Module History and Alternative Views of Macroeconomics 35 Module History and Alternative Views of Macroeconomics John Maynard Keynes & Milton Friedman KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: 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 monetary policy How challenges led to a revision of Keynesian ideas and the emergence of the new classical macroeconomics

Classical Macroeconomics: Money and the Price Level %∆ M = % ∆ PL Short-Run Effects Unimportant Focus on the Long- Run Keynes - “ (in the long run) we are all dead.” 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? Before 1930, most economists were aware that changes in the money supply affect aggregate output as well as aggregate prices in the short run. They were aware that the short­ -­ run aggregate supply curve slopes upward. But they regarded such short­ -­ run effects as unimportant, stressing the long run instead.

Classical Macroeconomics: The Business Cycle No theory of business cycles Lack of consensus Necessity is the mother of invention There was no consensus theory of how business cycles worked. However, 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.

Keynes’s Theory The General Theory Classical View Keynesian View   The failure of economic theory to predict, or fix, the Great Depression led many to rethink the way in which the business cycle moved, and the role of government policy in the economy. In 1936 John Maynard Keynes: presents his explanation of what was wrong with the economy during the Great Depression in a book titled The General Theory of Employment, Interest, and Money. Keynesian economics mainly reflected two innovations. 1. Short­ -­ run shifts in aggregate demand do affect aggregate output and the price level because there is an upward sloping aggregate supply curve. Rather than minor and temporary shifts, these short-run shifts are important. 2. 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. The General Theory Classical View Keynesian View “Animal Spirits” (business confidence)

Keynes’s Theory Classical Theory Keynesian Theory 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.   In the 1930s, economists were divided on the issue of government policy to affect the business cycle. 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 A Monetary History of the United States, 1867 - 1960 Great Depression caued by Fed contracting the money supply Monetary policy is important - less political Over the years, economists became much more aware of the limits to macroeconomic policy activism. Different theories, or “schools of thought”, were presented and have continued to evolve to shape economic policy. Monetary policy began to gain traction after WWII. Milton Friedman and Anna Schwartz (1963) published: A Monetary History of the United States, 1867–1960 .   They showed that business cycles had historically been associated with fluctuations in the money supply. In particular, the money supply fell sharply during the onset of the Great Depression. They persuaded most economists that monetary policy should play a key role in economic management. The revival of interest in monetary policy was significant because it suggested that the burden of managing the economy could be shifted away from fiscal policy—meaning that economic management could largely be taken out of the hands of politicians. What taxes, and for whom, should be cut? What programs should receive more government spending? A central bank, insulated from political pressures, should be able to conduct monetary policy more effectively than fiscal policy. University of Chicago Economist, Milton Friedman

Challenges to Keynesian Economics: Monetarism Milton Friedman led a movement that sought to eliminate macroeconomic policy activism while maintaining the importance of monetary policy.   Monetarism asserted that GDP will grow steadily if the money supply grows steadily. The monetarist policy prescription was to have the central bank target a constant rate of growth of the money supply, such as 3% per year, and maintain that target regardless of any fluctuations in the economy. By creating a kind of “monetary rule” the central bank would avoid the political perils of fiscal policy and the effect of large government spending crowding out investment spending. How would this crowding-out happen? Note: it might prove to be useful review for the students to draw these graphs as the instructor describes the chain of events. Suppose government spending increases. In the AD/AS model, AD shifts to the right. The price level rises, as well as the real GDP. In the money market, higher prices cause an increase in money demand. The interest rate begins to rise. Higher interest rates reduce private investment, which decreases AD. Thus the final effect of expansionary fiscal policy is weakened because private investment is crowded out. The Quantity Theory of Money emerges to justify the slow steady growth of the money supply. MV = PY If we assume that V, the velocity of money, is constant then a slow increase in M will increase PY or nominal GDP. In the 1980s, V becomes more erratic and the effectiveness of the Monetarism policies slides. Monetarism Discretionary Policies - bad Crowding Out Monetary Policy Rule Quantity Theory of Money, MV = PY Velocity of Money Erratic Velocity undermines Monetarism

Challenges to Keynesian Economics: Inflation and the Natural Rate of Unemployment Natural Rate Hypothesis Limit to Discretionary Policy Stagflation of 1970s proof of Hypothesis Natural Rate widely accepted Not all economists were convinced that monetarism was the way to go.   In 1968, Milton Friedman and Edmund Phelps of Columbia University, working independently, proposed the concept of the natural rate of unemployment. In Module 34 we saw that the natural rate of unemployment is also the non-accelerating inflation rate of unemployment, or NAIRU. Note: this could be a good opportunity to use the Phillips curve to review how higher inflation becomes embedded into expectations. In order to avoid accelerating inflation over time, the unemployment rate must be high enough so that actual inflation equals the expected inflation rate. The important result is that if the unemployment rate is kept below the NAIRU, inflation will start to rise. The natural rate hypothesis was validated with empirical testing and the influence of monetarism declined.

Challenges to Keynesian Economics: The Political Business Cycle Consequences of Keynes on Politics Election Day Economics Political Business Cycle The need for central bank independence Researchers have found statistical correlation between upcoming political elections and expansionary fiscal policy.   This means that, in months leading up to an election, government either cuts taxes or announces new spending programs. These policies put more money in the pockets of voters and also tend to lower the unemployment rate. The eventual cost is inflation, but by then the election is over and inflation can be addressed at a later date. This is even more justification for putting economic policy in the hands of a central bank that is free of political influence. President Obama and Senator McCain

Rational Expectations, Real Business Cycles, and New Classical Macroeconomics New Classical Macroeconommics Rational Expectations New Keynesian Economics Real Business Cycle Theory In the latter half of the 20th century, economists continued to develop and modify versions of classical and Keynesian economic models.   A. Rational Expectations In the 1970s a concept known as rational expectations had a powerful impact on macroeconomics. Rational expectations (John Muth in 1961) is the view that individuals and firms make decisions optimally, using all available information. What is the implication of this assumption for economic policy? According to the original version of the natural rate hypothesis, a government attempt to trade off higher inflation for lower unemployment would work in the short run but would eventually fail because higher inflation would get built into expectations. According to rational expectations, we should remove the word eventually: if it’s clear that the government intends to trade off higher inflation for lower unemployment, the public will understand this, and expected inflation will immediately rise. Most macroeconomists accept a notion of the New Keynesians that price stickiness does exist in the economy and that inflation is not always quick to rise, even if expectations are for higher prices. B. Real Business Cycles In the 1980s a number of 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. Believing that the aggregate supply curve is vertical, real business cycle theorists attribute the source of business cycles to shifts of the aggregate supply curve. A recession occurs when a slowdown in productivity growth shifts the aggregate supply curve leftward. A recovery occurs when a pickup in productivity growth shifts the aggregate supply curve rightward. RBC theory is widely recognized as having made valuable contributions to our understanding of the economy, and it serves as a useful caution against too much emphasis on aggregate demand. But many RBC theorists themselves now acknowledge that their models need an upward­ -­ sloping aggregate supply curve to fit the economic data—and that this gives aggregate demand a potential role in determining aggregate output. And as we have seen, policy makers strongly believe that aggregate demand policy has an important role to play in fighting recessions.

Unnumbered Figure 35.1 The End of the Great Depression Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 35.2 Fiscal Policy with a Fixed Money Supply Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 35.3 The Velocity of Money Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers