Macroeconomics CHAPTER 17 The Making of Modern Macroeconomics PowerPoint® Slides by Can Erbil © 2005 Worth Publishers, all rights reserved

2 What you will learn in this chapter: Why classical macroeconomics wasn’t adequate for the problems posed by the Great Depression The core ideas of Keynesian economics How challenges led to a revision of Keynesian ideas The ideas behind new classical macroeconomics The elements of the modern consensus, and the main remaining disputes

3 The Feds Response to the 2001 Recession

4 Classical Macroeconomics Money and the Price Level Classical macroeconomics asserted that monetary policy affected only the aggregate price level, not aggregate output, and 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. 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. As a result, increases in the money supply lead to inflation, and that’s all.

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

6 When Did the Business Cycle Begin?

7 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 Classical Versus Keynesian Macroeconomics

9 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.

10 Fiscal Policy and the End of the Great Depression

11 The Fisher Effect

12 Challenges to Keynesian Economics  The Revival of Monetary Policy – Milton Friedman  Monetarism - asserted that GDP will grow steadily if the money supply grows steadily. It called for a monetary policy rule as opposed to discretionary monetary policy and argued that GDP would grow steadily if the money supply grew steadily, was influential for a time but was eventually rejected by many macroeconomists.

13 Fiscal Policy with a Fixed Money Supply

14 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. Recalling the velocity equation: M × V = P × Y  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.

15 The Velocity of Money

16 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 hypothesis of the NAIRU, inflation eventually gets built into expectations, so any attempt to keep the unemployment rate below the natural rat will lead to an ever- rising inflation rate. The natural rate hypothesis became almost universally accepted, limiting the role of macroeconomic policy to stabilizing the economy, not seeking a permanently lower unemployment rate.

17 The Political Business Cycle A political business cycle results when politicians use macroeconomic policy to serve political ends. Fears of a political business cycle led to a consensus that monetary policy should be insulated from politics.

18 Rational Expectations, Real Business Cycles, and New Classical Macroeconomics New classical macroeconomics is an approach to the business cycle that returns to the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not aggregate output.

19 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.

20 Real Business Cycles? Real business cycle theory says that fluctuations in the rate of growth of total factor productivity cause the business cycle.

21 Total Factor Productivity and the Business Cycle Real business cycle theory says that fluctuations in the rate of growth of total factor productivity cause the business cycle.

22 The Modern Consensus Five Key Questions About Macroeconomic Policy:

23 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. There’s also a debate about whether monetary policy should take asset prices into account.

24 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.

25 The End of Chapter 17 coming attraction: Chapter 18: International Trade