15 of 41 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.

16 of 41 Fiscal Policy with a Fixed Money Supply

17 of 41 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

18 of 41 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.

19 of 41 ►ECONOMICS IN ACTION The Velocity of Money

20 of 41 Rational Expectations  Rational expectations is the view that individuals and firms make decisions optimally, using all available information.  The idea of rational expectations did serve as a useful caution for macroeconomists who had become excessively optimistic about their ability to manage the economy.

21 of 41 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.  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.

22 of 41 Five Key Questions About Macroeconomic Policy Classical macroeconomics Keynesian macroeconomics Monetarism Modern consensus Is expansionary monetary policy helpful in fighting recessions? NoNot veryYes Yes, except in special circumstances Is expansionary fiscal policy effective in fighting recessions? NoYesNoYes Can monetary and/or fiscal policy reduce unemployment in the long run? NoYesNo Should fiscal policy be used in a discretionary way? NoYesNo No, except in special circumstances Should monetary policy be used in a discretionary way? NoYesNoStill in dispute

23 of 41 Current Debate  There are continuing debates about the appropriate role of monetary policy.  Some economists advocate explicit inflation targets, but others oppose them.  Bernanke set a 2% target early in 2012  Inflation targeting requires that the central bank try to keep the inflation rate near a predetermined target rate.  Economists debate about whether monetary policy should take steps to manage asset prices (bubbles).  Economists debate about what kind of unconventional monetary policy, if any, should be adopted to address a liquidity trap.