Module 35/36: History and Alternative Views of Macroeconomics and the Modern Consensus Learning Target: I will assess how macroeconomic thinking has changed throughout history

Classical Economics: Money and the Price Level According to the classical model: Prices are flexible. The aggregate supply curve is vertical even in the short run. An increase in the money supply leads, other things equal, to a proportional rise in the aggregate price level. An increase in the money supply does not increase aggregate output. Key result is that increases in the money supply lead to inflation, and that’s all. Really!?  Keynes: “in the long run, we are all dead”

The Business Cycle (?) Wesley Mitchell (Bureau of Economic Research) There was no consensus theory of how business cycles worked! Many economists believed the economy would self-adjust to long-run equilibrium, they assumed that any downturn in the economy was only temporary! Active policy was not needed to alleviate a recession. And then . . . THE GREAT DEPRESSION! (neither predicted or fixable by classical economic theory)

Great Depression an Keynesian Revolution (1936) John Maynard Keynes: The General Theory of Employment, Interest, and Money Two innovations. Short run shifts in AD do affect aggregate output and the PL because there is an upward sloping AS curve; rather than minor and temporary shifts, these short-run shifts are important! The AD curve can shift because of several factors including “animal spirits” or business confidence, and that these were the main cause of business cycles (classical economists emphasized the role of changes in the money supply in shifting the aggregate demand curve, paying little attention to other factors)

Classical Versus Keynesian Macroeconomics Classical View: SRAS is vertical; Keynesian View: SRAS curve is upward sloping. Conclusion: Shifts in AD can increase output (in the short run); justifies use of Monetary and Fiscal policy to bring economy into LR Equilibrium (Yfe).

Results of Keynes’ work Legitimized macroeconomic policy activism—the use of monetary and fiscal policy to smooth out the business cycle (WE CAN DO SOMETHING!) Today there is broad consensus that active monetary and/or fiscal policy can play useful roles. The debate today is the degree to which policies should be taken.

Challenges to Keynesian Economics: The Revival of Monetary Policy Keynes had downplayed effectiveness of Monetary Policy Milton Friedman and Anna Schwartz (1963) published: A Monetary History of the United States, 1867–1960 Showed that business cycles had historically been associated with fluctuations in the money supply. Money supply fell sharply during the onset of the Great Depression! Persuaded most economists that monetary policy should play a key role in economic management. Suggested that the burden of managing the economy could be shifted away from fiscal policy (economic management could largely be taken out of the hands of politicians!) A central bank, insulated from political pressures, should be able to conduct monetary policy more effectively than fiscal policy!

Monetarism Monetarism: GDP will grow steadily if money supply grows steadily Discretionary Policies – bad! (creates instability) Crowding Out (AD movements “crowd out” private investment spending through changes in the interest rate Monetary Policy Rule: formula that determines central banks actions (i.e grow MS by 3% annually) Quantity Theory of Money, MV = PY Velocity of Money: ratio of GDP to money supply/number of times the average dollar bill is spent If we assume that V is constant then a slow increase in M will increase PY or nominal GDP; however during 1980s erratic Velocity undermined Monetarism

Inflation and the Natural Rate of Unemployment Friedman and Phelps suggested NAIRU Natural Rate Hypothesis: to avoid accelerating inflation over time, unemployment must be high enough that actual inflation = expected inflation Thus there is a limit to Discretionary Policy Stagflation of 1970s proof of Hypothesis! Natural Rate empirical tested and widely accepted; influence of monetarism declined.

Challenges to Keynes: The Political Business Cycle Researchers have found statistical correlation between upcoming political elections and expansionary fiscal policy. In months leading up to an election, government either cuts taxes or announces new spending programs; policies put more money in the pockets of voters and also tend to lower the unemployment rate. Eventual cost is inflation, but by then the election is over and inflation can be addressed at a later date! Result: more justification for putting economic policy in the hands of a central bank that is free of political influence (go Monetarism!)

Challenges to Keynes: Real Business Cycles, and New Classical Macroeconomics New Classical Economics: return to classical view that shifts in the AD affect only the PL Rational Expectations (John Muth, 1961): individuals and firms make decisions optimally, using all available information. Implication: If government trades off higher inflation for lower unemployment . . . Then the public will understand this, and expected inflation will immediately rise (no sticky wages/sticky prices) But this doesn’t accurately describe how the economy behaves! New Keynesian economics: price stickiness does exist in the economy and that inflation is not always quick to rise, even if expectations are for higher prices.

Challenges to Keynes: Real Business Cycles, and New Classical Macroeconomics (1980s) economists argued that slowdowns in productivity growth (which they attributed to pauses in technological progress) are the main cause of recessions. Real business cycle theory claims that fluctuations in the rate of growth of total factor productivity cause the business cycle.  RBC believes AS curve is vertical and shifts in AS cause the business cycle Recession: occurs when there is a slowdown in productivity growth (AS curve shifts left). Recovery: occurs when there is a pickup in productivity growth (AS curve shifts right). RBC has made valuable contributions to our understanding of the economy; caution against too much emphasis on aggregate demand. RBC acknowledges that models need an upward sloping AS to fit the economic data (AD then has role in determining output)

Should Monetary Policy Be Used in a Discretionary Way? Monetary Policy should play a central role in stabilization policy. Central bank should be Independent of political influence Discretionary fiscal used sparingly (b/c of lags and to avoid political influence) Central Bank Inflation Targets Should Fed support Asset Prices? (Maybe) Unconventional Monetary Policies (2008 Crisis)

The Great Recession! Arguments for Fiscal Policy Stimulus:

The Great Recession! Arguments against Fiscal Policy Stimulus: