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

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 modern consensus, and the main remaining disputes

The Feds Response to the 2001 Recession Figure Caption: The Fed responded to the 2001 recession, indicated by the shaded area in both panels, with a rapid expansion of the money supply (panel a) and sharp cuts in the Federal funds rate (panel b).

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. 5

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

When Did the Business Cycle Begin? Figure Caption: Figure 17-1: The Changing Character of the Nineteenth Century Economy In the first half of the nineteenth century, the United States was an overwhelmingly agricultural economy and probably didn’t have modern business cycles. By the late nineteenth century, it was mainly industrial, and the modern business cycle had come into existence. Source: Robert E. Gallman, “Economic Growth and Structural Change in the Long Nineteenth Century,” in Stanley L. Engerman and Robert E. Gallman, editors. The Cambridge Economic History of the United States, vol. II: The Long Nineteenth Century (Cambridge, UK: Cambridge University Press, 2000), pp. 1–55.

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 Figure Caption: Figure 17-2: Classical versus Keynesian Macroeconomics One important difference between classical and Keynesian economics involves the short-run aggregate supply curve. Panel (a) shows the classical view: the SRAS curve is vertical, so shifts in aggregate demand affect the aggregate price level but not aggregate output. Panel (b) shows the Keynesian view: in the short run the SRAS curve slopes upward, so shifts in aggregate demand affect aggregate output as well as aggregate prices.

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.

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.

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.

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.

Fiscal Policy and the End of the Great Depression Figure Caption: Figure 17-3: Fiscal Policy and the End of the Great Depression During the 1930s, in an effort to prop up the economy, the U.S. government began deficit spending. The deficits were, however, fairly small as a percentage of GDP. In 1937 the government even tried to balance the budget, only to face a renewed rise in unemployment. The U.S. entry into World War II in 1941 brought on deficit spending on a massive scale and ended the Great Depression. 14

The End of the Great Depression Figure 17-3 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.

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.

Fiscal Policy with a Fixed Money Supply Figure Caption: Figure 17-4: Fiscal Policy with a Fixed Money Supply In panel (a) an expansionary fiscal policy shifts the AD curve rightward, driving up both the aggregate price level and aggregate output. However, this leads to an increase in the demand for money. If the money supply is held fixed, as in panel (b), the increase in money demand drives up the interest rate, reducing investment spending and offsetting part of the fiscal expansion. So the shift of the AD curve is less than it would otherwise be: fiscal policy becomes less effective when the money supply is held fixed. 17

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.

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.

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?

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: as shown Figure 17-5, 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.

The Velocity of Money Figure Caption: Figure 17-5: The Velocity of Money From 1960 to 1980, the velocity of money was stable, leading monetarists to believe that steady growth in the money supply would lead to a stable economy. After 1980, however, velocity began moving erratically, undermining the case for traditional monetarism. As a result, traditional monetarism fell out of favor. 25

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 did serve 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.

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.

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. 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.

Total Factor Productivity and the Business Cycle Figure Caption: Figure 17-6: Total Factor Productivity and the Business Cycle There is a clear correlation between declines in the rate of total factor productivity growth and recessions (indicated by the shaded areas). Real business cycle theory says that fluctuations in productivity growth are the main cause of business cycles. Other economists argue, however, that business cycles cause productivity fluctuations, not the other way around. 31

Five Key Questions About Macroeconomic Policy Classical macroeconomics Keynesian macroeconomics Monetarism Modern 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? Can monetary and/or fiscal policy reduce unemployment in the long run? Should fiscal policy be used in a discretionary way? No, except in special circumstances Should monetary policy be used in a discretionary way? 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 about whether monetary policy should take steps to manage asset prices. Economists debate about 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.

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 only 1%—uncomfortably close to 0%.

After the Bubble In other words, the events of 2001–2003 probably intensified the debate over monetary policy and asset prices, rather than resolving it. The bursting of the housing bubble after 2006 offered another test. The case of the housing bubble also 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.

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 well-established 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.

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. 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.

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. 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 modern 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. 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.

Open-Economy Macroeconomics The End of Chapter 17 coming attraction: Chapter 18: Open-Economy Macroeconomics